Before dwelling further into what commodity trading actually is, let us first get our concepts right. This would help immensely to understand how commodity trading is carried out.
What is a commodity?
It is a product that offers little differentiation coming from one producer or from another producer — a barrel of oil is basically the same product, regardless of the producer.
How did commodity trading originate?
Rice futures have been traded in China dating 6000 B.C. Ancient civilizations traded a wide array of commodities, including livestock, seashells, spices and gold. Although the quality of product, date of delivery and transportation methods were often unreliable, commodity trading was an essential business. The might of empires can be viewed as somewhat proportionate to their ability to create and manage complex trading systems and facilitate commodity trades. They served as the wheels of commerce, economic development and taxation for the kingdom’s treasuries.
What are the categories of commodities?
The four categories of trading commodities which include:
- Energy (including crude oil, heating oil, natural gas and gasoline)
- Metals (including gold, silver, platinum and copper)
- Livestock and Meat (including lean hogs, pork bellies, live cattle and feeder cattle)
- Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar)
In India, commodity trading is carried out in energy, metals and agricultural products only. Commodity trading is generally carried out in the futures market. Futures market is one where I agree to purchase a product after a definite period of time at a pre-determined price.
Futures, forward contracts are a prevalent practice with commodities. Farming cooperatives also utilize this mechanism. Farmers who are uncertain of the monsoon pattern for that year want to hedge their risk against the monsoon. They enter into a contract with a large MNC who agrees to purchase the commodity at a pre-determined price. By fixing the price, the farmer has hedged his bets against the monsoon fury/drought and secured his income from farming.
Large organizations also try to hedge their bets. The airline sector is an example of a large industry that must secure massive amounts of fuel at stable prices for planning purposes. Because of this need, the airline companies engage in hedging and purchase fuel at fixed rates (for a period of time) to avoid the market volatility of crude and gasoline, which would make their financial statements more volatile and riskier.
The Gold Standard
Trading in precious metals (like Gold) can be used as a hedge against high inflation or in periods of currency devaluation. Gold has been historically viewed as a reliable, dependable metal with conveyable value. Gold can be used to hedge your portfolio risk in event of economy downturn. Gold prices moves inversely with Dollar value.
Organized Commodity Trading
With commodity trading playing a pivotal role in global economic markets and affecting the lives of most of the people on the planet, futures contract on commodity trade on organized exchanges and are highly standardized. A single clearinghouse is the counterparty to all futures contracts and is always hold other side of the position. In the history of U.S. futures trading, the clearinghouse has never defaulted a trade.
There are four ways to terminate a Commodity contract:
- The person on the “short” side can terminate the contract by delivering the goods and the person on the “long” side can terminate by accepting the delivery and paying the contract price. However, deliveries represent 1% of contract termination.
- Most of the commodity futures contract involve cash-settlement. You offer the counterparty the difference in the expected value of your bets. To cite an example, let us say you assume the oil price to be ₹150 per gallon. And another person assumed it to be ₹155. If the price hovers around ₹153, then you have to pay the counterparty ₹1.
- You can make a reverse trade. If you make the exact opposite trade to your current position, the clearinghouse would net your position.
- Deliver the good to the other side of the position (not the clearinghouse) off the floor of the exchange (called ex-pit transaction). You must contact the clearinghouse later to tell them your position.
Commodities can quickly become a risky investment proposition because of they can be affected by the eventualities that are difficult, if not impossible, to predict. These include unusual weather patterns, natural disasters, epidemics and man-made disasters. For example, grains have a very active trading market and can be volatile during summer months or periods of weather transitions. Therefore, it may be a good idea to not allocate more than 10% of a portfolio to commodities unless genuine insights indicate specific trends or events.)
The Bottom Line
Investing in commodities can quickly degenerate into gambling or speculation when a trader makes uninformed decisions. However, by using commodity futures or hedging, investors and business planners can secure insurance against volatile prices. Population growth, combined with limited agricultural supply, can provide opportunities to ride agricultural price increases. Demands for industrial metals can also lead to opportunities to make money by betting on future price increases. When markets are unusually volatile or bearish, commodities can also increase in price and become a (temporary) place to park cash.
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