Unit-IV

Introduction to Commodity Markets- History of commodity trading,

Major commodities traded in derivatives exchange in India, Participant in
commodity derivative markets, Commodity Market Indices, Commodity
Futures, Commodity Options, Uses of commodity derivatives- Hedging,
Speculation and Arbitrage.

Introduction to Commodity Markets

The commodity market is a physical or virtual marketplace where market participants
meet and buy or sell positions on commodity products like oil, gold, copper, silver,
wheat, and barley. Though started with Agri commodities initially, commodity markets
today trade in all commodities like base metals – gold, silver, copper, infrastructure like
oil, electricity, and even weather forecasts.
Types

The commodity market trading can be categorized under two

major categories based on the commodity type. These two
categories are:

#1 - Hard Commodities

Hard commodities consist of the commodities that are required by the

manufacturing industries. These should be mined and manually extracted
from the land or the ocean. They have limited reserves and are most
affected by geopolitical and economic conditions. Examples of such
commodities are Gold, Oil, silver, rubber, copper, etc. The major part of the
pricing is because of the process of extracting them.

#2 - Soft Commodities

Soft commodities constitute the commodities that are mainly Agri related or
livestock. Unlike hard commodities, they are not mined or extracted but are
produced through proper procedures. They have virtually unlimited reserves
and are not affected by geopolitical conditions but by the weather or natural
occurrences. Possible examples of such commodities are corn, wheat, barley,
sugar, pork, coffee, tea, etc.

How To Trade?

There are a few steps that the trader should follow in order to trade in this
market.

 It is necessary to gain knowledge about the market in advance, understand

its price dynamics, demand and supply, factors influencing prices and trading
instruments.

 The trader should be able to select the right broker of the firm which will
charge reasonable fees, provide proper trading tools, customer support and
has good track record.

 Next, the trader will have to open a trading account, complete the
documentation and make the required fund deposit.

 It is important to develop a proper trading plan as per the risk tolerance,

preferred commodities, trading goals and risk management techniques.

 Then the trader should check the market trends, past data, economic
condition, commodity market prices pattern and select the correct trading
instruments like futures contract, ETF, options, etc.

 Then they should place the buy or sell order. It is important to monitor the
order execution of the order and also use the risk management strategies to
limit losses and diversify the portfolio.

 Finally is is always important to monitor and make adjustment to the trades

as per the changes in the risk profile, market dyanmics, and learn from
experiences to improve in the process.

Example

If the price of a traded commodity fluctuates, the price of the corresponding

future contracts changes in sync. Consider the case of crude oil, whose
prices are decided ideally by demand and supply. Middle East countries, the
major oil-producing nations, tried to control crude oil prices by controlling the
supply. However, in a practical world, oil prices are affected by other factors,
too- the major geopolitical consideration.

For example, in the 2008 economic crisis, global growth was down, so oil
futures prices should have crashed big time. However, that was hardly the
case, and oil futures were at a lifetime high of $ 145 per barrel. This was
mainly because investors worldwide took out their money from equity and
bought commodities and futures contracts. This increased money flow led to
a surge in the oil and gold futures.

History Of Commodity Trading

India has a long-standing, enriching history in commodity markets. In fact, many
would argue that commodity trading started in India, long before it started in other
countries.

However, years of foreign rule, droughts, famines, and poor government policies
reduced the importance and popularity of commodity markets in India.

But with India becoming stronger in the global economy, the Indian commodity
markets have witnessed substantial growth. Commodity derivatives trading began in
India way before financial derivatives trading. Commodity derivatives trading began
around the same time as that of the U.K and U.S.A.

In India, commodity trading began with the set-up of the first organised commodity
trading centre, i.e the Bombay Cotton Trade Association in 1875 which laid the
foundation of futures trading in India.

Gradually, derivatives were developed for a broad basket of commodities. After the
establishment of the Bombay Cotton trade association, many cotton merchants and
mill owners were not happy with the functioning of the association.

This led to the establishment of the Bombay Cotton Exchange ltd in 1893 by a group
of unsatisfied cotton merchants and mill owners. This was later followed by the
establishment of futures markets in edible oilseeds complex, raw jute and jute
products and bullion.

The Gujarati Vyapari Mandli was created in 1900 to conduct futures trading in
groundnut, castor seed and cotton.

Calcutta Hessian Exchange was created in 1919 for futures trading in raw jute and
jute products. However, organised trading in jute started only with the set-up of East
India Jute Association Ltd in 1927. These two associations merged to establish East
Indian Jute and Hessian Ltd in 1945.

However, futures trading in Raw Jute was suspended in 1964 by the insistence of
the West Bengal government.
In 1920, futures trading began in gold and silver in Bombay, and later it spread to
Kanpur, Jaipur, etc.

The Bombay commodity exchange was established and registered on October 12,
1938 for trading in oil seed complex

Before the second world war broke in 1939, there were several future markets
trading oil seeds in Gujarat and Punjab. The most exemplary of them was the
Chamber of Commerce at Hapur, established in 1913.

In 1939, the government banned the trading of cotton derivatives. Further, Forward
trading was disallowed or prohibited in oilseed, and many other commodities
including foodgrains, spices, vegetable oils, sugar and cloth in 1943.

However, commodities trading again picked up steam, after India’s independence in

the early 1960s. But future trading was limited only to minor commodities such as
pepper and turmeric.

The commodity future market remained dismantled, and dormant for almost four
decades. With the turn of the new millennium, the Government started actively
encouraging commodities markets in India.

In 1992, futures trading in hessian was allowed. In April 1999, future trading in
various edible oilseed complexes was permitted. In May 2001, futures trading in
sugar was allowed. Since April 2003, future trading has been allowed in all
commodities by the Government of India.

Participant In Commodity Derivative Markets

The commodity derivatives market has many participants, including

producers, consumers, investors, and intermediaries.
Producers and consumers
 Farmers: Produce the commodity
 Processors: Process the commodity
 Suppliers: Supply the commodity, such as oil companies
 End-users: Use the commodity, such as ship owners and grain-houses
Investors
 Hedgers: Protect themselves from price fluctuations by taking a position on
the stock exchange
 Speculators: Take calculated risks based on future price predictions
 Arbitrageurs: Exploit price discrepancies
 Market makers: Ensure there are always buyers and sellers
 Financial investors: Include mutual funds, portfolio managers, and foreign
portfolio investors
Intermediaries
 Brokers: Facilitate transactions
 Banks: Facilitate transactions
Other participants Retail investors, Institutional investors, Foreign direct
investors, and Government agencies.
Commodity Market Indices

A commodity index is an investment tool that tracks prices and returns on a

basket of underlying commodities (consists of a single commodity or
combination of commodities). These indices would track various groups of
commodities such as energy, precious metals, agriculture, industrial metals,
and more. You must know that the value of each index would fluctuate on the
basis of the price movement of its underlying assets.

The major difference between commodity index and NIFTY or SENSEX is

the constituents. While the constituents of NIFTY or SENSEX are prices of
underlying stocks, MCX iCOMDEX consists of commodity futures.

Now let’s take a look at the salient features of MCX iCOMDEX before we
understand its various indices.
1. It consists of the following:

a. The composite index which is composed of futures contracts

across various segments

b. Two sectoral indices namely, Bullion Index and Base Metals

Index

2. The underlying constituents under this index are liquid futures contracts
traded on MCX
Types of commodity indices on MCX and NCDEX
The below table will give you a better understanding of all the commodity
indices on MCX and NCDEX.
Commodity
Index Exchange Constituents
MCX
iCOMDEX  Gold
Bullion
Index MCX  Silver

 Aluminum

 Copper

 Lead
MCX
iCOMDEX  Nickel
Base Metal
Index MCX  Zinc

MCX
iCOMDEX  Crude Oil
Energy
Index MCX  Natural Gas

 Guargram
NCDEX
Guarex NCDEX  Guarseed

Conclusion
This categorization of commodities into various indices helps investors
experience the commodity market without having to worry about the physical
delivery of the products. Each commodity index helps in understanding how
the underlying commodities are performing as a whole. To start trading in the
commodities, follow the below-mentioned trading session timings:

1. Monday to Friday – 09:00 am to 11:30 pm / 11:55 pm

2. On expiry day – 09:00 am to 05:00 pm

Commodity Futures

A commodity futures contract is the agreement to purchase or sell a

predetermined amount of a commodity at a particular price on a
specific date in the future. Commodity futures could be utilized to
hedge or protect an investment position or to bet on the directional
move of the underlying asset.

How Do Commodity Futures Work?

Most commodity futures contracts are closed out or netted at the

expiration date. The difference in price between the original trade
and the closing trade is cash-settled. Commodity futures are usually
used in taking a position in the underlying asset. The typical kind of
assets are:

 Silver

 Gold

 Crude Oil

 Wheat

 Natural Gas

 Corn

They are contracts that are called by the name of their expiration
month, which means a contract ending in the month of September is
a September futures contract. Some commodities could have a
significant amount of price volatility or price fluctuations.
As the outcome of this, there is the potential for large gains but
large losses too.

Objective of Commodity Futures

A motive to invest in the futures market is to protect a commodity's

price. Futures are used by businesses to lock in the prices of the
commodities they sell or utilize in their manufacturing.

Instead of speculating, the purpose of hedging is to prevent losses

from potentially unfavourable price movements. Many hedgers
employ or manufacture the underlying asset of a futures contract.
Farmers, oil producers, livestock breeders, and manufacturers are
just a few examples.

As commodities futures trade on an open market, they correctly

determine the price of raw resources. They also predict the future
worth of the commodity. Traders and their experts decide the
prices. They investigate their particular commodities all day and
every day. Each day's news and information are promptly included
in forecasts. If Iran threatens to completely close the Strait of
Hormuz - for example, commodity prices will fluctuate substantially
based on that news.

Commodity futures could sometimes reflect the trader's or market's

emotions rather than supply and demand. Speculators buy up prices
in anticipation of a shortage in the event of a crisis. When other
traders notice that a commodity's price amount is soaring, they start
a bidding battle. As a result of this, the price goes up even more.
The fundamentals of the supply and demand chain, however, have
not changed. The prices will fall back to earth after the crisis is
gone.

Benefits of Commodity Futures

Here are some advantages of trading commodity futures.

 Price discovery is the result of trading in these futures. Prices

are transparent, and liquidity guarantees that the proper prices
are offered.

 Since these contracts are regulated, it is easy to compare

pricing in different marketplaces around the world.

 These futures allow producers, traders, and end-users to hedge

against price swings, removing uncertainty.

 Investors profit from trading (in these futures) because it

allows them to diversify their holdings. Gold futures, for
example, can be used to hedge bets and safeguard portfolios
because gold prices move in the opposite direction of many
other assets.

How to Trade Commodity Futures?

Commodity funds are the safest way to invest in commodities

futures. Commodities exchange-traded funds and commodity
mutual funds are also options. These funds do invest in a wide range
of commodity futures that are available at any given time.

Commodity futures and options trading is both difficult and

dangerous. The price of commodities is quite volatile. Fraudulent
practices abound in the market. You can lose more than your
investment in the beginning if you aren't sure what you're doing.

Below mentioned is a step-by-step guide on how to trade commodity

futures online in a straightforward procedure.

Here are a few steps to take in getting started:

Step 1: Choose an online commodity brokerage firm that suits you.

Step 2: Complete the KYC that is asked for account opening.

Step 3: Find the account.

Step 4: Develop a trading plan that suits your personal risks and
returns goals.

Step 5: You can begin trading commodity futures.

Commodity Options

Commodity Options

An option is a type of derivative contract that allows the buyer the

right but not the obligation to purchase or sell an underlying. The
option holder pays the seller of this right a price (known as the
'option premium') in exchange for possessing this right. When a
buyer wants to exercise the option - then the seller (writer) of the
option is responsible for fulfilling the contract.
In the commodity market, there are essentially two sorts of
possibilities. There are possibilities in both American and European
styles. They are classified according to when the right to sell or buy
can be exercised. It is before the expiration date for American
options. For European options, it is solely on the contract's
expiration date.

What are Commodity Options?

Derivative contracts are commodity options. Commodity options, on

the other hand, are derived from commodity futures, unlike stock
options, which are derived from stocks. The contract, similar to
stock options, is to acquire the underlying at a specific time and at a
specific price.

In commodities options, there are buyers and sellers. The option

buyer has the right but not the responsibility to fulfil the contract. If
he believes the agreement is profitable, he can either exercise the
contract or let it expire. A commodity options contract is purchased
at a premium by the purchasers.

When the buyer chooses to exercise the contract, the seller must
honour it. When a contract is signed, the seller receives the
premium.

Types of Commodities

Metals: Gold, silver, platinum, and copper are examples of metals

commodities. Some investors would choose to invest in precious
metals - particularly gold, during moments of market turbulence or
bear markets because of its status as a reliable, dependable metal
with the actual, and transferable value. Investing in precious metals
could also be used as a hedge against periods of high inflation or
currency depreciation.

Energy: Crude oil, heating oil, natural gas, and gasoline are
examples of energy commodities. Oil prices have traditionally been
increased in response to global economic changes and decreasing
oil outputs from established oil wells around the world. As the
demand for energy-related products has increased at the same time
that oil supplies have dwindled.

Agriculture: Corn, soybeans, wheat, rice, cocoa, coffee, cotton, and

sugar are examples of recent agricultural commodities. Grain prices
could be extremely volatile in the agricultural industry throughout
the summer months or during any period of weather-related
transitions. Population increase, paired with restricted agricultural
supply, can give chances for agricultural investors to profit from
rising agricultural commodity prices.

What is Options Trading in the Commodity Market?

Contracts for commodity trade options provide you with the right to
buy (call option) or sell (put option) underlying commodity futures at
predetermined prices on the contract's expiration date. It's crucial to
realize that, unlike equities options, which give you the right to sell
or purchase stock at predetermined prices, commodity trading
works a little differently.

Since the spot or cash market in commodities in India is overseen by

state governments, and the SEBI primarily oversees the commodity
derivatives market, market regulators in India typically only
allow options trading in the commodity futures market and not the
commodity spot market.

How to Start Options Trading?

Here are the basic steps to begin options trading:

Step 1: Create a trading account and begin trading online.

Step 2: Make sure F&O trading is turned on in your trading account.

Step 3: Make a list of the stock options/index options you'd like to

trade in.

Step 4: Start with index options that are more liquid and easier to
predict.

Step 5: Then stick to approximately 10-20 highly liquid stocks.

Step 6: Choose OTM options that aren't too deep. Limit yourself to
ATM or OTM alternatives.

Uses of commodity derivatives- Hedging, Speculation and Arbitrage

The main purpose of evolution of commodity derivatives market was price discovery
amongst buyers and sellers as well as price risk management for users of
commodity as a raw material. As you know from earlier chapters, there are three
types of participants in the commodity derivatives market. They are traders,
hedgers and arbitrageurs.

Let us deep dive into different uses of commodity derivatives.

Hedging
It is a price risk management tool adopted by actual users such as
processors, miners, exporters, importers, manufacturers, etc.

Hedging means taking a position in the derivatives market that is the

opposite of position in the physical market with an objective of reducing or
limiting risks associated with price changes. Generally, there are two types
of hedgers, namely commodity users and commodity producers.

Speculation/Trading
Speculation is the practise of trading in order to profit quickly from price
changes. It covers the purchase and sale (short sale) of securities,
commodities, and other financial assets. Speculators never use the item for
physical purposes because their goal is to benefit quickly from price
fluctuations.

Each of the financial markets get two types of speculators or traders. They
are long speculators and short speculators.

Long speculators or traders are those market participants who buy securities
expecting the price to rise while short speculators or traders sell securities in
anticipation of a fall in the price of securities.

Arbitrage
You may have come across price differences for the same commodity in two
different shops or markets and may have thought: Why can’t I buy from the
market where it is quoted lower and sell in the market or shop where it is
quoted high? If you are thinking or doing so, it is called arbitrage.

Arbitrage is the process of buying and selling simultaneously in two different

markets to profit from price differences in those two markets. There are
mainly two types of arbitrages, namely Cash-and-carry and Reverse cash-
and-carry arbitrage.

Cash-and-carry arbitrage
Cash-and-carry arbitrage refers to the simultaneous purchase of a physical
commodity using borrowed funds and the sale of a Futures contract. When
the contract expires, the tangible commodity is delivered. This opportunity
comes when the commodity's Futures price exceeds the sum of the Spot
price and the cost of carrying it until the expiration date.