How Commodity Trading Works

How Commodity Trading Works

How Commodity Trading Works - Commodity Futures Trading Guide & Essentials of Commodities TradingWe come across a lot of news about how commodity prices of items such as crude oil, gold and silver impact the global economy. Commodities futures’ trading is an investment vehicle which exists in the market along with stocks and options. Let us understand the essentials of commodities trading.

Exchanges create products called “future contracts” based on different commodities such as cocoa, sugar, wheat, soya bean, precious metals, oil and many more which find use in industries. Such future contracts are known as commodity futures.

In simple words, a futures contract is an agreement between the buyer and the seller in which the buyer agrees to take delivery of the specified item at the specified price at the end of a particular period of time from the seller. Suppose a company which manufactures bread needs a steady supply of wheat flour for its operations and does not want the price of wheat to fluctuate in the course of the year.

This company will enter into a futures contract with a company which sells packaged wheat to buy its entire requirement for the year from them at a fixed price. They will take delivery of the amount they need every month, since the price has been fixed beforehand their cash flows will remain constant. This is a simple example of how commodity futures are used by businessmen.

How commodities markets work?

The fundamentals of demand and supply influence the pricing of commodities. So if you want to avoid the price risk associated with demand and supply mismatch, you are likely to transfer the risk to somebody else who is willing to take that risk. Manufacturers who consume commodities for their business will use this type of transactions to protect their margins, this is called hedging. On the other hand, there are speculators who participate in the market purely with the intent to make money, they have no interest in the actual commodity being traded. Based on their judgment of whether the price will rise or go down, they will take a long or a short position on the corresponding commodity future. Speculators provide liquidity to the market.

Futures Contract

The contract specification describes the commodity being used as the underlying in terms of the exact quantity and quality of the item. It mentions the price agreed upon by the buyer and the seller, the length of the holding period and the expiry date. A small amount of money, known as margin, has to be deposited by buyers and sellers of futures contracts.

The full price of the commodity has to be paid only on expiration. When you buy a commodity futures contract, you are ensured of a certain purchase price. Now on the settlement date if the price is higher than the price you had entered in the contract, then you stand to make a profit. Conversely when you sell a futures contract, you are ensured of a certain selling price and on the settlement date if the price is lower than the price you had entered in the contract, you have booked you profit.

As the contract’s expiry approaches, the difference in the price in the spot market will decrease. Liquidity i.e. the ease with which futures contracts can be traded in the market is very important. Liquidity is measured in terms of two parameters, volume and open interest. Volume is the total number of futures contracts traded on that day and open interest is the total number of outstanding contracts that have not been closed or offset.

As a trader, you should determine your own limits for profit and loss. You should fix the amount and quantity of commodities to be sold and bought. You need to keep a few points in mind when it comes to commodities trading, even if there is a small profit margin, sell and close your position. If you observe constant loss, then again close the position at the earliest to reduce losses.

You can cover the losses later in another deal. Always think of the bigger picture rather than focusing on profit or loss of each deal. Commodities trading is for those who can make right decisions at the right time, you should be able to digest a short term loss with the goal being long term profit, with the right attitude you can make bigger profits here than the stock market. But it comes with an equal amount of risk also and if you are not quick enough to take calls based on the change in prices, you may burn your fingers badly in commodities.

When you invest in the stock market you need to have the entire amount upfront, but when it comes to commodities you can trade with 10 to 15% margin money. This is how you get the advantage of leverage. You have to put in a small fraction of the total value of the underlying contract as margin payment. It’s very rare for traders to exchange the actual value of the contract on delivery. Another advantage is that the commodity futures investor will not be charged interest on the difference between the margin and the total contract value.

For a mature commodities market, liquidity is very important. If transaction can be close faster the risk due to adverse market trends can be lowered. The lag between the decision to trade and time of trade should ideally be minimal.

How To Trade In The Commodities Market

One way is to study the analysis of experts and come up with the approximate value of a commodity and sell it in the commodity market, it will be harvested after several months. Suppose you hold 50 tones of soya bean in the futures market and you fix a deal to sell the same in the futures market for Rs. X per ton. Now if the price starts to go down in the futures market, you can again buy back the quantity of soya bean that you had sold, this is known as squaring and you gain in two ways. You realize profit from the trade in the futures market and you can again sell in the spot market the moment the price is higher than the amount you bought for.

The converse can also be done, you can sell the commodity in the spot market when you have its stock, and with that cash you can take a position in the futures market when the price is rising. When the profit margin is reasonable, you can sell and book your profits.

Impact on the Economy

Commodity trading leads to price discovery as experts analyze and predict the prices in the future. Oil is one of the most widely followed commodities globally. Any change in the price of oil has a cascade effect on every other service and goods produced. As traders follow this information and use it to price their trades, the global oil prices are impacted and thus the overall economy is affected significantly.

Acording with the Digital Millennium Copyright Act (“DMCA”), Pub. L. 105-304 If you believe that your copyrighted work is being infringed, notify our team at the email [email protected]

@[email protected] business money

MORE ABOUT How Commodity Trading Works