FAQ Understanding Commodity Trading

Understanding Commodity Trading

This predominantly depends on the exchange you are trading in.

In India, commodity trading is predominantly done on two exchanges: Multi Commodity Exchange (MCX) and National Commodity & Derivatives Exchange (NCDEX). The following commodities are actively traded in these two Exchanges:

  • Bullion: Gold and Silver
  • Metals: Aluminum, Copper, Zinc etc.
  • Oil and Oil Seed: Refined Soy Oil, Soy Bean etc.
  • Energy: Brent crude oil, Crude oil, etc.
  • Other commodities: Urad, Chana, Wheat, Guar Seed, Sugar, Potato etc.
  • Bullion: Gold and Silver
  • Metals: Aluminum, Copper, Nickel, Sponge iron and Zinc.
  • Oil and Oil Seed: Castor oil, Crude Palm oil, Soy Oil, Soy Bean etc.
  • Energy: Brent crude oil, and Furnace oil.
  • Agro Commodities: Cotton, Chana, Maize, Guar seed, Sugar, Rubber, etc.

For a list of newly listed commodities, please visit www.mcxindia.com and www.ncdex.com.

In the derivatives market, you pay only a small portion of the actual value of the trade. You do not have to pay the entire sum upfront like in the spot market or while buying stocks. This is called Margin.

Simply put, the Margin is the amount you are required to deposit with your broker before you can execute a commodities trade on any exchange.

The amount of money that buyers and sellers of futures contracts are required to deposit upfront with their brokers is known as Initial Margin. This amount ensures that your account has enough money at all points in time. This is mainly for daily settlement of your contract, even if you make a loss on it.

Maintenance Margin is the amount you need to deposit over and above the Initial Margin. This is to ensure that the balance in your account never goes below a pre-specified level. Think about it as the threshold below which your Margin cannot fall. If it does, then you will be asked for Additional Margin.

Additional Margin is the amount your broker will ask you to bring in if the balance in your account falls below the maintenance margin. The objective of bringing in this amount is to protect your open positions from unexpected market volatility.

Every day, the value of your contracts and trades are adjusted to reflect the current market price. This is called Marking to Market (MTM).

So, on the day you enter a futures contract, Mark to Market or MTM is the difference between your entry value and the day’s closing price. In the case of a carried forward position, it is the difference between the day’s market price and the previous day's closing price.

MCX and NCDEX are open for trading during the following hour:

Agro-based commodities

Monday to Friday

10.00am - 5.00pm

Saturdays

10.00am - 2.00pm

Precious / Base metals and Energy

Monday to Friday

10.00am - 11.30pm

Saturdays

10.00am - 2.00pm

Both exchanges have done exceedingly well over the years, in terms of risk management, volumes and launch of new & better commodity trading products. But before choosing an exchange, you may still check the following:

  • Is the commodity you wish to trade in listed on the exchange?
  • Do the specifications of the contracts offered by the exchange best suit your interest?
  • Is there enough liquidity on the exchange for commodities of your interest?
  • Are the commodity prices quoted on the exchange in sync with physical market / benchmark prices?

A spot market is where you buy and sell commodities. The futures (or derivatives) market is where you AGREE to buy or sell commodities at a future date.

In the futures market, the contract or agreement to buy or sell is standardised. This is not so with the spot market.

A hedge is an investment that mitigates the risk of adverse price movements of an asset. The prices of commodities keep fluctuating. To hedge against such price risks, players buy or sell positions in the commodity futures markets. It is mainly the producers/sellers of commodities (e.g., farmers producing wheat) and the consumers/buyers of commodities (e.g., bread manufacturers who use wheat as raw material) who undertake commodity hedging.

For more details, refer to our page on Hedging.

It can so happen that momentarily, the commodity may be trading at different prices on the spot and futures markets. In this case, you can purchase at a lower price in one market and sell it at a higher price in the other market. This is called Arbitrage—taking advantage of the difference in prices in two different markets. This is why arbitrage transactions are usually risk-free.

Arbitrage helps ensure prices do not vary from each other in two markets. The higher price keeps falling while the lower price rises over time. Eventually, when prices become similar in both markets, arbitrage stops.

Warehouse receipts are title documents issued by warehouses to depositors against the deposited commodities. These documents are transferred by endorsement and delivery. Only the holder of these receipts can claim the commodities from the warehouse.

For more details, refer to our page on dematerialisation.

Every stock has a unique number or code by which the system identifies it. It is called ISIN. Similarly, commodities too have a unique identification number. This is called ICIN number. Every commodity has a different ICIN at different exchanges.

When you trade in the Commodity Futures market, you have a standardised contract. Meaning, every trade has some common traits.

The Lot size refers to this common quantity prescribed. You can only trade in multiples of this quantity or lot.

However, the quantity for delivery may differ from the minimum lot size. This is called Delivery size.

So for example, if one lot for a commodity was 100 grams and the delivery size was 200 grams, then you need to trade in at least two lots to be eligible for delivery.

It costs money to hold commodity products. This is called Cost of Carry. It includes expenditures like storage costs, insurance, interest payments, etc. This is usually taken into account in the commodity futures price like this:

Commodity Futures price = Future Spot price + Cost of Carry.

A commodity basis is the difference between the spot price of a commodity and the futures price of the same commodity at any given time. The spot price of a commodity is the prevailing cash price in the local market. The futures price represents the market opinion of the spot price on some future date.

For more details, refer to our page on Commodity Basis.

Contango is a market condition where the futures price of a commodity is higher than the expected spot price. In contango, the spot price of a commodity in the future is less than its current price. However, people are willing, at present, to pay more for the commodity at some point in the future than the actual expected price of the commodity at that point.

For more details, refer to our page on Commodity Basis.

This is the opposite of a Contango. This is when the futures price are lower than the spot price for a commodity. So, Backwardation states that as a futures contract approaches expiration, it will trade at a higher price compared to when the contract was further from expiration.

For more details, refer to our page on Commodity Basis.

Just before the contract is due for expiry, you have to make up your mind regarding the settlement and delivery of the commodity. This is called Tender period.

This is the difference between the Futures prices of a particular commodity over different tenures. For example, the Futures price of a commodity may be Rs 100 for the 1-month contract and Rs 110 for the 2-month contract. This difference is called the Spread.

This is when you practically try to push your delivery. You do so by closing your current Contract and entering a similar contract due for another month.

This is when enter into two contracts: One to to buy a certain commodity over one expiry period; the second to sell the same commodity over another period. 

Towards the end of the expiry period, the Futures price tends to meet the Spot price. One increases while the other decreases to meet at a common point. This is called Convergence.

To get out of a contract, you need not take the delivery of the commodity. You can simply pay the difference between the Buy and Sell contracts in cash. This is called Cash settlement.

You have to pay the following charges:

1) Brokerage Fees

2) Service Tax

3) Exchange Transaction Charges

4) Education Cess

Yes, there are circuit limits (upper and lower) or daily price ranges (DPR) to protect investors from extreme price movements. When a circuit limit is hit, trading is stopped for fifteen minutes. After this trading begins with fresh circuit limits. For updated commodity specific circuit limits, please visit www.ncdex.com and www.mcxindia.com.

Yes, there are maximum permissible holding limits for clients and members. These limits vary by commodity and exchange. Please see contract specifications on www.ncdex.com and www.mcxindia.com for position limits at client and member level.

Yes, there are circuit limits (upper and lower) or daily price ranges (DPR) to protect investors from extreme price movements. When a circuit limit is hit, trading is stopped for fifteen minutes. After this trading begins with fresh circuit limits. For updated commodity specific circuit limits, please visit www.ncdex.com and www.mcxindia.com.

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