Commodity Trading: Details of Types and Strategies

In this article, we will discuss

• Commodity Trading: Types and Strategies
• What is Commodity Trading?
• What Are the Types of Commodities?
• What Are the Most Traded Commodities in the Market?
• What Are the Different Commodity Trading Strategies?
• Trading Strategies with the Help of Common Indices
• Conclusion
• FAQs

Commodity Trading: Types and Strategies 

If you are a new entrant into the vast world of investments, remember that there are diverse opportunities that go beyond equities. Commodity trading is becoming an increasingly popular and lucrative investment option in India for the many benefits associated with it. To begin with, investment in commodities acts as a hedge against inflation, which is an important reason behind its rising popularity. But, not all investors have a clear idea about the types and strategies of commodity trading. So, in this blog, we’ll explore some of the crucial details about commodity trading.

What is Commodity Trading? 

First, let us quickly touch upon what commodities are. These are raw materials or standardised resources which carry intrinsic value. Commodities are important resources required to produce/manufacture refined goods. Commodity trading, on the other hand, can be defined as the buying/selling/trading of commodities. In India, it takes place through derivatives contracts, for example, commodity futures and options. These derivative contracts derive their value from their underlying commodities. The general norm is to carry out commodity trading in lots, for example, kilograms of wheat, barrels of oil and bushels of corn.

What Are the Types of Commodities? 

Before we delve into the types and examples of each commodity, it’s important to note something. Commodities can be broadly categorised into hard and soft commodities.

• Hard commodities 

Commodities that are mined or extracted from nature are referred to as hard commodities. Examples of such commodities include gold, silver, copper, etc.

• Soft commodities 

Commodities that are grown, raised or nurtured are known as soft commodities. If we look at history, we’ll find that soft commodities were some of the oldest traded products across the world. Examples include agricultural products like pulses, cotton, rice and sugar.

What Are the Most Traded Commodities in the Market? 

When we look at the global commodity market, we'll find that gold, silver, crude oil, and natural gas are some of the most traded commodities in India. Some of the widely traded commodities are listed below:

• Agriculture 

The most common commodities under the category of ‘agriculture’ are as follows:

• Grains: Rice, wheat, maize, jeera, Basmati rice

• Pulses: Chana, yellow peas, tur dal, urad

• Oils and oilseeds: Soy seeds, castor seeds, soy meal, refined soy oil, crude pal, soy meal

• Spices: Red chilli, pepper, jeera, turmeric and cardamom

• Metals and materials 

Given below is a list of the popular commodities traded under this category:

• Bulk commodities: Iron ore, bauxite, coking coal and steel

• Base metals: Aluminium, nickel, copper, tin, zinc

• Others: Chemicals, soda ash, rare earth metals

• Precious metals and materials
  • Gold, silver, palladium and platinum

• Energy
  • Natural gas, crude oil, thermal coal, Brent crude, alternative energy

• Services
  • Mining services, oil services and others

What Are the Different Commodity Trading Strategies?  

Often, traders end up using the following strategies while trading in commodities:

• Spread trading strategy 

If you’re a commodity trader, you can use this strategy to reap returns from market movements, which are generally uncertain. The spread trading strategy entails adopting a long and short position simultaneously for a commodity or between two different but related commodities. Details of two common spread trading strategies are as follows:

• Intra-commodity spread 

If you wish to follow the intra-commodity spread strategy, you have to adopt a long and short position in two futures contracts of a particular commodity. However, these futures contracts must have different maturity dates. For example, a commodity trader can purchase March futures for rice and sell off the August futures to benefit from the price movements. The intra-commodity spread strategy can be further classified into bull spreads and bear spreads. When you buy a far-month’s contract and sell off the current month’s contract, it’s known as a bull spread. A bear spread is its reverse. The ideal time for implementing the bull-spread strategy is when the contract of the current month is overvalued and that of the far-away month is undervalued. On the other hand, you can use a bear spread strategy if the current month’s contract is undervalued and that of the far-away month is overvalued.

• Inter-commodity spread

You can use the inter-commodity spread by undertaking long and short positions in commodity futures for different but closely related commodities. A noteworthy point here is that these commodities may have different or same trading contracts. Let’s again use an example. Suppose there’s a trader named Kumar who is optimistic about gold. But he is bearish about silver. Kumar can use the inter-commodity spread strategy by buying gold futures and selling off silver futures.

• Options trading strategies 

If you’re a commodity trader, you can implement the following options trading strategies:

• Put buy and put sell 

Put options provide holders the right, but not an obligation, to sell off the options on expiry dates. As a commodity trader, you can buy/sell put options at various strike prices if you expect a decrease in the price of an underlying commodity.

• Call buy and call sell 

Suppose there’s a situation where a commodity trader feels that the price of underlying commodities will rise. In such cases, traders can buy/sell call options at various strike prices. A commodity trader has to pay a premium when he buys a call option. On the other hand, they have to pay off a margin amount when they decide to sell off a call option.

• Covered short put 

In a covered short-put strategy, a commodity trader will sell off a put option and receive the premium. At the same time, the trader will hold a long position with respect to the underlying commodity. People should note that a covered short put position acts as a good hedging strategy. Apart from minimising risks, it also improves returns.

• Covered short call 

In simple words, a combination of a short call option and a long underlying position is known as a covered short call option. Apart from improving returns, it protects a long underlying position in a financial market which stagnates.

• Strangles and straddles 

One of the most common options strategies would be to buy calls and puts at the same time to profit from changes in market volatility. Generally, commodity traders adopt long positions when they anticipate market volatility. However, when traders feel that volatility would be normal, they take a short position. A long straddle strategy is followed by traders when they pay a premium to buy a call and put option with the same strike price and expiry date. When it comes to a long strangle strategy, the trader buys a call and put option where the strike prices vary, but the expiry date remains the same.

Trading Strategies with the Help of Common Indices 

If you’re a person who has just ventured into the world of investments, you can get exposed to commodities gradually with the help of common indices. Generally, these are cash-settled contracts, which are smaller to futures contracts in lot size.

Conclusion

You can consider commodity trading if you’re on the lookout for an investment option which would also act as a hedge against inflation. You can categorise commodities into hard and soft. Some of the most-traded commodities include agricultural commodities like rice, grains, pulses and oils. There are various strategies for commodity trading. What you need to do is check your trading objectives and choose a strategy accordingly.

FAQs 

• Who are the participants in commodity trading in India? 

Speculators and hedgers are the main participants in commodity trading in India. Generally, speculators try to exit their long or short positions either on the same trading day or within a few days. However, hedgers take a contrary investment position to balance out their gains and losses from an underlying asset.

• What are some of the important commodities?

Gold, cotton, natural gas, sugar, uranium, wheat, coffee, corn and crude oil are some of the important and most traded commodities in India.

• What is the role of stock exchange in commodity trading? 

The main role of a stock exchange is to facilitate trading in commodity derivatives. These exchanges work under the regulations of SEBI (Securities Exchange Board of India). Standardised derivatives contracts are always available on stock exchanges. However, the trading platform consults all the stakeholders involved before adding the specifications.

• What is the meaning of Mark-to-Market? 

The closing price at the end of a trading day determines the Mark-to-Market. Paying it is the responsibility of the buyer in case the price falls. But, the seller has to pay it in case the price rises.

• What is the Final Settlement Price (FSP)? 

FSP is the final settlement price of every open position upon expiry. The Clearing Corporation determines it after a contract expires. If there’s an open position on the expiry day of a contract, it would lead to compulsory delivery.