Commodity Trading - Types, Exchnages, Advantages & Disadvantages

Trading involves robust engagement in the financial markets in comparison to investing, which works on a buy-and-hold strategy. Trade is a primary economic concept which involves the buying and selling of commodities and services between producers and consumers within an economy.

Today, we'll be learning about commodities trading, types of commodities available in the market along with the exchanges and its advantages and disadvantages.

Since ancient times, commodity trading has been happening in India and with the introduction of National Commodity & Derivatives Exchange Limited (NCDEX) & Multi Commodity Exchange (MCX), its popularity has increased significantly among traders.

Commodity Trading

• Types of Commodity Trading & Trading Exchanges
• Advantages of Commodity Trading
• Disadvantages of Commodity Trading

Types of Commodity Trading:

• Metals: Gold, Silver, Copper, Zinc, Lead, Nickel, and Brass. Some exchanges list gold and silver in the Bullion category.
• Agricultural Commodities: Crude oil, Palmolein, Castor oil, Mentha oil, Rubber, Crude Palm Oil, Rubber, Black Pepper, Cotton, Kapaas, Guar, etc, Maize (Kharif/ South), Maize (Rabi), Chana, Moong, Barley, Wheat, Paddy (Basmati), etc.
• Spices: Pepper, Jeera, Coriander, Turmeric, etc.
• Energy: Natural Gas, Crude Oil, Coal

Commodity Trading Exchanges in India:

• Multi Commodity Exchange (MCX)
• National Commodity and Derivative Exchange (NCDEX)
• Indian Commodity Exchange (ICEX)
• National Stock Exchange (NSE)
• Bombau Stock Exchange (BSE)

Advantages of Commodity Trading

• Protection against inflation: Demand and Price are directly proportional to each other. When the demand for goods and services rises, it leads to an increase in the price of the goods and services as the cost of the raw materials i.e. commodity increases. In such an environment, interest rates tends to rise which leads to an increment of the cost of borrowing and subsequently, reduces the income of the company. Facing such a decline in the income of the company also affects the profits of the shareholders. Therefore, during inflation the stock prices also fall. And hence, investors flee to commodity futures to protect their capital from the effects of inflation and maintain their value.
• Hedge against political tensions: When there is an occurrence of conflicts, riots, wars; it causes a disruption in the market which affects the supply chain of the raw materials resulting in scarcity of the resources. The scarcity of resources then leads to difficulties in the procurement and transportation of those raw materials in order to convert them into finished goods, causing the price of the commodities to rise exponentially. During such events there is pessimism in the market that leads the investors to invest in commodities in order to help themselves stem losses in their investment portfolio.
• Facility for high leverage: Derivatives like future and options in the area of commodity provide an exceptionally high degree of leverage. Any insignificant move in the prices of the commodities result in an exponential rise in the high gains. Hence,the possibility of humongous returns can be created by leveraging in commodity trading.
• Transparency: Compared to the past system, commodity trading now is conducted through an electronic trading platform which is accessible to all the market participants. This leads to fair price discovery enabling broad scale participation with no intervention or manipulation. In the electronic system, the price is determined by the supply and demand of the resources, with no risk of manipulation from the buyer or the seller. As the buyer and seller are anonymous, transparency is enabled in price discovery.

Disadvantages of Commodity Trading:

• Leverage: Leverage is considered to be a double-edged sword that helps you control big positions with little upfront capital. Therefore, low margin requirements encourage excessive risks, which can wipe out the entire investment capital.
• Volatility: As the prices of commodities depends upon the demand and supply of the same, they are highly volatile in nature giving rise to price inelasticity. Price inelasticity means that the increase and decrease of the price factor depends upon the demand and supply of the particular commodity.
• Not diversification friendly: The common consensus is that there is a negative or low correlation between the prices of commodities and the prices of stocks. As explained earlier, when the prices of stocks are tumbling, the prices of commodities should go skywards.However, this assumption or theory did not hold true during the 2008 Global Financial Crisis when along with the stocks, even the prices of commodities like oil and gas fell drastically. During the 2008 financial crisis, there was a fall in the overall demand, which led to unemployment.
• Lower returns with high volatility: The drawback of the cyclical nature of commodities is it entices long-term investors who are mesmerized by the size of short-term gains. However, such returns are always given back while at the same time eroding the value of the investment.

Conclusion

Commodity Trading is a lucrative investment avenue with its own pros and cons. The investor should not get mesmerized by the short-term gains and invest in commodities for the long-term. CapitalVia also provides investment advice in Commodity Trading.