Title of the topic: Commodity Derivatives Trading in India - Volume: 13/2021 - SHCIL Services Ltd
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Title of the topic:
Commodity Derivatives
Trading in India
Volume: 13/2021
SSL Research Centre, Educate Yourself, Volume: 13/2021, 26th February, 2021
1Commodity Derivatives Trading in India
Introduction
Commodity trading is the buying, selling and trading of commodities. Commodity trading in India is usually done through
derivative contracts such as commodity futures and options.
A commodity is generally considered to be any kind of tangible good that can be interchanged with other goods of
the same type. According to the Securities Contracts (Regulation) Act, 1956 (SCRA) "goods" mean every kind of movable
property other than actionable claims, money and securities. Commodities are mostly used as inputs in the production of
other goods or services. Grains, Gold, Crude Oil, Copper, Natural Gas are some examples of commodities.
A commodity derivative contract like futures and options derives its value from the underlying asset i.e., commodity. The
underlying commodities are raw materials or primary goods such as wheat, gold, crude oil, etc. rather than manufactured
or processed products, Commodity trading is usually done in lots, such as barrels of oil, bushels of corn, kgs of wheat, etc.
On maturity, you can either take the physical delivery of the product or settle in cash, as per the terms of the contract. You
can also profit from the price fluctuations in commodities without directly investing in futures or other derivative instruments
through exchange-traded funds or exchange-traded notes.
Illustrate
Take a gold futures (1 kilo) contract expiring on February 5. Based on the base value of 10 gms of Rs 37,900, the contract
value is Rs 37.9 lakh. Assuming a buyer pays a margin to trade of 5 per cent, the leverage offered is 20X (Rs 1,89,500).
Now, if the price rises the next day by Rs 200 per 10 gm, the gain to the trader at contract value is Rs 20,000. But if the
price falls by the same amount the loss is 10.5 per cent SINCE futures trading is a zero-sum gain, meaning one man’s loss
is the other man’s gain.
History of Commodity trading in India
Commodity derivatives trading is an oldest economic pursuit of mankind it started in India way before financial derivatives
trading. Commodity trading has evolved from the barter system to spot markets and now derivatives markets. In India,
commodity trading started 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. In 1893 the Bombay Cotton Exchange ltd was
established by a group of cotton merchants and mill owners. A few years later Gujrati Vyapari Mandali was set up for trading
in castor seed, groundnuts and cotton. In the year 1919 the Calcutta Hessian Exchange was setup which started trading in
raw jute and jute goods. Subsequently, many other commodity derivatives trading centres emerged across the country in
places such as Hapur, Amritsar, Bhatinda, Rajkot, Jaipur, Delhi, etc. This was later followed by the establishment of futures
markets in edible oilseeds complex, raw jute and jute products and bullion. To regulate the markets in 1952 parliament
passed Forward Contracts Regulation Act. Then later this act was repealed and regulation of commodity derivatives market
was shifted to the Securities and Exchange Board of India (SEBI) under Securities Contracts Regulation Act (SCRA) 1956
with effect from 28th September, 2015.
Types of Commodities Traded in the Commodity Derivatives Market
Trading in commodity is the smart way to diversify the portfolio. Commodities are a diverse asset class comprising various
sectors. Every sector has a number of characteristics that are important in determining the supply and demand for each
SSL Research Centre, Educate Yourself, Volume: 13/2021, 26th February, 2021
2commodity, including ease of storage, geopolitics, and weather. The commodities traded in the Indian commodity derivative
markets are usually classified into four segments.
These are as follows:
I. Agricultural Commodities: These are generally perishable agricultural products such as soybean, cotton, chana,
maize, sugar, guar seed etc. Processed agricultural commodities like soybean oil, palm oil, guar gum etc. are
also considered as agricultural commodities.
II. II. Bullion and Gems: This segment predominantly consists of precious metals like gold, silver and precious
gems like diamond.
III. III. Energy commodities: This segment includes commodities that serve as major energy sources. These
commodities are traded in both the unprocessed form in which they are extracted or in various refined forms or
by-products of refining / processing. Crude oil, natural gas etc. are examples of energy commodities.
IV. IV. Metal commodities: This segment includes various non-precious metals that are mined or processed from
the mined metals such as copper, brass, iron, steel, etc.
Major commodity exchanges in India are:
• Multi Commodity Exchange
• National Commodity and Derivatives Exchange
• Indian Commodity Exchange
• National Commodity Exchange of India
• National Stock Exchange
• Bombay Stock Exchange
Participants in commodity derivatives market can be categorised as hedgers, speculators and arbitrageurs, and are
represented by manufacturers, traders, farmers / Farmer Producer Organisations (FPO), processors, exporters, and
investors. An efficient market for commodity futures requires a large number of market participants with diverse risk
profiles.
• The National Commodity & Derivatives Exchange Limited (NCDEX) allows trading in commodities such as
barley, chana, mazie, moong, paddy (basmati), kapas, 29 mm, cotton, guar seed 1 mt, guar seed 10 mt, guar
gum, castor seed, cotton seed oilcake, soybean, refined soy oil, mustard seed, crude palm oil, sugar, pepper,
turmeric, jeera and coriander.
• The Multi Commodity Exchange of India Limited (MCX) allows trading in bullion products (Gold, Gold Mini, Gold
Guinea, Gold Petal, Silver, Silver Mini, Silver Micro), base metals (Aluminium, Aluminium Mini, Brass, Copper,
Lead, Lead Mini, Nickel, Zinc, Zinc Mini), energy (Crude Oil, Crude Oil Mini, Natural Gas) and agri items (Black
Pepper, Cardamom, Castor Seed, Cotton, Crude Palm Oil, Mentha Oil, RBD Palmolein, Rubber)
• The ICEX not just allows trading in agri products, plantation (rubber), fiber (jute), but also commodities like
diamonds and steel.
SSL Research Centre, Educate Yourself, Volume: 13/2021, 26th February, 2021
3Advantages & Disadvantages of Commodity Trading - A Snapshot:
SSL Research Centre, Educate Yourself, Volume: 13/2021, 26th February, 2021
4Various Players in the Commodity Derivatives Market:
The players in the commodity derivatives market can be classified into two major categories - risk givers and risk takers.
Risk givers or hedgers refer to those who have a risk due to physical exposure to the commodity, and are looking to
pass on their risk by taking a sell or buy position on Stock Exchange. Risk takers or investors refer to those who do not
have physical exposure to the commodity, but who are willing to take a buy or sell position or risk with the aim of making
gains from inequalities in the market. Financial investors and arbitrageurs are the investors in this market.
Players Represented by Objectives Implications
Hedgers Manufacturers, traders, To reduce risk due to price Hedging implies taking
farmers / Farmer Producer fluctuations in the spot position in the futures
Companies (FPCs) / market markets that is equal and
Farmer Producer opposite to the physical
Organizations (FPOs), market position, such that
processors, exporters, the overall net market risk
other value chain is reduced, or eliminated.
participants of a commodity
Financial Investors Traders including day To anticipate the future Willingly accept price risk in
traders, position traders, price movement and take order to profit from price
and market makers who suitable position in the changes
are generally not having an futures market with an
offsetting position in the intent to make a profit
physical market
Arbitrageurs Arbitrageurs To earn riskless profit by Aim to earn risk-free profit
buying and selling in
different markets at the
same time to profit from
price discrepancies
Factors influencing the Commodity Prices
1. Demand & Supply: Demand for the commodity and supply of the same are the two basic factors that drives
commodity prices. Higher the demand for the commodity dearer will be its price and higher the supply of
commodities cheaper will be the price.
2. Seasonality: some commodities follow a certain schedule of production cycle which can impact the prices of
the commodities. For example, agricultural commodities, in harvesting season, due to an increase in supply,
prices of commodities can come down whereas in sowing season supply remains lower which results in increase
in prices.
3. News: just like any other financial product, commodity prices are sensitive to the news and rumours. Hence any
important news / directly related news can affect the commodity prices significantly.
4. Economic conditions: the domestic and macroeconomic conditions can influence the commodity prices.
Various economic indicators like GDP growth rate, industrial production, inflation rate etc. plays very important
role in determining price trend of the commodity.
5. Weather conditions: weather is one of the important factors that can affect the prices of commodity specially
agriculture commodity at high levels.
SSL Research Centre, Educate Yourself, Volume: 13/2021, 26th February, 2021
56. Geo-political developments: commodities that have global demand like crude oil are subject to price
fluctuations. For example, tensions in the middle-east region may affect prices of crude oil potential disturbances
in supply chain.
Tips and Tricks for a Beginner in Commodities Trading
✓ Diversify
You must be humble enough to accept that despite numerous forecasts, extensive analysis, and technical
research, mistakes are bound to happen. However, a successful trader is not the one who never makes losses, but
someone who anticipates such losses and accordingly diversifies his portfolio in different commodities, such that
losses suffered in one set of commodities is offset by the gains attained in another set of commodities.
Also, the factors that determine the price of one commodity may be very different from those that determine the price
of another commodity.
E.g., an economy in decline may lessen the production activity, due to reduced demand for discretionary items such
as cars. This will invariably reduce the demand for crude oil, hence slashing their prices. However, the prices of
wheat may be unaffected as these are essential commodities required for subsistence. Therefore, it is vital not to
pin all your hopes on one set of commodities to help generate wealth in the commodities markets.
✓ Understand the cyclical nature of the commodities market
Usually, all commodities move in cyclical trends which are determined by the interplay of demand and supply and
economic and geopolitical factors. As a successful investor, you must spot the stage in the cycle; the commodities
market is currently at to benefit from the price swings in the market. Also, as a trader, you play a crucial role in driving
the cycle and bringing about the supply and demand equilibrium.
➢ There is an increase in demand
➢ Capital expenditure is increased to increase the production to meet the growing demand
➢ This pushes the prices up due to high capital expenditure, and also due to demand outweighing the supply.
➢ However, higher prices start dampening and eroding the demand
➢ The supply slowly exceeds the demand leading to a fall in commodity prices to increase the demand.
➢ Capital expenditure is reduced to accommodate the reduction in prices, which reduces the supply and
subsequently bringing about a supply and demand equilibrium
➢ And then the process starts all over again
✓ Select an appropriate exchange
You must select an exchange where there is ample liquidity, so commodity futures can be freely bought or sold,
without the constant worry of finding a buyer or a seller. Also, the clearinghouse of the exchange acts as a
counterparty to both the parties involved in the trade. This eliminates any credit risk. Also, the risk is reduced further
as all the leading exchanges require the positions in commodity futures to be marked to market on a daily basis.
Hence, any counterparty risk is eliminated on selecting an appropriate exchange. Also, you must select an exchange
based on their track record in commodities. E.g., MCX is renowned and strong for non-agri commodities, while
NCDEX is stronger in agri commodities.
SSL Research Centre, Educate Yourself, Volume: 13/2021, 26th February, 2021
6A learner in the commodities market must be well-acquainted about the facts and mechanics of the leading
commodity exchanges.
✓ Manage volatility
Volatility is a word you will continuously hear and associate with while trading in commodities. Volatility is the degree
of variation in the prices of the commodities i.e. the rate at which the prices increase or decrease. The volatility in
commodities is unmatched and uncompromising. It is like a tornado that can swipe away all your profits, but on the
other hand, if adequately cashed in can offer huge gains. So, in commodity trading, you must understand that
commodities have different volatilities. You must establish the price range of each commodity and trade accordingly.
You must determine the lot sizes based on the extent of the volatility and not based on margin requirements.
Volatility will determine the risk/return profile of commodities as highly volatile products generate high returns at the
same time; there is increased risk due to the unpredictability and higher degree of fluctuation in the prices of the
commodities.
A beginner trader should take more significant positions in commodities with low volatility like gold, oil, and lower
positions in commodities with high volatility like copper, and agricultural products. These are some of the tips in
commodity trading that a beginner trader should follow to garner profits. It is advisable to restrict trading to a few
commodities, and once you become a seasoned trader, you can expand your portfolio to include more commodities.
SSL Research Centre, Educate Yourself, Volume: 13/2021, 26th February, 2021
7SSL Research Centre
Head – Research
S. Devarajan s.devarajan@shcilservices.com 022-61778621
(Technical & Derivatives)
Gauri Hanmantgad Research Associate gauri.hanmantgad@shcilservices.com 022-61778600
Disclaimer
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that may arise to any person from any inadvertent error in the information contained in this recommendation or any action
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SSL Research Centre, Educate Yourself, Volume: 13/2021, 26th February, 2021
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