Commodity trading is flourishing in the Indian stock market. Still, many Indians are unaware of what commodities are, how they are traded, and the pros and cons of commodities trading.
We will not only introduce commodities in this blog but also discuss their advantages and disadvantages.
So, what are Commodities?
Commodities are any raw materials, basic goods or manufactured finished goods that have their inherent value and can be exchanged for money or other goods and services.
When it comes to trading, commodities include fuels, agricultural products, and in recent times even financial products like foreign currencies and indexes on specific exchanges.
Traditional examples of commodities can be grains, oil, natural gas, gold and silver.
Examples of Commodities
- Agricultural Commodities-Wheat, Cotton, Mentha Oil, Rubber, etc
- Energy-Natural Gas, Crude Oil
- Metals-Gold, Silver, Platinum, Copper, Lead, Aluminum, Zinc, Nickel
How Commodities can be traded
- Futures
- Options
- Forwards
- Exchange Traded Funds
Futures
A commodity future is a contract or an agreement to buy or sell a prefixed amount of a commodity at a certain price on a certain date in the future. Futures are essentially meant for hedging the prices at a future date and to minimise the loss if any.
Mostly, commodity futures are used to protect an investment position or to speculate on where the underlying asset is moving.
Options
Commodity options are financial contracts where the owner has the right to buy or sell underlying goods at a price on a future date. Here, commodities function like stock options. The following commodities are available for options trading as of now:
- Gold
- Silver
- Copper
- Zinc
- Crude Oil
- Lead
Forwards
Unconditional forward transactions are called forwards. Forwards transactions are the opposite of spot transactions, where delivery is postponed until a future date. Similar to Futures, Forwards are also majorly known as hedging tools.
However, the difference between futures and forwards is that futures are traded on exchanges. Therefore, Forwards are more flexible than futures.
Exchange Traded Funds
Agricultural commodities, natural resources, and precious metals are physical commodities that are invested in commodity ETFs. Commodity ETFs typically invest in commodities futures contracts or hold a single commodity in physical storage.
Commodities traded are governed by different commodities exchanges. They function as the regulatory body and oversee the sale and purchase of commodities. The sale and purchase of commodities are typically done in the form of futures contracts on exchanges like NSE, BSE, MCX, NCDEX, etc while maintaining the minimum standards set by the exchanges.
When you buy a commodity, you buy it with the expectation of receiving a future price appreciation so that you can sell it later.
Also, to trade in commodities you will require a Demat Account and a Trading Account. You can open one for free with the best commodity trading platform in India, Goodwill Wealth Management.
Now that you know a bit about how commodities trading works, we can dive into the pros and cons.
Pros of Trading in Commodities
Trading is a domain where you, as a trader, will experience both losses and gains. You should keep this in mind while reading the pros because when it comes to trading. You cannot always expect profits, even if the pros may seem to outweigh the cons.
Diversification
If you are already a trader, this word will not be new to you. However, if you are new, you may not understand what diversification means. Let us break it down.
Diversification refers to dividing your capital across several financial instruments so that you can minimise risk while maximising returns. Trading in commodities online allows you to diversify your investments and reduce the risk of loss.
If an economy is performing well, investors will prefer investing in equities rather than investing in gold or silver.
To understand this better, let’s take an example of two countries at war. A situation like this will make investors feel apprehensive. So, rather than investing in stocks/bonds, they will invest in commodities such as gold and silver.
You must know that commodities have negligible or little connection to equity stocks. Commodities are typically raw materials needed to make finished goods. Let us look at an example to gain better clarity.
If one day, oil prices rise, the cost of owning a car or using the car will also rise. This will negatively affect car sales, causing the prices of auto stocks to fall eventually. Similarly, when metal prices rise, the cost of building houses will also rise. This will reduce the demand for real estate, which will negatively impact the prices of real estate stocks.
As mentioned earlier, there is little to no correlation between commodities and stocks. So, you can adjust the loss you experience in stocks with the help of commodities, which help you gain profit. Therefore, trading in commodities can provide diversification to your portfolio.
Inflation
People who trade in physical commodities dread the word “inflation”. However, if you are an online commodity trader, “inflation” might just be your best ally.
Inflation means an increase in the prices of commodities. So, if you hold a commodity whose price is rising, it will increase the value of your portfolio. It also ensures your purchasing power remains the same when the inflation rate is at an all-time high.
While stocks and bonds usually witness a fall in prices when inflation rises, the demand for goods and services increases, thereby increasing the price of goods and raw materials that make the commodities.
Because of the price drop of stocks in the market, investors usually fall back on commodities futures so that they can protect their capital from the ill effects of inflation while maintaining their value.
Therefore, for regular traders, inflation can be harmful because during such times there will be a drop in their income from stocks and bond investments. On the other hand, commodities will usually be a positive investment during inflation.
High Leverage
Futures, Options, and other Commodities offer exceptionally high amounts of leverage.
You have the advantage of controlling a large position by paying only 5 or 10% of the contract value as an upfront margin.
Any move in the prices of commodities is considered to be insignificant because it can result in exponential gains.
That’s why trading in commodities creates the potential to gain humongous returns with the help of leverage when it comes to online commodity trading.
Hedge Against Geopolitical Tensions
If you are a new investor, the word “hedge” may be new to you. Hedge refers to a method where one can protect themselves from financial loss or other adverse circumstances.
Commodities provide a hedge against geopolitical tensions. Events such as wars, riots, or conflict can disturb the supply chain, causing resources to become scarce. So, it becomes difficult to procure or transfer one’s goods.
During such times, commodities can help you shield against loss because there is disbelief in the market, resulting in prices falling drastically.
So, if the price of a commodity is expected to go up, the trader can buy commodity futures and hedge against the risks of high prices.
Liquidity
Online commodity investments are a better option than real estate or fixed deposits. That’s because they are 100% liquid and you can sell them anytime.
Just like stocks, commodities are easy to buy and sell. If you want better authority over your funds, you can choose to invest in commodity derivatives too.
Other advantages of trading in commodities include transparent trading, profitable returns, and lower margin compared to other asset classes.
Now, let us take a look at some of the cons below.
Cons of Trading in Commodities
Leverage
When compared to stock traders, online commodity traders usually get high leverage. However, high leverage may also make it difficult to control the urge for over-trading.
Considering the market goes opposite to your calculations, you will be losing money rather than gaining it. This way, leverage can be a double-edged sword.
For example, if the initial margin requirement is 5%, then you can buy commodity futures worth Rs. 2,00,000 with only 10,000. A minor change in the price of the contract will have a massive effect on your losses and gains.
If the price falls by Rs.10, you will end up losing Rs. 2,000 if the lot size is 200. Low margin requirements also instigate excessive risk which has the potential to wipe out your entire investment.
High Volatility
Commodities are twice as volatile as stocks. They are four times more volatile than bonds. Commodities such as crude oil, gold, etc, are more volatile than others. Such large price swings might make you lose focus and play havoc with your calculations.
The prices of commodities are highly volatile and highly dependent on demand and supply factors. The demand and supply of commodities are price inelastic.
Price inelastic refers to when price increases or decreases, the supply of the commodity remains unchanged.
For example, extracting natural gas from underground, extracting iron from deposits of iron ore and so on.
Commodities are the basic need of daily lives. So, price changes will not affect their demand as consumers are used to them. Therefore, looking for some alternative option is not a choice.
The collective inelastic demand and inelastic supply lead to a circumstance where even a small shift in the market can generate large price swings.
Adverse climatic conditions or natural disasters can have a huge impact on commodity prices, which makes commodities highly vulnerable to anomalies, causing financial instruments based on these commodities to become highly volatile.
Speculative
As mentioned earlier, the disadvantage of trading in commodities can be its speculative nature. If you are trading to solely gain profit based on the price of a commodity, then you are simply speculating and not investing.
Your asset will not produce any underlying cash flows, meaning your profit is entirely dependent upon the price of the commodity.
Other disadvantages include exposure to economic or geopolitical factors and weather.
The Advantage of Trading with Goodwill
Like any investment avenue you choose, it will come with both risks and rewards. You, as an investor, need to understand the commodity market first before deciding to start your investment journey. We hope this blog serves as a good introduction to investing in commodities.
If you are looking for a trading platform, then look no further than Goodwill Wealth Management! We are one of India’s best trading platforms. With us, you will get the best commodities to trade in India.
Stay updated on the list of commodities in India as we provide regular market updates and statistics on commodities and other markets as well.
Apart from this, we offer Free Demat Account Opening in 10 minutes. Now, you can also trade conveniently and easily with our exclusive trading app GIGA. Achieve your financial goals and gain by trading in commodities through Goodwill! Use the commodities market services provided by Goodwill thereby paving the way for your wealth creation!
