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Commodity online: Online commodity trading

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Commodities are basic goods that are used in daily life. They may include food grain, oil, cotton, and metals, among many other physical substances. For an investor, commodities also represent an alternative avenue for investment. They provide investors with a way to look beyond traditional financial securities like stocks and bonds.

Commodity trading gives investors the opportunity to buy and sell many types of commodities. But such trading can only be carried out on exchanges that specialise in commodities. These commodity exchanges are regulated by the Securities and Exchange Board of India (SEBI). On these exchanges, you will find commodities under three main categories:

  • Metals (e.g. gold, silver, copper, nickel, aluminium)
  • Energy (e.g. crude oil, natural gas)
  • Agricultural (e.g. rice, cotton, sugar, turmeric, livestock)

What is online commodity trading?

To put it simply, online commodity trading is the trading of commodities on exchanges. It can encompass both the cash market and the futures market. However, this article will focus mainly on the futures market. That is because the futures trades in commodities exceeds the quantum and value of commodity trades in the cash market. If all this is new to you, it is important to understand how online commodity trading works.

Whenever you buy or sell a particular instrument, you can exit the trade by taking an opposite trade in the same commodity.

  • Say, you go long. That is, you agree to purchase a commodity in a certain lot size.
  • You can exit this trade by going short. In other words, you would be selling the commodity with the same lot size.

Example: If you agree to purchase 10 barrels of crude oil, you can exit the trade by selling 10 barrels of crude oil. The difference between the purchase price and the sale price is your profit.

There are broadly two financial instruments available for commodity trading online: futures and options.

1. Futures are instruments that give you the right to purchase or sell the underlying commodity at a fixed price in the future. If you hold on to the future till maturity, you will need to fulfil the obligation. That is, you will need to either buy the commodity from the counterparty or sell it to the counterparty.

2. Options work in a similar way, but there is a slight difference vis-à-vis futures. An options contract gives you the right but not the obligation to purchase or sell the commodity. So, if the price movement is not profitable for you, you could let the option lapse.

How to start online commodity trading

The first step to starting online commodity trading is to open a commodity trading account. This account is separate from a regular trading account that you use to purchase stocks and mutual fund units. Commodity brokers who offer commodity trading accounts are registered with the commodity exchanges in India. Three of the main commodity exchanges in India are:

  • Multi Commodity Exchange (MCX)
  • National Commodity Derivatives Exchange (NCDEX)
  • Indian Commodity Exchange (ICE)

MCX and NCDEX handle the bulk of the commodity trades in the country.

It is very important to select the right commodity broker. Checking for customer reviews is a good place to start. Inquiring about the services that a broker provides and the cost for these services can help you to compare different brokers. Need further guidance? Click here for a detailed article on how to open a commodity trading account.

Understanding margin account

To gain familiarity with online commodity trading, you must understand how the margin account works. Normally, when you purchase stocks or invest in mutual funds, you pay the full amount due upfront. Things work a little differently when you trade in commodities through your margin account.

In case of margin trading, you don’t have to pay the full amount right away. Instead, you could deposit a small amount with the broker. This sum is called margin money. The total value of your trade will be a multiple of your margin money. Say, you wish to purchase gold futures at Rs 46,000. If you have a margin account, you won’t need to put up the entire amount. Your broker will ask you to deposit a much smaller sum—say Rs 5,000. In effect, you would be borrowing the remaining Rs 41,000 from your commodity broker. This additional amount is called leverage or margin.

Each broker has their own margin-related requirements. Before you start commodity trading, get the details clarified from the broker. Once you open a commodity trading account, you will have to pay an initial margin to the broker. You can then use this to make trades.

Another important concept is mark to market. Here, the market price is compared to the price at which the derivative was traded. Any gain or loss is credited or debited to the margin account. This is like a daily profit and loss adjustment. Once you have adequate returns on your investment, you can exit the trade. In case of losses, however, the amount will get debited from your margin account, and this could impact your other trades. You might even have to deposit more funds with the broker to make good on the shortfall in the margin account.

Important in this respect is the concept of maintenance margin. This is the minimum amount of margin money that you need to maintain. If your margin balance drops below this, you will have to transfer funds to your broker to replenish the amount. Here are 5 things to know about margin calls.

Commodity trading tips

1. Use simulations to understand how the market works

Some websites allow users to simulate commodity trades. This can help you gather some initial practice in the commodity market. Practice is critical because commodity trades are leveraged margin trades. A single trade going wrong could lead to huge losses. That is also why you should carry out thorough research before taking any trading positions. If you need help, here’s an article to help you identify market trends.

2. Awareness of the news can help with trading

Metals and agricultural commodities, for example, are traded all over the world. So, events in some other part of the world can have an impact on the prices in India. Suppose the Northern hemisphere experiences a cold winter. The demand there for heating and furnace oil will rise, leading to an increase in demand. Consequently, crude oil prices will increase in the markets and may impact your trades. Consider also how precious metals like gold and silver register price increases following a disaster of some kind. This may happen because investors flock to invest in these assets. There may be indirect impacts as well. For example, a flood somewhere in the world could affect the supply of certain agricultural commodities. If India produces the same commodities, there may be an opportunity for price rises in the domestic sector.

3. Choose a few commodities for your portfolio

Keeping up with the movements of a wide range of commodities and the news surrounding them is impossible. This is why it is better to pick three to four commodities that you can focus on thoroughly. Keep in mind that the commodity markets are open 24 hours a day. So, following too many commodities could stretch you out completely. You could also hire an investment adviser who is an expert on the commodity markets to give you trading calls. Just remember that trading calls are subject to risk.

4. Find the right broker

To engage in commodity trading online, you will need to open a separate commodity trading account with a broker that is registered with a commodity exchange. The broker must provide you with the right back-end support for your trades while keeping their brokerage fees affordable. While opening the account, you will need to sign a Broker and Client Agreement. You do not need to open a separate demat account though. Simply use your existing demat account and link it to your commodity trading account. Any trades you make in the commodity market will get debited or credited to your demat account.

5. Choose your instrument wisely

As a commodity trader, you get to choose between futures and options. Futures contracts give you the right to buy or sell a commodity at a fixed price in the future on a specified day. If you do not square off your trade before that date, you will have to purchase or sell the commodity at the price mentioned in the contract. Options, on the other hand, offer a little more flexibility. They give you the right but not the obligation to buy or sell the commodity at the predetermined price. For instance, should you go long in a crude oil option, you could choose not to purchase the crude oil. Your loss in the trade would then be restricted to the option premium you paid when investing in the option. Click here to learn the differences between futures and options.

6. Fix an entry price and exit price

Intraday traders generally set entry and exit prices on each trade. This helps them to book profits and reduce losses. The same strategy is helpful for commodity traders as well. Knowing exactly when to enter a trade will give you more control over choosing the right time to exit. Your exit strategy should consist of a profit trigger and a stop loss target. You can then create a standing order that will execute your trade if the exit price or stop loss is met. The simplest tip to trade in commodities online is to buy low and sell high. But you could also enter a sell trade first and then square off the trade by buying the commodity at a lower price. Learn more about stop loss orders.

Conclusion

Online commodity trading can be an effective way to diversify your financial portfolio. Just keep in mind that commodity trades carry a degree of risk. This is primarily because their prices are impacted by various national and international factors, including weather patterns and natural or man-made disasters. However, seasoned investors recognise the importance of detailed research and analysis. Also it helps to open an account with a broker like Kotak Securities that has its own research division. You could then refer to their in-depth research reports and recommendations before making any trading decisions.