What are Commodity Futures: Objective, Benefits & How to Trade
After equity, the commodity market is a highly active segment where traders trade in various commodities through futures. Though in all the commodities, you can trade in futures while to invest in Gold and Silver, you can also choose the ETF or trade in futures as your trading strategy.
Understanding commodity futures is important if you are interested in trading in this market. Here we are going to discuss the commodity futures market in India, how it works, its objectives or benefits and how you can trade in the commodity market in India.
What are Commodity Futures?
Commodity futures are a contract between buyer and seller to buy or sell a particular commodity at a predetermined price on a future date. These commodity futures contracts are traded in commodity exchanges like MCX or NCDEX, which offer a fully regulated trading platform for commodity trading.
The futures are the legal contract between buyer and seller to transact in the commodities from various categories like precious metals, base metals, oil or energy and grains or pulses. The traders take positions in commodity futures to hedge their positions against the volatility in the price of commodities, with the speculation to earn profit from expected price movements.
How Does Commodity Futures Trading Work?
In commodity futures trading, when transactions take place between buyer and seller, both are obligated to buy and sell a particular commodity in a specific quantity at a predefined price on any future date. The commodity futures contracts are standardised, specifying the quantity, price and date of the commodity.
Commodity Futures Trading Process:
- Trade Position: The first step into commodity futures trading is entering into a trade position in which the buyer and seller buy or sell a contract with speculation of price movement in a particular direction.
- Margin Deposit: Here, while trading in a futures contract, especially when you short or sell a contract, you have to deposit a margin to complete your trade. Apart from depositing the initial margins, you need to maintain the minimum margin balance that will be reminded to you through margin calls.
- Settlements: As per the price movement, the settlement is done. The profit or loss is calculated on the basis of the price movement of the commodity futures.
- Liquidation: Finally, to liquidate your position in commodity futures, you have to sell your contract. You will get the profit in your trading account or incur a loss as per the price movement.
Objectives of the Commodity Futures Market
One of the main objectives of the commodity futures market is price discovery and giving hedging opportunities for traders. However, there are various other purposes of commodity futures as listed below.
- Price Discovery: The future price of commodities discovers the true price as per the demand and supply in the market. The futures contract price reflects the combined expectations of market participants that provide information on the current price of the commodity to producers, consumers and traders.
- Hedging: Various participants, like producers, consumers and investors, trade in the commodity futures to hedge against unexpected movement in the price of the commodity. Taking positions in commodity futures ensures a guaranteed price despite the fluctuation in the market.
- Speculation: The commodity futures provide an opportunity for traders to speculate on the movement in the price of various commodities and take the opportunity to earn profits from such speculations.
- Liquidity: The commodity futures market offers a well-organised trading platform to enter or exit and liquidate their trade positions while ensuring the smooth functioning of the market.
- Portfolio Diversification: Apart from this, commodity futures trading also provides traders with an opportunity to diversify their investment into different types of commodity futures and get balanced returns.
Types of Commodity Futures
There are different types of commodity futures you can find in the market to trade. In fact, they are categorised into various categories like energy, metals and agro products. Let’s find out what the different types of commodity futures are traded in the market.
- Metals: Gold, silver, platinum, and palladium come into precious metals, while Copper, aluminium, steel, nickel, zinc, lead and energy are base metals commodities.
- Energy Products: After precious metals, crude oil and natural gas are the high-volume traded commodities in the commodity futures market.
- Agricultural Commodities: Popular agri products like wheat, soybean, cotton, coffee, sugar, cocoa and corn. However, apart from demand and supply in the market, the price of these commodities is also affected by various factors like weather conditions, production levels, crop yield and seasonal demand.
- Other Agro Products: Apart from key agricultural products, other agro commodities traded in the market are species, oil seeds, menthol oil, sugar grains and fibres like cotton and guar gum.
Also Read: Exploring the Top 5 Commodities for Long-Term Investment Goals
Benefits of the Commodity Futures Market
Trading in commodity futures has several benefits, attracting traders to trade in this segment. Commodity futures trading is not only completely regulated but also completely transparent, providing the most advanced online trading platforms with high liquidity in the market. Let’s find out the key benefits of commodity trading.
- Price Discovery: Commodity futures trading helps in price discovery with information on real-time prices based on the demand and supply in the global market.
- High Liquidity: There are significant volumes of trades in most of the commodities future markets. Popular commodities like silver, gold and crude oil have high trading volume, providing a highly liquid market to enter and exit from their trade positions with minimum slippage in the prices.
- High Leverage: Traders can enjoy the high leverage of trading with a small initial deposit, allowing them to amplify their potential returns on such trades.
- Hedging: It offers an opportunity for the traders, commodity producers and end-users to lock their positions against price fluctuations due to unfavourable market conditions.
- Regulated & Transparency: The exchange and every transaction in the commodity futures market are highly regulated with a transparent mechanism to execute and complete every transaction.
- Long Trading Hours: Various commodities like crude oil, gold and silver globally trade round-the-clock due to global market movement, which provides extended trading hours benefit for the traders.
Disadvantages of Commodity Futures
Just like benefits, commodity futures trading also comes with various disadvantages due to various risk factors. Let’s explore these factors.
- Highly Volatile: Compared to equities, bonds and other financial instruments, commodity futures are highly volatile due to exposure to various factors like global demand and supply, natural disasters, and geopolitical tensions, increasing the risk of unexpected losses for the traders.
- Risk of Leveraging: Due to the benefit of high leveraging, traders enter into high-value trade positions, increasing their exposure to the risk of high losses if the market moves against their expectations.
- Complexity of Trading: The commodity futures trading market is highly complex in terms of understanding the key factors like expiration dates, backwardation, lot sizes, margin of trading required and the right trading strategies. It requires deep knowledge and experience to understand market dynamics.
- Exposed to Global Factors: The price of the commodities is highly vulnerable due to various global factors like geopolitical tensions, political instability, natural disasters and unexpected regulatory actions.
How to Trade Commodity Futures?
To trade in the commodity futures market, you need to follow the right procedure to make your trade journey not only hassle-free but also improve the chances of earning profits and avoiding losses. Let’s find out the steps involved while trading in the commodity futures market.
- Open Demat & Trading Account: First, find an MCX or NCDEX-registered broker providing the commodity trading facility and open demat account and online trading account with them.
- Complete the KYC Verification: Submit the required documents to verify your KYC and validate your trading and demat account for commodity trading.
- Choose the Trading Platform: Now choose the right trading platform providing the trading facility along with all tools, techniques and real-time data to trade in the market with all resources.
- Analyse the Market Conditions: Now analyse the market conditions, the demand and supply of a particular commodity in the market with historical price movement and other factors affecting the commodity price.
- Choose Trading Strategy: Before you enter into any trade position, you need to choose the right trading strategy as per the current market conditions and your risk-reward expectations.
- Deposit Margin Money: Here, you need to deposit a certain amount as an initial deposit to enter into a trade position. It is calculated as per the current market price of the commodity future contract and lot size.
- Place the Order: Now you can place the order and wait for the next movement. Always trade with a proper risk management strategy, such as using a stop-loss to minimise losses in uncertain market movements.
- Monitor Your Position: Never leave your open trades without monitoring, as you can miss the opportunity to book profits or exit from unexpected or sudden price movement.
- Book Profit or Close the Position: You need to close your position before the date of contract expiration, or you can also book the profit any time before the expiry. Otherwise, the position will be automatically closed.
Summing-up
Commodity futures are derivative instruments of the various commodities, allowing various stakeholders like producers, sellers, consumers and traders to discover true price as per the demand and supply in the market. It is traded on registered exchanges, which is a highly regulated environment with complete transparency.
You can also trade in commodity futures to hedge your positions against fluctuations in the price, with the opportunity to diversify your investment or trading strategies. You can choose from gold, silver, crude oil and other commodities to trade with the benefit of high margin and extended trading hours.
