Introduction to Commodity Markets: Trading Physical Assets

Introduction: Trading the World’s Building Blocks

“Commodities are the raw materials that build our world—and trading them is as old as civilization itself.”

From gold and crude oil to wheat and cotton, commodities form the foundation of the global economy. Commodity markets allow producers, consumers, and investors to trade these essential goods, manage price risks, and speculate on price movements. Let’s understand how these markets work.

What Are Commodities?

Definition

Commodities are basic goods used in commerce that are interchangeable with other commodities of the same type. They are standardized products where one unit is essentially the same as another.

Key Characteristics

Types of Commodities

1. Hard Commodities (Extracted)

2. Soft Commodities (Grown)

Commodity Markets Structure

Spot Markets

Definition: Where commodities are bought/sold for immediate delivery.

Characteristics:

• Physical delivery
• Current market price (spot price)
• Immediate settlement
• Used by actual users/producers

Examples:

• Agricultural mandis (APMCs)
• Metal spot markets
• Oil spot transactions

Futures Markets

Definition: Where standardized contracts for future delivery are traded.

Characteristics:

• Standardized contracts
• Future delivery date
• Margin-based trading
• Mostly cash settled (in India)

Uses:

• Price discovery
• Hedging
• Speculation
• Investment

Spot vs Futures

Commodity Exchanges in India

MCX (Multi Commodity Exchange)

Established: 2003 Regulator: SEBI (since 2015) Focus: Bullion, metals, energy

Key Contracts:

NCDEX (National Commodity & Derivatives Exchange)

Established: 2003 Regulator: SEBI Focus: Agricultural commodities

Key Contracts:

Other Platforms

Market Participants

Hedgers

Who: Producers, consumers, processors Purpose: Lock in prices, reduce risk

Examples:

• Farmer hedging wheat price
• Jeweler hedging gold cost
• Refinery hedging crude price

Speculators

Who: Traders, investors, funds Purpose: Profit from price movements

Role:

• Provide liquidity
• Absorb hedger risk
• Enable price discovery

Arbitrageurs

Who: Sophisticated traders Purpose: Profit from price discrepancies

Activities:

• Spot-futures arbitrage
• Exchange arbitrage
• Calendar spread arbitrage

Institutional Participants

How Commodity Trading Works

Contract Specifications

Example: MCX Gold

Trading Example

Scenario: Buying Gold Futures

• Contract: MCX Gold Feb
• Current Price: ₹62,000/10g
• Lot Size: 1 kg (100 units of 10g)
• Contract Value: ₹62,00,000
• Margin Required: ~₹3,10,000 (5%)

If price rises to ₹63,000:

• Profit: (63,000 - 62,000) × 100 = ₹1,00,000
• Return on Margin: 32%

Settlement

Cash Settlement (Most Common):

• Price difference settled in cash
• No physical delivery
• MTM (Mark-to-Market) daily

Physical Delivery (Optional):

• Take/give actual commodity
• Quality/quantity as per contract
• Delivery through exchange-approved warehouses

Commodity Pricing

Factors Affecting Prices

Supply Factors:

• Production levels
• Weather (agricultural)
• Inventory levels
• Production costs
• Geopolitical factors

Demand Factors:

• Economic growth
• Industrial activity
• Seasonal demand
• Consumer preferences
• Government policies

Price Relationships

1. Basis: $$Basis = Spot\ Price - Futures\ Price$$

2. Contango (Normal): Futures > Spot (carry costs)

3. Backwardation: Spot > Futures (supply shortage)

Indian vs International Prices

For Globally Traded Commodities: $$Indian\ Price = International\ Price \times Exchange\ Rate + Import\ Costs$$

Example: Crude Oil

• Brent Crude: $80/barrel
• USD/INR: 83
• Import Duty + Costs: 5%
• Indian Price: 80 × 83 × 1.05 = ₹6,972/barrel

Major Commodities

Gold

Indian Context:

• World’s 2nd largest consumer
• Cultural significance (weddings, festivals)
• Investment demand strong
• Import dependent

Key Drivers:

• US Dollar movement
• Interest rates
• Inflation expectations
• Safe haven demand

Crude Oil

Indian Context:

• 85% import dependent
• Major forex outflow
• Impacts inflation (transport, manufacturing)

Key Drivers:

• OPEC production
• Global demand
• Geopolitical tensions
• US inventory data

Agricultural Commodities

Unique Factors:

• Monsoon dependence (India)
• Government MSP policies
• Storage infrastructure
• Export-import policies

Key Crops (India):

• Soybean, Mustard
• Chana (Chickpea)
• Cotton, Sugar
• Spices (Cardamom, Pepper)

Hedging with Commodities

Producer Hedging

Example: Wheat Farmer

• Expected harvest: 100 MT in March
• Current futures price: ₹2,200/quintal
• Concern: Price might fall by harvest

Hedge:

• Sell 100 MT futures at ₹2,200
• At harvest, if spot is ₹2,000:
  • Physical sale: ₹2,000
  • Futures profit: ₹200
  • Net realization: ₹2,200

Consumer Hedging

Example: Jewelry Manufacturer

• Need: 10 kg gold in 3 months
• Current price: ₹60,000/10g
• Concern: Price might rise

Hedge:

• Buy 10 kg gold futures at ₹60,500
• After 3 months, if spot is ₹65,000:
  • Physical purchase: ₹65,000
  • Futures profit: ₹4,500
  • Net cost: ₹60,500

Investing in Commodities

Direct Trading

Requirements:

• Commodity trading account
• Adequate margin capital
• Market knowledge

Pros: Direct exposure, leverage Cons: Requires expertise, time, capital

ETFs and Funds

Gold ETFs:

• Track gold prices
• Backed by physical gold
• Easy to buy/sell on exchange

Commodity Funds:

• Invest in commodity futures
• Professional management
• Diversified exposure

Sovereign Gold Bonds (SGBs)

Features:

• Government issued
• 2.5% annual interest
• No storage concerns
• Tax-free LTCG if held to maturity

Risks in Commodity Trading

Price Risk

• High volatility
• Gap openings (overnight news)
• Limit moves

Leverage Risk

• Small margin controls large position
• Losses can exceed margin
• Margin calls

Liquidity Risk

• Some contracts thinly traded
• Wide bid-ask spreads
• Difficulty exiting large positions

Delivery Risk

• Physical delivery complexity
• Quality disputes
• Storage and logistics

Regulatory Risk

• Policy changes
• Trading restrictions
• Tax changes

Regulatory Framework

SEBI Oversight

Since 2015:

• Merged FMC into SEBI
• Unified regulation
• Investor protection measures

Key Rules:

• Position limits
• Margin requirements
• Delivery norms
• Price bands

Recent Developments

• Commodity options introduced
• Institutional participation increased
• Integration with equity brokers
• Options on goods allowed

Key Takeaways

1. Commodities = Real assets – Raw materials, metals, energy
2. Two markets: Spot (immediate) and Futures (future delivery)
3. MCX for metals/energy – NCDEX for agriculture
4. Hedging tool – Producers and consumers manage price risk
5. High leverage – Small margin, big exposure
6. Global linkages – International prices + forex matter
7. Alternative investment – Portfolio diversification

Disclaimer

This article is for educational purposes only. Commodity trading involves substantial risk of loss. Past performance doesn’t guarantee future results. Only trade with capital you can afford to lose. This is not trading advice.

Frequently Asked Questions

Q: Do I need to take physical delivery? A: Most traders close positions before expiry (cash settled). Physical delivery is optional and complex. Less than 5% of contracts result in delivery.

Q: Can retail investors trade commodities? A: Yes, through MCX and NCDEX. You need a trading account with a commodity broker. Many equity brokers now offer commodity trading.

Q: How are commodity profits taxed? A: Treated as business income (speculative or non-speculative depending on delivery). CTT (Commodity Transaction Tax) applies similar to STT.

Q: What’s the best commodity to trade? A: Gold and crude oil are most liquid on MCX. Start with these for learning. Agricultural commodities require understanding of crop cycles and policies.

Q: How much capital is needed? A: Minimum lot margins vary: Gold Mini (₹50,000), Crude (₹60,000). Practically, ₹2-3 lakh gives adequate cushion for margin and MTM.

Commodity markets connect the physical world of farms, mines, and oil wells to the financial world of exchanges and traders. Understanding commodities gives you insight into global economics—because ultimately, everything we build, eat, and use starts with these basic materials.