UnderstandiHow the Commodity Market Works | Research 360 by Motilal Oswal

How the Commodity Market Works in India?

09 Sep, 2024 16:45pm
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Beyond stock trading, there are various market segments for retail traders and investors in India. Among these is the commodity market, which consists of various agricultural and non-agricultural assets and various derivative instruments linked to them. Beginners in the commodity market may not be aware of how it works, what instruments to trade in and how to find and leverage opportunities in the market. 

If you are also a beginner to commodity trading, you need to understand the nuances of this market segment before you start placing trade orders. In this article, we take a closer look at the different commodity market instruments, how the commodity market works, the basics of commodity trading and more.

 

What are Commodity Market Instruments?

Commodity market instruments are the goods and financial products traded in this segment of the financial markets. These goods can be classified as agricultural products, metals and energy resources. Agricultural commodities include wheat, cotton, castor seeds, rice and the like. Metals traded in the commodity market include brass, aluminium, gold, silver and other similar products. Energy resources traded as commodities include gas, crude oil and the like. 

In addition to these physical commodities, various commodity market instruments are also traded here. They include derivatives like options and futures contracts with physical commodities as the underlying assets. So, commodity trading can occur with physical commodities or with the derivatives linked to such goods.

 

Commodity Trading Basics

Commodity trading in India occurs in the secondary market via commodity exchanges. The main exchanges in this market segment include the following: 

  • Multi Commodity Exchange of India (MCX)
  • National Multi Commodity Exchange India (NMCE)
  • Indian Commodity Exchange (ICEX)
  • National Commodity and Derivative Exchange (NCDEX)
  • National Stock Exchange (NSE)
  • Bombay Stock Exchange (BSE)

You can trade in two types of commodities — namely, hard commodities and soft commodities. Hard commodities include natural resources like gold, silver and crude oil, while soft commodities include agricultural products like wheat, sugar and cotton.

If you are trading in the commodities market, you need to be prepared for the volatility in this segment. The prices of commodities can fluctuate greatly, as can the prices of the derivatives linked to them. These prices are affected by many factors like general demand and supply, seasonal changes, regulatory policies, geopolitical changes and market sentiment. 

Another important aspect of commodity trading basics is risk management. Due to factors like general commodity market volatility and price unpredictability, traders must use measures like stop-loss limits and hedging to limit the downside risk. 

 

How Does the Commodity Market Work?

Beyond the aspect of commodity trading basics, you must also understand how the commodity market works. From production to consumption, the physical commodities market has four stages, as outlined below:

  • Stage 1: Production

This is the primary stage of production where the raw material or the commodity is produced, obtained or cultivated. It involves agricultural processes for commodities like wheat and sugar, and non-agricultural processes like mining or extraction for metals and crude oil. 

  • Stage 2: Conversion

Some raw materials need to be further processed or converted after production to transform them into usable commodities. For example, cotton must be converted into yarn or fabric, crude oil must be refined and some agricultural products need to be processed further. 

  • Stage 3: Sale

Once the commodities have been converted as required, they can be sold to wholesalers, retailers or even the end users directly. This stage forms the distributary phase of how the commodity market works. The prices of commodities are determined in this stage, based on factors like production and conversion costs, profit margin, demand and supply.

  • Stage 4: Consumption

The last stage of the commodity market process is consumption, where the end consumer utilises the products or services produced and sold for their benefit. This phase is the reason the other three stages exist, and a decrease or increase in consumption can affect the demand prevailing in the commodity market. 

 

How Commodity Trading Works?

Now that you have seen how the commodity market works, let us delve into how commodity trading works. In India, commodity trading primarily operates through derivatives like options and futures contracts. 

A futures contract is an agreement between two parties to buy or sell a specific quantity of a commodity at a predetermined price on a future date. These contracts are traded on exchanges like the MCX, NCDEX, BSE and NSE. To trade in futures, you must pay margin money, which is a small percentage of the contract’s total value. If the market moves in your favour, you can profit from the price difference. However, losses can also occur if the market moves against your position. 

In options trading, you get the right but do not have an obligation to buy or sell a commodity at a certain price before the contract expires. There are two types of options: call options, where you get the right to buy the underlying commodity, and put options, where you get the right to sell it. 

 

Conclusion

Whether you choose to trade in commodity options or futures, you need to open a trading account with a broker. What’s more, you also need to have the right tools at your disposal to understand how the commodity market works. So, ensure that you have the necessary trading tools and services required to trade successfully in this dynamic and volatile segment of the financial market.

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