Commodity trading in share market
Commodities are the actual physical goods like corn, soybeans, gold, and crude oil. They are interchangeable with other goods and can be bought and sold physically as well in future market. They are tradable in the same way as financial futures with only one difference that this commodity can have physical settlement and asset quality is taken into consideration unlike financial futures.
Futures are contracts of commodities that are traded at a futures exchange like the Chicago Board of Trade (CBOT), COMEX in USA and MCX and NCDEX in INDIA. They are standardized contracts among buyers and sellers of commodities that specify the amount of a commodity, grade/quality and delivery location. Each futures contract has a standard size that has been set by the futures exchange it trades on.
Each contract has fix delivery month. Date of expiry has to do with delivering the actual commodity The contract will expire after the designated date in the delivery month.
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Major types of commodities
Agri commodity: Guarseed, Wheat, Jeera, Sugar, Rice, Soyabean, Potato, Cotton, Chilly, Dhaniya, Cottonseed, Bajra, Castor, Chana Metal: Gold, Silver, Lead, Nickel, Zinc, Copper, Alluminium Energy: Crude oil, Natural gas In USA orange juice is the most heavily traded commodity. Even commodities like cocoa, coffee, and sugar, lumber are traded. Before one starts investing in any commodity he should analyze following queries
- Which country/countries hold the largest reserves of the commodity?
- Is that country politically stable or is it vulnerable to turmoil?
- How much of the commodity is actually produced on a regular basis? (Ideally, get data for daily, monthly, quarterly, and annual basis.)
- Which industries/countries are the largest consumers of the commodity?
- What are the primary uses of the commodity?
- Are there any alternatives to the commodity? If so, what are they and do they pose a significant risk to the production value of the target commodity?
- Are there any seasonal factors that affect the commodity?
- What is the correlation between the commodity and comparable commodities in the same category?
- What are the historical production and consumption cycles for the commodity?
Research is a critical part of a commodity trader’s regime. After understanding the basics of commodity one can apply fundamental as well as technical analysis to particular commodity to find long term as well as short term trend. Fundamental analysis is a means of analyzing commodities and trying to predict where the prices of commodities should be trading and what they will do in the future.
The main basis for fundamental analysis is supply and demand. Commodities trade in cycles. Sometimes supplies will be tight and prices will be high. Other times, we just have too much of a commodity and prices fall. Price movements in commodities using fundamental analysis can be broken down into these simple formulas:
Demand > Supply = Higher Prices Supply > Demand = Lower Prices
Supply of Commodities
The supply of a commodity is the amount that is carried over from previous year(s) of production and the amount that is being produced during the current year. Typically, the more that is carried over from the previous season, the lower the prices will fall. There are many factors that can impact the supply of commodities like weather, amount of acres planted, production strikes, crop diseases and technology.
The main thing to remember when using fundamental analysis is that high prices for commodities will lead to an increase in production, as it is more profitable to produce commodities when prices are higher. As you might expect, demand will typically drop as prices move higher.
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Demand for Commodities
Demand for commodities is the amount that is consumed at a given price level. The rule of thumb is that demand will increase when the price of a commodity moves lower. Oppositely, demand will decrease as the price of a commodity increases. One should look for trends that are developing that will cause a shift supply and demand factors.
One should look for trends in production and consumption and trade with that bias. For example, if the supplies of corn are at a five-year high and we just planted a record amount of acres of corn for this season, it is likely that corn future will trade with a downward bias.Now, at some point, the price of corn will get too low and demand will increase. Or, there might be weather problems during the growing season that will lower the production of corn.
In these cases it trades with upward bias. The longer-term trends in commodities are easier to spot with fundamental analysis Most professional commodity traders like to know what the big picture is with commodities using fundamental analysis and then they use technical analysis to time their entries and exits because price is factoring in everything.
Fundamental news which are going to come are already factored in the price . So technical analysis of price allow us to enter and exit early before the news. Yellow arrow in the below chart shows that when fundamentally silver was in down trend silver price technically had started giving the bullish signal.
One can also use intermarket relationship when predicting future of commodity. If inflation is high interest rates are high so equity market will decline, currency weakens and price of commodity rises. When interest cycle reverts again commodity will decline and stock rises higher. On 10th July when budget was announced, Nifty started its distribution process and declined sharply. Gold and silver along with crude triggered a sharp rise. This shows how hedge funds and FII do their asset allocation and rearrangement of portfolio.
Players of Commodity market Different participants ensure liquidity and efficient price discovery in the market.
- Commercials: The entities involved in the production, processing or merchandising of a commodity.
- Large Speculators: A group of investors that pool their money together to reduce risk and increase gain. Like mutual funds in the stock market, large speculators have money managers that make investment decisions for the investors as a whole.
- Small Speculators: Individual commodity traders who trade on their own accounts or through a commodity broker. Both small and large speculators are known for their ability to shake up the commodities market.
- Arbitragers: They do the simultaneous purchase and sell in different market or different contract and take the advantage of mispricing of commodities. They help to equalize price and restore market efficiency
- Hedgers: They use the future market to reduce the risk of the commodity in which they deal.
Commodity trading offers a more level playing field for traders than the stock market Here traders need not guard against inside cliques. Dividends are not unexpectedly passed or increased overnight in the cotton market or in wheat or corn.
In the long run commodity prices are governed but by one law – the economic law of demand and supply. But just like other side of coin there are inherent risks with trading in Commodities. One of the inherent risks of commodities is that the world’s natural resources are located in various continents and the jurisdiction over these commodities lies with sovereign governments, international companies, and many other entities.
For example, to access the large deposits of oil located in the Persian Gulf region, oil companies have to deal with the sovereign countries of the Middle East that have jurisdiction over this oil.International disagreements over the control of natural resources are quite commonplace. Recent situation of Iraq is exemplary of this fact. Also there is speculative risk with commodities.
The commodities markets, just like the bond or stock markets, are populated by traders whose primary interest is in making short-term profits by speculating whether the price of a security will go up or go down. One should constantly check the pulse of the markets, finding out as much as possible about who the market participants are so that one can distinguish between the commercial users and the speculator.