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What is a Commodity ?

A commodity is a good for which there is demand, but which is supplied without qualitative differentiation across a market. It is a physical substance, such as food, grains, and metals, which is interchangeable with another product of the same type, and which investors buy or sell, usually through futures contracts. The price of the commodity is subject to supply and demand. Risk is actually the reason exchange trading of the basic agricultural products began. Commodities are often substances that come out of the earth and maintain roughly a universal price. A commodity is fungible, that is, equivalent no matter who produces it.
In the broadest sense, a commodity is anything that has value, from watches to time to oranges. In a more specific market sense, however, a commodity is an item which is roughly the same market value across the board, with no difference based on quality.
The mainstream commodity market can be split into a number of different markets: precious metals, industrial metals, livestock, agricultural products, energy, and some commodities that don’t easily fall into a classification. Precious metals include gold, silver, platinum, and palladium. Industrial metals include aluminum, aluminum alloy, nickel, lead, zinc, tin, recycled steel, and copper. Livestock includes live cattle, feeder cattle, pork bellies, and lean hogs. Agricultural products include soybeans, soybean oil, soybean meal, wheat, cotton number two, sugar numbers eleven and fourteen, wheat, corn, oats, rice, cocoa, and coffee. Energy includes ethanol, heating oil, propane, natural gas, WTI crude oil, Brent crude oil, Gulf Coast gasoline, RBOB gasoline, and uranium. The commodity market also includes rubber, wool, polypropylene, polyethylene, and palm oil.

Commodity derivatives market

commodity derivatives trade contracts for which the underlying assets is a commodity like, wheat, soyabean, cotton etc or precious metal like Gold and Silver. The commodity derivatives differ from the financial derivatives mainly in the following two aspects: Firstly, due to the bulky nature of the Underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Secondly, in the case of commodities, the quality of the asset underlying a contract can vary largely

Commodity market in India

India has a long history of future trading in commodities. In India, trading in Commodity future has been existence from the 19th Century with organised trading in Cotton, through the establishment at Bombay Cotton Association Ltd. in 1875. Over a period of time, other commodities were permitted to be traded in future exchanges. Spot trading in India occurs mostly in regional mandis and unorganized market, which are fragmented and isolated.
There were booming activities in this market at one time as many as 100 Unorganized exchanges were conducting forward trade in various commodities. The securities market was a poor competitor of this market as there were not many papers to be traded at that time.
However, many feared that derivatives fuelled unnecessary speculation and were detrimental to the healthy functioning of the market for the underlying commodities. As a result, after independence, commodity option trading and cash settlement of commodity future were banned in 1952.
A further blow come in 1960’s when following several years of several droughts has forced many farmers to default on forward contact and even caused some suicides, forward trading was banned in many commodities considered primary or essential. Consequently, the commodities derivatives market dismantled and remained dormant for about four decades until the new millennium when the Govt. in a complete change in policy, started actively encouraging the commodity derivatives market.
The year 2003 marked the real turning point in the policy frame work for commodity market when the government issued notifications for withdrawing all prohibitions and opening up forward trading in all commodities. This period also witnessed other reforms, such as, amendments to the Essential Commodities Act, Securities (contract) Rules, which have reduced bottlenecks in the development and growth of commodity markets of the country is total GDP, commodities related and dependent industries constitute about roughly 50-60% which itself cannot be ignored.

Why are commodity derivatives required:

India is among the top 5 producer of the most of the commodities in addition to being a major consumer of bullion and energy products. Agriculture contributes more than 23% to be GDP of Indian economy. It employees around 57% of the labour force on a total of 185 million hectares of land. Agriculture sector is an important factor to achieving a GDP growth of 8.10. All this indicates that India can be promoted as a major centre for trading of commodity derivatives.
It is common knowledge that prices of commodities, metals, shares and currencies fluctuate over time. The possibilities of adverse price change in future creates risk for business. Derivatives are used to reduce or eliminate price risk arising from unforeseen price change. A derivatives is a financial contract whose price depends on, or is derived from the price of another assets.

Two important derivatives are future and options.

Commodity Future Contract:

A future contract is an agreement for buying or selling a commodity for a predetermined delivery price at a specific future time. Futures are standardized contract that are traded on organized facture exchanges that ensure performance of the contract and remove the default risk. The commodity futures have existed since the Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and merchants together the major function of future market is toe transfer price risk from hedger to speculators. For example suppose a farmer who is expecting the crop of wheat to be ready in three months time, but is worried that the price of wheat may decline in this period, in order to minimize his risk, he can enter into a future contract to sell his crop in three months time at a price determined now.
Just take an another example. All we know that woolen garments demand picks up in winter season. A garment factory owner can by a factory contract of cotton to get the raw material for his products as predetermined price. This way both time is able to hedge their risk arising from a possible adverse change in the price of theirs commodity or raw material.

2. Commodity Option Contract:

Like futures, option are also financial instruments used for hedging and speculation. The commodity option holder has the right, but not the obligation to buy (or sell) a specified quantity of a commodity at specified price on or before a specified date. Option contract involve two parties – the seller of the option writes the option in favour of the buyer (holder) who pays a certain premium to the seller as a price for the option. There are two types of commodity options. A ‘call’ option gives the holder a right to buy a commodity at an agreed price, while a ‘put’ option gives the holder a right to sell a commodity at an agreed price on or before a specified date which is called expiry date.
The option holder will exercise the option only if it is beneficial to him, otherwise he will let the option lapse. Suppose a farmer buys a put option to sell 10 MT of wheat of Rs. 13000/- MT and pays a ‘premium’ of Rs. 500/- MT. If the price wheat decline, to say Rs. 1000/- MT before expiry, the farmer will the exercise his option and sell his wheat at the agreed price of Rs. 1300/- MT. However, if the market price of wheat increases by Rs. 1000/-MT, it will be better for the farmer to sell it directly in the open market at the spot price, rather than his option to sell at Rs. 13000/- MT.
Future and options trading therefore helps in hedging the price risk and also provide investment opportunity to speculators who are willing to assume risk for a possible return. Future trading and the ensuing discovery of price can help farmers to deciding which crops to grow.
Thus future and options market perform important functions that cannot be ignored in modern business environment. At the same time, it is true that too much speculative activity in essential commodities would destabilize the markets and therefore, these markets are normally regulated as per the law of the country. Commodity Options trading is not permitted in India till now.

Modern commodity exchange

To make up the loss of growth and development during the four decades of restrictive Govt. policies, FMC and the government encouraged setting up commodity exchanges using the most modern system and practices in the world. Some of the main regulatory measures imposed in the FMC include daily market to market system of margins, creation of trade guarantee fund, back office computerization for the existing single commodity exchanges , online trading for the new exchanges, demutualization for the new exchanges and one third representation of independent Directions the Board of existing Exchanges etc.
National Level Commodity Exchanges in India are:-

  • NMCE : National Multi Commodity Exchange of India.
  • NCDEX : National Commodity Derivatives Exchange Ltd.
  • MCX : Multi Commodity Exchange of India Ltd.

NMCE : (National Multi Commodity Exchange of India Ltd
It is the first demutualised electronic commodity exchange of India granted the National exchange on Govt. of India and operational since 26th Nov, 2002. The Head Office of NMCE is located in Ahmadabad. There are various commodity trades on NMCE Platform including Agro and non-agro commodities.
NCDEX (National Commodity & Derivates Exchange Ltd
NCDEX is a public limited co. incorporated on April 2003 under the Companies Act 1956, It obtained its certificate for commencement of Business on May 9, 2003. It commenced its operational on Dec 15, 2003. NCDEX is located in Mumbai and currently facilitates trading in 57 commodity mainly in Agro product.
NSEL (National Spot Exchange Limited)
National Spot Exchange Limited (NSEL) is a National level Institutionalized, Electronic, Transparent Spot trading platform which commenced its live operations on 15th Oct, 2008. At present NSEL is operational in 13 states, providing delivery based spot trading of 26 commodities.
MCX Multi Commodity Exchange of India Ltd
Headquartered in Mumbai, the exchange started operation in Nov, 2003. MCX is a demutalised nation wide electronic commodity future exchange. Set up by Financial Technologies (India) Ltd. permanent recognition from government of India for facilitating online trading, clearing and settlement operations for future market across the country. MCX is well known for bullion and metal trading platform.
MCX offers futures trading in

Metal               Aluminium, Copper, Lead, Nickel, Sponge Iron, Steel Long (Bhavnagar), Steel Long (Govindgarh), Steel Flat, Tin, Zinc
BULLION        Gold, Gold HNI, Gold M, i-gold, Silver, Silver HNI, Silver
FIBER             Cotton L Staple, Cotton M Staple, Cotton S Staple, Cotton Yarn, Kapas
ENERGY         Brent Crude Oil, Crude Oil, Furnace Oil, Natural Gas, M. E. Sour Crude Oil
SPICES            Cardamom, Jeera, Pepper, Red Chilli
PLANTATIONS    Arecanut, Cashew Kernel, Coffee (Robusta), Rubber
PULSES             Chana, Masur, Yellow Peas
PETROCHEMICALS      HDPE, Polypropylene(PP), PVC
OIL & OIL SEEDS       Castor Oil, Castor Seeds, Coconut Cake, Coconut Oil, Cotton Seed, Crude Palm Oil, Groundnut Oil, Kapasia                      Khalli,              Mustard Oil, Mustard Seed (Jaipur), Mustard Seed (Sirsa), RBD Palmolein, Refined Soy Oil, Refined Sunflower Oil, Rice Bran DOC, Rice Bran Refined Oil, Sesame Seed, Soymeal, Soy Bean, Soy Seeds
OTHERS Guargum, Guar Seed, Gurchaku, Mentha Oil, Potato (Agra), Potato (Tarkeshwar), Sugar M

Regulator of commodity exchanges:

FMCL (Forward Market commission) headquarted in Mumbai, is regulation authority which is overseen by the minister of consumer affairs, food and public distribution Govt. of India, It is a statutory body set up in 1953 under the forward contract (Regulation) Act 1952.

Needs for future trading in commodities:

Commodity futures, which terms an essential component of commodity exchanges, can be broadly classified into precious metals, agriculture, energy and other metals. Current future volumes are miniscule compared to underlying spot market volumes and thus have a tremendous potential in the near future. Future trading in commodities result in transparent and fair price discovery. It reflects videos and expectations of wider section of people related to a particular commodity. It provides effective platform for price risk management for all segment of players ranging from producers, trades and processors of a commodity. It aids in improving the cropping platform for farmers, thus mimizing the losses to the farmers. It also acts as a smart investment choice in providing hedging, trading and arbitrage opportunities to market players. Historically, pricing, in Commodities future has been less volatile compared with equity and bonds, thus providing an efficient portfolio diversification option. Raw Materials form the most key element of industries. The significance of raw materials can further be strengthened by the fact that the increase in raw material cost means reduction in share prices. Industry in India a today runs the raw material price risk. Hence going forward the industry can hedge this risk by trading in commodities market.

Risk associated with commodities market:

No risk can be eliminated, but the same can be transferred to someone who can handle it better or to someone who has the appetite for risk. Commodity enterprises primarily face the following classes of risk. Namely: The price Risk, the quantity risk, the yield/output risk and the political risk, talking about the nationwide commodity exchanges, the risk of the counter party not fulfilling his obligations on due date or at any time therefore is the most common risk.
This risk is mitigated by collection of the following margins:-

Initial margins
Exposure margins
Mark to Market on daily positions.

Key factors for success of commodities market:

The following are source of the key factors for the success of the commodities market:

  • How can one make the business grow
  • How many products are covered
  • How many people participate in the Platform.

Key factors for success of commodity exchanges:

Strategy, method of execution, background of promoters, credibility of the institution, transparency of platforms, scaleable technology, robustness of settlement structure, wider participation of Hedgers, speculators and arbitragers, acceptable clearing mechanism, financial soundness and capability, covering a wide range of commodity, reach of the organization and adding value to the ground.

Arbitrage: The simultaneous purchase and sale of similar commodities in different markets to take advantage of a perceived price discrepancy.

Basis: The difference between the current cash price and the futures price of the same commodity for a given contract month.

Bear Market: A period of declining market prices.

Bull Market: A period of rising market prices.

Broker: A company or individual that executes futures and options orders on behalf of financial and commercial institutions and/or the general public.
Call Option: An option that gives the buyer the right, but not the obligation, to purchase (go “long”) the underlying futures contract at the strike price on or before the expiration date of the option.
Cash (Spot) Market: A place where people buy and sell the actual (cash) commodities, i.e., grain elevator, livestock market, etc.
Commission (Brokerage) Fee: A fee charged by a broker for executing a transaction.
Convergence: A term referring to cash and futures prices tending to come together as the futures contract nears expiration.
Cross-hedging: Hedging a commodity using a different but related futures contract when there is no futures contract for the cash commodity being hedged and the cash and futures markets follow similar price trends
Daily Trading Limit: The maximum price change set by the exchange each day for a contract.
Day Traders: Speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day.
Delivery: The transfer of the cash commodity from the seller of a futures contract to the buyer of a futures contract.
Forward (Cash) Contract: A cash contract in which a seller agrees to deliver a specific cash commodity to a buyer at a specific time in the future
Fundamental Analysis: A method of anticipating future price movement using supply and demand information.
Futures Contract: A legally binding agreement, made on the trading floor of a futures exchange, to buy or sell a commodity or financial instrument sometime in the future. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. The only variable is price, which is determined on an exchange trading floor.
Hedger: An individual or company owning or planning to own a cash commodity – corn, soybeans, wheat, etc. and concerned that the costs of the commodity may change before they intend to either buy or sell it in the cash market. A hedger achieves protection against changing cash prices by purchasing (selling) futures contracts of the same or similar commodity and later offsetting that position by selling (purchasing) futures contracts of the same quantity and type as the initial transaction and at the same time as the cash transaction occurs.
Hedging: The practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Hedgers use the futures markets to protect their business from adverse price changes.
Margin: Margin is the percentage amount required by the exchange from the trading member for carrying out trading activities in the particular contract. The member in turn collects the margin from the client entering into trade in that contract. Though the margin amount as a whole is more significant, it can be broken into 4 kinds of margin:

Initial Margin
Exposure Margin
Additional Margin
Special Margin

Initial Margin: The amount a futures market participant must deposit into his/her margin account at the time he/she places an order to buy or sell a futures contract.
In-the-Money Option: An option having intrinsic value. A call option is in-the-money if its strike price is below the current price of the underlying futures contract. A put option is in-the-money if its strike price is above the current price of the underlying futures contract.
Intrinsic Value: The difference between the strike price and the underlying futures price for an option that is in-the-money.
Liquidate: Selling (or purchasing) futures contracts of the same delivery month purchased (or sold) during an earlier transaction or making (or taking) delivery of the cash commodity represented by the futures contract.
Long: One who has bought futures contracts or plans to own a cash commodity.
Lot Size: There are generally 2 kind of lots associated with commodity futures
Trading lot
It is the lot size in which trading activities are carried out. It means that the minimum quantity in which trading would be conducted for any particular contract of a commodity. Eg. With lot size of Crude Oil being 100 barrels, any trader / investor would have to buy / sell a minimum of 100 barrels of crude oil on the trading platform. No fractions are allowed to trade on the exchanges and the trading is carried out in multiples of lot size only.
Delivery lot
It is the minimum size for conducting delivery in the particular commodity. It can differ from the trading lot but would be always in the multiples of the trading lot. It can’t be smaller than trading lot as the delivery would not be possible in that case. Generally, the delivery lot is decided on the basis of the standards of the delivery procedure carried out in spot markets.
Maintenance Margin: A set minimum margin (per outstanding futures contract) that a customer must maintain in his margin account.
Nearby (Delivery) Month: The futures contract month closest to expiration. Also referred to as spot month.
Open Interest: The total number of futures or options contracts of a given commodity that have not yet been offset by an opposite futures or option transaction nor fulfilled by delivery of the commodity or option exercise. Each option transaction has a buyer and a seller, but for calculation of open interest only one side of the contract is counted.
Option: A contract that conveys the right, but not the obligation, to buy or sell a futures contract at a certain price for a specified time period. Only the seller (writer) of the option is obligated to perform.
Option Premium: The price of an option-the sum of money that the option buyer pays and the option seller receives for the rights granted by the option.
Out-of-the-Money Option: An option with no intrinsic value, i.e., a call whose strike price is above the current futures price or a put whose strike price is below the current futures price.
Purchasing Hedge (long hedge): Buying futures contracts to protect against a possible price increase of cash commodities that will be purchased in the future. At the time the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those that were initially purchased.
Put Option: An option that gives the option buyer the right but not the obligation to sell (go short) the underlying futures contract at the strike price on or before the expiration date of the option.
Price Limit: Price Limit is put into the place by the Exchanges on directives from FMC, the regulatory body, to keep a check on extreme price movements within a single trading session.
A price limit is defined for each commodity in percentage terms which is calculated from the previous close of the contract. If the prices hit the circuit limit on either side, the trading is halted for 15 minutes, which is often termed as cooling period. Then the trading limit gets relaxed for another 50% of the initial limit specified and margin on the contract gets increased. The revised limit is the maximum price on the higher / lower side at which trading can take place.
Different commodities have different price limits. Same commodity might be having different price limits on different exchanges but different contracts of same commodity can’t have varying price limits (in percentage terms) on same exchange
Selling Hedge (short hedge): Selling futures contracts to protect against possible declining prices of commodities that will be sold in the future. At the time the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those that were initially sold.
Short Position: One who has sold futures contracts or plans to sell a cash commodity. Selling futures contracts or initiating a cash forward contract sale without offsetting a particular market position.
Speculator: A market participant who tries to profit from buying and selling futures and option contracts by anticipating future price movements. Speculators assume market price risk and add liquidity and capital to the futures markets. They do not hold equal and opposite cash market risks.
Spread: The price difference between two related markets or commodities. For example, the April-August live cattle spread.
Strike Price: The price at which the futures contract underlying a call or put option can be purchased (call) or sold (put). Also called exercise price.
Symbol: Exchange provides symbol to each commodity traded on its platform. These symbols are unique within the exchange.
Symbols on MCX are quite simple and easy to identify as the name is the symbol in most cases. Eg. Gold is written as ‘GOLD’, Silver as ‘SILVER’, Copper as ‘COPPER’ and Crude Oil as ‘CRUDEOIL’
On the other hand, NCDEX has a different method of allotting symbols. Each symbol carries alphabets from the following:

Name of the commodity
Quality of the commodity
Delivery centre

Technical Analysis: Anticipating future price movements using historical prices, trading volume, open interest, and other trading data to study price patterns.
Time Value: The amount of money option buyers are willing to pay for an option in the anticipation that, over time, a change in the underlying futures price will cause the option to increase in value. In general, an option premium is the sum of time value and intrinsic value. Any amount by which an option premium exceeds the option’s intrinsic value can be considered time value.
Tick Size: Tick size is the minimum price movement permissible for the particular contract. It means that the minimum price fluctuation (if any) in a commodity would be the tick size. Eg. Tick Size for Wheat at NCDEX is Rs. 0.20 which means that if the wheat is quoting at Rs. 850, then the next price on the higher side should be minimum Rs. 850.2. It cannot be Rs. 850.10.
Underlying Futures Contract: The specific futures contract that can be bought or sold by exercising an option.
Volatility: A measurement of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.
Volume: The number of purchases or sales of a commodity futures contract made during a specified period of time, often the total transactions for one trading day.

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