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Commodity Market: Definition, History, How it Works          

Commodity Market: Definition, History, How it Works, and Different Types

Commodity Market: Definition, History, How it Works, and Different Types

Commodity markets play a pivotal role in the global economy by facilitating the trading of raw materials, crops and energy sources between producers, consumers and speculators. Commodity markets underpin industries worldwide and influence inflation trends. The buying and selling of commodities occurs on exchanges through standardized futures contracts, allowing market participants to hedge supplies and lock-in prices. 

Price discovery in commodity markets is a complex interplay between demand and supply forces. Production costs, weather events, government policies and geopolitical uncertainties cause volatility. Multiple participants, including farmers, miners, manufacturers, traders and investors, transact to balance these dynamics. Over the decades, regulatory reforms and electronic trading have modernized commodity exchanges in India and abroad. Measures like warehouse infrastructure upgrades and participation incentives have deepened liquidity.

This article provides a comprehensive overview of commodity markets. It explores the history and evolution of the Indian commodity trading landscape. Various aspects, such as regulated exchanges, traded products, risk management instruments, and the diverse range of market participants, are examined. The article also analyzes factors impacting prices and the regulatory framework. With continuous innovation, commodity exchanges continue fulfilling their essential role of facilitating global trade and mitigating risks for economic agents.

What exactly is the commodity market?

A commodity market is a virtual marketplace where primary goods and materials are traded. A commodity market is comparable to a stock market. But here, commodities are traded instead of stocks. Commodity markets trade in the primary economic sector. There are two main types of commodities – hard and soft. 

How does the commodity market work in simple terms?

The commodity market allows the buying and selling of raw materials and farm products. These are known as commodities. Commodities include things like metals, energy sources and crop items. People and companies in the market trade these commodities. The market helps buyers and sellers find a fair price for a commodity. They determine this based on how much supply is available and how much demand exists.

Traders actively trade commodities on organized exchanges rather than in a central location. Examples of exchanges include the Chicago Mercantile Exchange. The market uses standardized future contracts to trade commodities. This sets the price for delivering the commodity at a later date. This helps reduce risks from price changes. People and companies participate in the commodities market for different reasons. Producers and users of commodities look to protect against risks. Individual traders aim to earn profits by predicting price movements.

What is the history of the commodity market?

The history of the commodity market in India dates back to 1875 when the Bombay Cotton Trade Association was established, which laid the foundation for futures trading in the country. Commodity trading has been an integral part of the Indian economy since ancient times. However, the modern commodity market as we know it today has evolved over the decades, with government regulations playing a key role. The 19th century saw the emergence of organized commodity markets in India. In 1875, the Bombay Cotton Trade Association was set up to organize cotton contracts.

This was followed by the establishment of the Bombay Cotton Exchange Ltd. in 1893 by a group of dissatisfied cotton merchants and mill owners. The cotton futures market became quite popular, and soon exchanges emerged for trading in oilseeds, bullion and other agro commodities. The Gujarati Vyapari Mandli, established in 1900, conducted futures trading in groundnut, castor seed and cotton. The Calcutta Hessian Exchange was set up in 1919 for futures trading in raw jute and jute products, even though organized trading in jute started only after the establishment of the East India Jute Association Ltd. in 1927. These two associations merged to form the East Indian Jute and Hessian Ltd. in 1945. However, futures trading in raw jute was suspended in 1964 at the insistence of the West Bengal government.

Futures trading in gold and silver began in 1920 in Bombay and later spread to other cities like Kanpur and Jaipur. The Bombay Commodity Exchange was established in 1938 to trade oilseeds. By 1939, before the Second World War, there were several futures markets trading oilseeds in Gujarat and Punjab. The government banned cotton futures trading in 1939. Subsequently, forward trading was prohibited for oilseeds, food grains, spices, sugar, and other commodities in 1943 during the Second World War. This led to the closure of the commodity derivatives market, which remained dormant for almost four decades after independence. Only futures trading in very minor commodities like pepper and turmeric was permitted. 

In the 1960s, some efforts were made to revive commodity trading. Futures trading in Hessian was allowed in 1962. However, it took until the 1980s and 1990s for the commodity markets to start growing again. In 1992, futures trading in Hessian was reintroduced. The real revival of Indian commodity markets occurred in the 2000s. In April 2003, the government allowed futures trading in all commodities, which led to the establishment of modern exchanges like the Multi-Commodity Exchange (MCX), National Commodity & Derivatives Exchange (NCDEX), etc. These exchanges brought in transparency and electronic trading platforms and addressed counterparty risks.

With the commodities transaction tax introduced in 2013, commodity trading volumes declined temporarily but soon recovered. Today, India is one of the major commodity trading hubs globally. The commodity markets cater to the needs of farmers, processors, traders, exporters/importers, SMEs and other stakeholders, providing price risk management, better discoverability and other benefits. Agricultural commodities form a major share of commodity futures trading in India. NCDEX dominates trading in agri-commodities like wheat, soybean, chana, mentha oil, guar seed, etc. MCX specializes more in bullion, base metals, crude oil and energy commodities. 

Commodity options trading was permitted in 2017. Options provide better risk management flexibility compared to futures contracts. The participation of institutional players such as mutual funds and portfolio managers has increased the depth of commodity derivatives markets. Today, SEBI is the regulator for commodity markets, while warehousing infrastructure has improved significantly. Assured liquidity incentives are provided by the regulator to ensure the depth of the markets. Commodity exchanges have launched new products like options on goods, futures on indices, etc., to meet the evolving needs of stakeholders.

Which exchanges trade in the commodity market?

Multi Commodity Exchange of India (MCX) is the largest commodity exchange in India, and it was established in 2003. It offers futures trading in various commodities, including bullion, energy, spices, plantation, metals, and other commodities. MCX allows the trading of commodity derivatives contracts in gold, silver, copper, crude oil, natural gas, mentha oil, cotton, pepper, cardamom, etc. It uses an electronic trading platform with a nationwide presence. National Commodity and Derivatives Exchange (NCDEX) commenced operations in 2004 as a national-level technology-driven online commodity exchange.

It offers futures trading in agricultural commodities such as wheat, rice, oilseeds, pulses, spices, coffee, rubber, cotton, etc., as well as non-agricultural commodities like steel, aluminium, nickel, zinc, copper, crude oil, Brent crude oil, natural gas etc. NCDEX uses varied distribution architectures, including VSATs, internet and leased lines, to integrate participants across India. National Multi Commodity Exchange (NMCE) was incorporated in 2002; NMCE facilitates trading of various commodities such as bullion, metals, energy, cereals, pulses, spices, coffee, rubber and others. It utilizes a mix of technologies like VSAT, leased lines and the internet to connect participants. NMCE merged with the Indian Commodity Exchange Limited (ICEX) in 2018.

Indian Commodity Exchange (ICEX) started operations in 2009, offering futures trading in bullion, energy, base metals, spices and agro commodities. It uses technology to provide a nationwide online marketplace for commodity trading. In 2018, ICEX merged with NMCE to consolidate its business positions.

What are the types of commodities traded in the commodity market?

Below are the types of commodities traded in the commodity market.

Commodity exchanges
Commodity Market: Definition, History, How it Works, and Different Types 7
Exchange NameTypes of CommodityTrading Volume
Chicago Mercantile Exchange (CME)Metals, Livestock, Agricultural Products, Energy, Interest RatesVery High
Intercontinental Exchange (ICE)Energy, Agricultural Products, Softs (coffee, sugar, cocoa)High
New York Mercantile Exchange (NYMEX)Energy (crude oil, natural gas, etc.), MetalsHigh
Multi Commodity Exchange of India (MCX)Metals, Energy, Agricultural ProductsHigh (especially within India)
London Metal Exchange (LME)Base Metals (aluminium, copper, zinc, etc.)High
Dalian Commodity Exchange (DCE)Agricultural Products (corn, soybeans), Iron OreHigh (especially within China)
Shanghai Futures Exchange (SHFE)Base Metals, Rubber, EnergyHigh (especially within China)

Does the commodity market trade electronically?

Yes, commodity markets, like stock markets, have transitioned to electronic trading platforms and exchanges over the last few decades. Electronic trading has become the norm for executing commodity trades rapidly and efficiently. 

Major commodity exchanges like the Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE) operate electronic trading systems for commodities like metals, agricultural products, and energy contracts. The systems match buy and sell orders from traders worldwide and provide real-time price discovery and trade execution.

Electronic trading brings several benefits to commodity market participants. It allows for faster trade execution and processing compared to traditional open outcry pits. Traders execute complex spread and combination trades electronically, which is difficult to do manually. The increased speed and efficiency enable commodity traders to respond quickly to news and events that impact prices.

Electronic platforms also improve pricing transparency in commodities. Real-time price data is available to all market participants, unlike earlier, where floor brokers have had an information advantage. The live order book gives traders insight into market depth and sentiment. This helps improve price discovery and fairer pricing.

The lower transaction costs are another major advantage of electronic trading. Executing trades electronically reduces brokerage fees, exchange fees and settlement costs compared to manual trading. Automated order matching eliminates intermediaries required for physical trading. This reduces the barriers to entry, allowing more participants and greater liquidity in commodity markets.

In many ways, the transition to electronic trading in commodities mirrors the electronification seen in equity markets over the past decades. Stock exchanges like NYSE and NASDAQ also operate efficient electronic platforms after shutting down physical trading floors. The benefits are similar – lower costs, faster trades, improved transparency for stocks.

However, commodity markets have their unique features and risks. Commodities are physical assets vulnerable to supply/demand shocks. They trade in a globally dispersed marketplace involving producers, consumers, and traders. Risk management is complex due to the volatility and price uncertainties.

So electronic platforms use features like volatility guards, velocity logic and pre-trade risk checks for commodities. This ensures market integrity and prevents errors, unlike stocks, where prices move more smoothly. Cryptographic security protects transactions and funds transfer on commodity platforms.

Electronification has made commodity trading faster, more cost-efficient and more accessible. However, human oversight and robust risk management are still essential. The unique risks in commodities, like extreme volatility and geopolitical factors, mean electronic trading needs prudent safeguards.

On the flip side, electronic trading has also impacted commodity market microstructure. Liquidity is fragmented across trading venues. Platform diversity makes price discovery complex. Algorithmic and high-frequency trading have also affected short-term price behaviour in commodities, such as stocks. 

Regulators still grapple with ensuring fair market access and preventing manipulation on electronic commodity platforms. However, efficiency and transparency have benefited end-users like producers/consumers in managing commodity price risks.

Going forward, technological innovation will continue shaping commodity trading. Areas like machine learning, blockchain and cloud computing further transform electronic platforms. Big data analytics will support smarter, faster trading and improved surveillance.

However, human expertise remains vital in commodity markets. Domain knowledge in agricultural commodities, metals, and energy is still key to analysing supply/demand, inventories, and geopolitics affecting prices. This distinguishes commodities from stocks, where quantitative skills dominate today.

What instruments are used in the commodity market?

The main instruments used in commodity markets are commodity derivatives like futures contracts, forward contracts, and options. Other important instruments are spot contracts, swaps, and commodities traded on exchanges or over the counter. The derivatives allow investors to hedge risk or speculate on commodity prices. The spot and cash markets facilitate the immediate buying and selling of physical commodities. These instruments provide investors exposure to commodity prices with varying degrees of risk and flexibility.

What instruments are used in commodity market
Commodity Market: Definition, History, How it Works, and Different Types 8

1.Commodity derivatives

Commodity derivatives are financial instruments derived from underlying physical commodities such as agricultural produce, precious metals, oil, etc. They allow investors to hedge against price risks associated with commodities without having to physically trade the commodity. Commodity derivatives include futures contracts, options, and swaps that are traded on exchanges like MCX and NCDEX. These help commodity producers and consumers hedge against adverse price movements. Commodity derivatives were introduced in India in 2003 and have gained prominence since then.

They provide an efficient way for players in the commodity market to manage price volatility and ensure stable revenues. Commodity derivatives add depth to the commodity market, improve price discovery, and help diversify investment portfolios. Commodity derivatives have enabled more efficient risk management and price discovery in the Indian commodity markets since their introduction.

2. Future contracts

Future contracts are standardized derivative contracts that obligate the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. In commodity markets, future contracts allow producers, consumers and traders to lock in commodity prices and hedge against price volatility. For instance, a farmer enters a futures contract to sell his crop at a fixed price at the time of harvest, protecting against price declines.

On the other hand, a consumer buys a futures contract to purchase the commodity at a set price, insulating from price rises. Commodity futures contracts were introduced in India in 2003 and are traded on exchanges like MCX and NCDEX. They have brought in more participants into commodity markets, enabling better price discovery and risk management. Future contracts have added depth to the commodity derivatives market and brought stability to commodity prices since their introduction in India. They continue to be an important tool for hedging price risks in commodities.

3. Forward contracts

A forward contract is a customized derivative agreement between two parties to buy or sell an asset at a specified price on a future date. In commodities, forward contracts are used by producers and consumers to hedge against adverse price movements. For example, a wheat farmer enters a forward contract to sell his harvest at a predetermined price to a food processing company, locking in future revenue. The food company also fixes input costs by buying a forward contract.

Commodity forward contracts are private agreements, unlike standardized futures contracts. They became popular hedging tools in commodities much before the introduction of futures in 2003. Forward contracts bring stability to prices and revenues for commodity market participants. Though less liquid than futures, forward contracts continue to be used for commodity price risk management as they are customized to the needs of the parties involved. They provide an effective hedging tool, especially for commodities that have limited futures trading.

4. Spot contracts

A spot contract is an agreement to buy or sell a commodity at the current market price for immediate delivery. In commodity markets, spot contracts are used by producers, consumers and traders to purchase and sell commodities in the spot market. The buyer must make full payment and take delivery of the commodity on the spot, while the seller must deliver the commodity as per the contractual specifications. Spot contracts allow commodities to be traded for immediate settlement, enabling efficient price discovery and liquidity in the commodity markets.

They have existed since the origin of commodity trading. With the creation of commodity exchanges, standardized spot contracts are now traded on platforms like NCDEX and MCX, regulated for improved transparency. Spot contracts continue to be a key trading mechanism in commodity markets even after the advent of futures and other derivatives. They provide real-time information on commodity prices and allow flexibility compared to derivatives.

5. Call options

A call option is a derivative contract that gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price on or before a specific date. In commodity markets, call options allow traders to speculate on rising prices. For example, a trader who expects wheat prices to rise purchases a call option to buy wheat at a fixed price in the future, benefiting if prices increase. On the other hand, producers buy call options to hedge against falling commodity prices.

Commodity call options were introduced in India after trading in commodity derivatives was allowed in 2003. They are traded on commodity exchanges like MCX and NCDEX. Call options add liquidity to the commodity markets, enable better price discovery and allow risk management. They allow participation from more market players, thereby bringing more stability to commodity prices. Call options have become an important commodity trading instrument since their introduction.

6. Swaps

A swap is a derivative contract between two parties to exchange cash flows or liabilities in the future. In commodity markets, swaps allow producers and consumers to hedge against adverse price movements. For example, a wheat farmer enters a swap contract to receive a fixed price for his produce while the buyer pays a floating market price. This protects the farmer against falling wheat prices. On the other hand, a flour mill pays a fixed wheat price via a swap contract to hedge against rising input costs.

Commodity swaps were introduced in India after 2003, when commodity derivatives trading commenced. They are traded over the counter between parties. Swaps enhance hedging capabilities in the commodity markets as they are customized as per individual needs, unlike standardized futures. Swaps bring stability to prices and revenues for commodity market players. They have gained traction since their introduction and are an important tool for managing commodity price risk.

7. Cash market

The cash market, also called the spot market, refers to the physical marketplace where commodities are traded for immediate delivery. It enables producers, consumers, traders, etc., to buy and sell commodities at current market prices. For instance, a cotton farmer sells his harvest to a textile mill in the cash market. The transaction involves immediate payment and delivery of the commodity. The cash market plays a crucial price discovery role in commodity markets, providing real-time information on prevailing commodity prices based on supply and demand.

It also enables commodity grading and quality assessment. Cash markets have existed since the inception of commodity trade. With the advent of commodity exchanges, the cash market has become more organized and transparent. Standardized spot contracts are now traded on exchanges like NCDEX and MCX, with assured delivery and settlement. The cash market continues to be the foundation of all commodity market activity, providing the basis for the pricing of derivatives like futures.

8. Exchange-traded commodities (ETCs)

Exchange Traded Commodities (ETCs) are financial instruments that track the performance of an underlying commodity index or price of a commodity. They allow investors to gain exposure to commodities without trading futures contracts. ETCs are listed and traded on stock exchanges just like stocks. In commodity markets, ETCs enable participation from investors who want exposure to commodity prices without direct participation. ETCs were introduced in India in the late 2000s after commodity derivatives trading became legal in 2003.

They have expanded the investor base in commodities, bringing in more liquidity. ETCs have made gaining exposure to commodities easier for investors compared to futures contracts which need active trading. They also reduce transaction costs. The introduction of ETCs has allowed more investors to participate in the commodity markets, enhancing liquidity and price discovery. ETCs have become an important route for gaining commodity exposure in India since their introduction.

9. Over-the-counter commodities (OTC)

Over-the-counter (OTC) commodities refer to the trading of commodity derivatives directly between two parties outside of the exchanges. OTC commodity contracts include forwards, swaps, options, etc., which are customized as per the requirements of the parties involved. In commodity markets, OTC contracts allow producers, consumers, and traders to design contracts to manage specific commodity price risks. For instance, a corn farmer enters an OTC forward contract with a starch manufacturer to hedge price risk.

OTC contracts bring flexibility and customization for commodity price risk management. They existed in commodities much before exchange-traded derivatives were introduced in 2003. Though less liquid, OTC contracts continue to play an important role in commodities that have limited exchange-traded derivatives. They enable tailored hedging strategies based on individual needs. OTC commodities provide an effective alternative hedging mechanism outside of the exchanges.

What factors affect commodity market prices?

Factors affecting commodity market prices are supply and demand, production costs, government policies, market speculation, weather and natural disasters, geopolitical events, and competition. These factors cause commodity prices to fluctuate significantly. 

Supply and Demand

The most basic factor affecting commodity prices is the relationship between supply and demand. Prices tend to rise when demand is high, and supply is limited. Prices usually fall when supply is plentiful and demand weakens. For example, an unexpected freeze in coffee-growing regions reduces supply and drives up coffee prices due to the supply shortage. Prices would then drop when the supply recovers. Changes in supply and demand happen rapidly, causing volatility in commodity markets.

Production Costs 

The costs involved in producing a commodity heavily influence its market price. Higher production costs typically translate to higher prices. Major inputs that impact production costs include labour, raw materials, transportation, and energy. It squeezes profit margins for producers if any of these becomes more expensive. To maintain profits, producers will seek to pass on the increased costs to consumers through higher prices. For instance, rising energy costs have contributed to price hikes for many commodities that use significant energy in their production and transportation.

Government Policies

Government policies and regulations are a major factor affecting commodity prices. Policies like production subsidies, trade tariffs and quotas, environmental regulations, and speculation limits all impact commodity supply, demand, and prices. Government stimulus programs or restrictions on commodity trading also indirectly influence price fluctuations in commodity markets. Some government actions are taken specifically to control prices, like releasing oil from strategic reserves to reduce energy costs or limiting food exports to control domestic food inflation.

Market Speculation 

Speculation in commodity futures and other derivatives markets amplifies price volatility. Investors essentially bet on the future prices of commodities, buying when they predict prices will rise and selling when they think prices will fall. This speculative trading behaviour causes ballooning investment in commodities when prices are expected to increase, driving prices up further. High levels of speculation exacerbate short-term price swings and lead to price bubbles, which inevitably burst and result in sharp declines. Regulators sometimes step in to limit excessive speculation that distorts commodity prices.

Weather and Natural Disasters

Extreme weather events and natural disasters that damage crops disrupt transportation or destroy production facilities severely impact commodity supply. For agricultural commodities like grains, floods, droughts, early freezes, hurricanes, and insect infestations greatly reduce yields and output, resulting in less supply and higher prices. With mined commodities like metals or energy, disasters like mine collapses, oil spills, and refinery explosions halt production and send prices upward. Even relatively minor weather incidents cause significant price movements if they happen in critical producing regions.

Geopolitical Events

Major geopolitical events like wars, conflicts, trade embargos, and labour strikes all affect commodity production and transportation, disrupting supply chains and availability. Political turmoil in key exporting nations limits supply, while conflicts that threaten critical trade routes hamper transport and drive up shipping costs. State actions like export bans also temporarily constrain supply. For instance, Middle East conflicts often spark oil price spikes. Labour unrest, like strikes at major ports, makes it difficult to transport commodities to market. These supply disruptions lead to price increases for affected commodities.

Competition and Alternatives

In some commodity markets like energy and metals, new supply sources and alternative materials influence price trends. The emergence of new producers who increase supply depresses prices. The development of renewable energy and synthetic alternatives to natural resources also reduces demand for the original commodity, applying downward price pressure. For example, advancements in hydraulic fracturing expanded oil and gas output, while cheaper solar power ate into coal demand – both factors that contributed to declining fossil fuel prices. The availability and cost dynamics of substitutes affect prices as they compete for market share with the original commodity.

The interaction of these influences causes commodity markets to be highly volatile and makes commodity prices difficult to forecast with accuracy over the long term.

Who are the participants of the commodity market?

The participants of the commodity market are producers, consumers, traders, investors, arbitrageurs, hedge funds, commodity pools, and exchanges that enable interaction between them. The diverse participants include businesses hedging against price risk, investors seeking profits, intermediaries facilitating transactions, and speculators betting on price swings. Their interaction and trading activity determine the demand, supply, and, ultimately, the price of commodities.

Producers

Commodity producers are major market participants, as they extract or grow the physical goods being traded. Producers include farmers who harvest agricultural commodities, miners who unearth mineral and metal resources, oil and gas companies who drill for fossil fuel reserves, and more. Producers use commodity markets for price discovery and to hedge against falling prices. By locking in future sales via derivatives like futures contracts, they protect revenues from potential price drops. Producers provide the supply that serves as a baseline for commodity market activity.

Consumers 

Commodity consumers drive the demand that underpins market prices. They include manufacturers, retailers, restaurants, utility companies, and numerous other businesses that require commodities as inputs to produce final goods and services. Consumers use commodity markets to hedge against rising input costs by fixing future purchase prices. This shields their profit margins from commodity price spikes. The needs of commercial commodity consumers ultimately create the demand that commodity producers aim to meet via supply.

Traders

Commodity traders are intermediaries that facilitate transactions between producers, consumers, and other players. Traders range from individual brokers to large investment banks. They access commodity exchanges and over-the-counter markets to execute orders for clients. Traders hedge commodity prices on behalf of clients and provide market information to help them manage risk. They also trade for their own accounts, speculating to profit from commodity price changes. Their trading facilitates price discovery and liquidity in commodity markets.

Investors

A broad range of investors actively participate in commodity markets, attracted by portfolio diversification and upside potential from volatile prices. Investors include hedge funds, pension funds, insurance companies, endowments, high-net-worth individuals, and more. They invest directly in physical commodities or commodity derivatives like futures, options, and swaps to gain exposure to the asset class. Investors’ trading adds substantial liquidity but also increases speculation, which destabilizes commodity prices.

Arbitrageurs 

Arbitrageurs identify and capitalize on pricing inefficiencies between related commodity markets and derivatives. Suppose a commodity is trading at different prices in separate futures markets; arbitrageurs simultaneously buy and sell the commodity in each market to lock in small, low-risk profits. Their trading activity realigns cross-market prices and improves pricing efficiency. Arbitrage enhances liquidity and contributes to commodity price discovery between linked markets.

Hedge Funds

Hedge funds are active speculators in commodities, using leverage and complex strategies. They take directional views on commodity price movements, profiting from correctly anticipating ups or downs. Hedge funds also pursue arbitrage and spread trading opportunities across commodity markets. Their substantial trading volumes and liquidity demands influence price trends, especially in volatile conditions. Hedge fund positioning is a key indicator monitored by other commodity market participants. 

Commodity Pools

Commodity pools aggregate investor money to trade commodity futures and options on behalf of the group. They provide diversified exposure to commodities as an asset class for individual investors with limited capital. The sheer size of assets under management by some commodity pools means their trading decisions impact prices. One risk they pose is herding behaviour that overwhelms markets during periods of extreme volatility.

Exchanges

Commodity exchanges like the Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE) provide centralized platforms for trading futures, options, and derivatives contracts. This connects commodity buyers and sellers in open markets to discover pricing and transfer price risk. Exchanges offer transparency, regulation, clearing services, and tools for risk management. The growth of electronic commodity trading on exchanges has opened these markets to more participants and improved pricing efficiency.

Commodity markets involve diverse participants ranging from producers and consumers who transact for operational needs to investors and speculators seeking financial returns and exchanges facilitating price discovery – all influencing the complex forces of supply and demand that determine commodity prices.

Why should you trade in the commodity market?

You should trade in commodity markets as they offer diversification, profit opportunities in any market climate, leverage, and the ability to hedge positions and capitalize on volatility and price trends.

1. Diversification

Trading commodities allows investors to diversify their portfolio beyond just stocks and bonds. Commodities like agricultural goods, metals, and energy help balance a portfolio since they often move independently of equities. This provides greater stability and reduces overall risk. Having exposure to commodities through futures or ETFs hedge against inflation as well since commodity prices tend to rise with inflation.

2. Ability to Profit in Any Market Condition

Commodities rise even when stocks are falling, allowing for-profit opportunities in bear markets. For example, oil and gold tend to perform well when stocks are down. Likewise, commodities also fall during bull markets for stocks and bonds. This low correlation provides diversification and allows commodity trading to smooth out portfolio returns over time. Investors go long or short to profit in up or down markets. 

3. Leverage

Commodity futures contracts are traded on margin, meaning only a small percentage deposit called “margin” is required to open a position. This provides leverage, allowing traders to put up just a fraction of the full value of the contract. With futures, a 5-10% move in the commodity price leads to gains of 50% or more on the margin amount. This leverage significantly enhances returns but also increases the risk of loss. Proper risk management is essential when trading leveraged instruments.

4. Ability to Hedge Positions

Commodities allow producers and consumers to hedge their physical positions in the underlying hard asset. For example, a gold mining company could short gold futures to lock in prices and protect against falling gold prices. An airline company that uses jet fuel could buy oil futures to lock in fuel costs. Hedging with futures helps protect profit margins for companies with commodity price exposure. The ability to hedge is a major benefit of commodity markets.

5. Volatility and Price Trends

The commodity markets are full of trends and volatility that active traders take advantage of. Supply and demand imbalances often lead to sustained moves and trends that last weeks or months. These trends are traded with futures, options, ETFs, and stocks. Volatility expands profit potential compared to lower volatility assets. Major geopolitical events, weather, supply disruptions, and shifts in demand trigger price spikes and drops that lead to trading opportunities.

6. Around-the-Clock Access 

The futures markets trade virtually 24 hours a day, opening on Sunday afternoon and closing on Friday afternoon. This continuous access allows traders to react to news and events whenever they happen. The futures markets only close for a few holiday periods per year. This constant access increases liquidity and trading opportunities.

7. Liquidity

The futures markets trade with high liquidity, meaning transactions are executed swiftly and at desired prices. Even large commodity orders are filled quickly. The high liquidity comes from the participation of large institutions, producers, consumers, and speculators. This benefits traders by keeping bid-ask spreads tight and allowing efficient order execution.

8. Transparency

Commodity futures markets are highly transparent, with real-time price quotes, trading volumes, open interest, and settlement prices updated throughout the day. Detailed fundamental data on supply, demand, production, weather, and more are widely disseminated. This allows traders to make informed decisions based on a wealth of market information. Transparency enhances market efficiency.

9. Ability to Go Long or Short

Traders have the ability to buy futures contracts to profit from rising prices or sell futures short to profit from falling prices. This flexibility lets traders participate in all types of markets. The ability to trade both sides is a major advantage compared to just buying assets outright. In addition, options on futures contracts allow leveraged exposure to price movements without having to buy or sell futures directly.

10. Wide Array of Markets

Hundreds of futures markets exist across commodities like agriculture, energy, metals, currencies, interest rates, and stock indexes. This allows trading opportunities across asset classes, geographies, and economic sectors. With so many markets, there are always trends and volatility to capitalize on somewhere. The variety caters to all trading interests and strategies.

11. Low Costs

Futures trading involves very low fees since contracts are standardized. The brokerage commission on a commodities trade is around Rs.5 per contract. The total transaction cost is under Rs.10 for a round-turn trade when exchange fees are included. This makes futures cost-efficient to trade compared to stocks. Low trading costs benefit active traders. Options for future contracts also trade at low commission rates.

12. Technical Trading

Commodity prices tend to form very identifiable technical patterns and trends that are traded with price charts and indicators. This allows for technical analysis across time frames ranging from very short-term to long-term. Disciplined technical trading with stop losses limit risks. Many successful professional traders rely solely on technical analysis in future markets. The ability to technically trade futures and options is a major appeal.

Commodity markets offer diverse trading opportunities through leveraged and low-cost futures and options, providing the ability to profit in any market condition, hedge physical positions, capitalize on volatility, and diversify a portfolio. The around-the-clock access, liquidity, transparency, and technical nature of commodities make them an attractive asset class for traders.

What are the limitations of the commodity market?

The limitations of commodity markets include high volatility, leverage risks, opacity, regulatory uncertainty, and the extensive expertise required to trade effectively.

1. Volatility and Risk 

Commodity prices are highly volatile due to factors like weather, geopolitics, natural disasters, supply constraints, etc. This volatility leads to increased price risk compared to stocks and bonds. Sharp price swings lead to large losses if proper risk management is not employed. Commodities like crude oil, gold, and grains are prone to huge price spikes and drops that catch traders off guard. New traders often underestimate the volatility.

2. Leverage Can Multiply Losses

Trading commodity futures involves high leverage since contracts only require a margin deposit. While this amplifies gains, it also compounds losses. Losses mount quickly and wipe out an account if not managed properly. Always use stop losses and appropriate position sizing when trading leveraged futures. Margin requirements are also raised during periods of heightened volatility, requiring additional capital. Leverage requires traders to maintain sufficient margins to avoid forced liquidations.

3. Lack of Fundamentals for Individual Traders

While institutions have extensive fundamental data on commodities, it is difficult for individual traders to obtain meaningful supply and demand forecasts. This makes trading based on fundamental analysis tough. Technical analysis tends to be the main approach for most small traders, but ignoring fundamentals completely is risky in the long term. Limited fundamental visibility is a handicap.

4. Limited Holding Period

Commodity futures contracts have defined expiration dates, requiring positions to be closed out or rolled over into new contracts. This makes longer-term investing difficult. Frequent rollovers also incur trading costs. ETFs and similar instruments hold longer-term commodity exposure but lack the leverage of futures. The limited holding period forces traders to have a short-term focus.

5. Complex and Contract-specific

Each commodity market has its own contract specifications, delivery mechanisms, margin requirements, expiry dates, etc. This complex array of parameters requires research. Contracts are not standardized across all markets like stocks. The intricacies increase the learning curve. Being unaware of contract details leads to errors and losses. Traders must thoroughly understand what they are trading.

6. Tracking Error with Commodity ETFs

While commodity ETFs provide long-term exposure, they deviate substantially from the spot price over time. This “tracking error” reduces expected gains compared to the commodity’s actual performance. The ETFs use futures contracts under the hood, which introduces rollover effects over time. Traders must understand these potential tracking deviations.

7. Potential for Manipulation

Past instances of market manipulation highlight vulnerabilities in the commodity futures markets. While regulation has increased, critics argue the extensive use of futures for speculation increases pricing distortions. Herding, corners, and spoofing tactics still pose risks in these markets. Traders must account for periods of questionable price discovery and distortion risk.

8. Political and Regulatory Risks

Geopolitics and changing government policies introduce uncertainties that rapidly impact commodity markets. Export tariffs, sanctions, rotting food stockpiles, and outright market interventions have all led to major price dislocations. Regulatory risk is always present. Environmental policies could reshape demand over time as well. Political factors introduce unpredictability.

9. Unknown Counterparty Risk 

With futures brokers, traders must rely on the financial stability of the carrying broker and clearinghouse. Broker risk was evident during periods like the MF Global bankruptcy. Central clearing reduces but does not eliminate counterparty risks that are opaque to most traders. Due diligence on brokers is critical for risk management.

10. Extensive Research Required

Being successful in trading commodities requires ongoing research into factors like weather, acreage planted, mine output, pipeline logistics, import/export flows, and more. This research burden is a limitation compared to just trading stocks based on company fundamentals. Complex global supply chains introduce more variables to track. Maintaining sound research is demanding.

11. Access to Trading Expertise 

While online brokers provide access to trading commodities, they generally provide little strategic guidance or mentorship for traders. Successful trading requires skill development beyond just opening an account. New traders often lack mentors. Locating experienced trading expertise is challenging compared to trading stocks. This slows skill growth.

12. Difficult to Develop Long-Term Models

Commodity prices follow more short-term cyclical patterns rather than long-term trends based on growth and valuations. This makes statistically based trading systems challenging to develop and backtest compared to the stock market. Effective trading strategies require flexibility to adapt to the inherent short-term nature of commodities.

Commodity markets pose risks from volatility, complexity, and lack of fundamentals, requiring extensive expertise. Caution and research are warranted when trading commodities.

What are the top traded commodities?

The top traded commodities include energy, metals, and agriculture. Energy commodities like crude oil, natural gas, gasoline, and heating oil see huge volumes traded daily on commodity exchanges globally. Metals such as gold, silver, platinum, and copper are also among the most liquid commodities traded worldwide. Additionally, agricultural commodities, including wheat, rice, and various types of seafood, make up significant shares of international commodity trading. 

Who regulates the commodity market?

The commodity market in India is regulated by multiple agencies, both at the central and state government levels. The key regulators are the Forward Markets Commission (FMC), the Securities and Exchange Board of India (SEBI), state governments, and industry associations. 

The Forward Markets Commission is the main regulatory body for commodity futures trading in India. Headquartered in Mumbai, FMC is an autonomous body set up under the Ministry of Finance. It supervises the functioning of commodity exchanges like MCX, NCDEX, NMCE, ICEX, etc. FMC ensures transparency and fair trading practices in commodity derivative markets. It specifies rules and bylaws of commodity exchanges, clears new commodity contracts, specifies margin requirements, limits positions taken by traders, and monitors open interest and price movements. FMC also regulates warehouse service providers that store physical commodities tied to futures contracts. FMC regulates both commodity spot and derivative markets in India.

The Securities and Exchange Board of India is the regulator of securities and commodity derivatives markets in India. SEBI regulates commodity futures and options contracts listed and traded on recognized stock exchanges. It issues regulations and guidelines on trading commodity derivatives, their risk management, product design, settlement and more. SEBI also regulates foreign institutional investors and their limits on commodity derivatives.  

At the state level, respective state governments regulate the physical spot commodity markets under their jurisdiction. State laws on essential commodities, weights and measures, prevention of food adulteration, agricultural produce marketing, etc., govern the trading of commodities. State governments regulate spot exchanges, agricultural markets, and more through their designated departments and agencies.

In addition, industry associations like FMC, SEBI, BSE, NSE, Solvent Extractors Association and others contribute to the self-regulation of their member commodity brokers, traders and exchanges. The associations issue industry best practices, ethical codes, and standard contracts and provide training and arbitration services.

What is the difference between the commodity market & stock market?

The commodity market refers to the trading of raw or primary products, such as metals, agricultural produce, oil and gas. Commodities are tangible goods used as inputs in the production of other goods or services. Some of the major commodity markets include energy commodities like crude oil, natural gas, and coal; precious metals like gold and silver; industrial metals like aluminium, copper and nickel; livestock and meat products; and agricultural commodities like corn, wheat, soybeans, coffee and sugar. 

The stock market refers to the trading of stocks, which represent ownership claims on businesses. It includes exchanges like the New York Stock Exchange and Nasdaq, where investors buy and sell shares of publicly traded companies. The stock market allows businesses to raise capital by issuing shares while providing investors an opportunity to gain ownership in companies and benefit from their growth and profitability.

The commodity market deals in raw materials and primary products, while the stock market deals in company securities and ownership claims. The commodity market involves producers, users, traders and speculators of tangible physical assets. In contrast, the stock market connects retail investors, institutional investors, brokers and publicly listed companies seeking to raise capital and provide shareholder returns. 

Commodity prices depend on demand/supply dynamics, production costs, transportation expenses, geopolitical events and macroeconomic factors. However, stock prices rely on a company’s earnings, growth prospects, management strength, market sentiment and sector-specific factors. In the US, trading of commodities and stocks occurs under different regulators – the Commodity Futures Trading Commission oversees commodities, while the Securities and Exchange Commission regulates stocks.

Another difference lies in standardization and liquidity. Commodities are relatively standardized products that are easily interchangeable, even though agricultural commodities tend to be less liquid than metals or energy. Meanwhile, every stock represents unique ownership in a firm, and large-cap stocks feature higher liquidity than small-cap stocks. The settlement also differs – commodity futures lead to physical delivery, while equity trades result in cash and ownership transfer.

What is the commodity price index?

A commodity price index tracks the prices of various commodities over time. It represents the aggregated or average price changes in a basket of selected commodities. Some of the major commodity price indices include the Thomson Reuters/CoreCommodity CRB Index, the Bloomberg Commodity Index, and the S&P GSCI (Goldman Sachs Commodity Index). These track prices of commodities across energy, metals, agricultural and livestock sectors. The weights assigned to each commodity in the index depend on their relative importance in the global economy.

Commodity price indices serve several purposes – they reflect price trends and inflationary pressures, inform production and inventory decisions, allow commodity futures trading, and provide benchmarks for investment products. These indices are crucial for commodity producers and consumers to gauge price expectations and make hedging or investment decisions. They also give policymakers an idea of future inflation trends. A rise in commodity prices is reflected in the higher index values.

What is a commodity index fund?

A commodity index fund is an investment vehicle that tracks the performance of a commodity index. It allows investors to gain broad exposure to the commodity market without trading futures contracts. The fund invests in futures contracts across various commodities like energy, metals, livestock and agriculture, in proportion to their weighting in a commodity index. As the underlying index changes based on the price movements of constituent commodities, the fund reflects this in its net asset value. Commodity index funds are passively managed and aim to match the index returns through replication.

They provide portfolio diversification benefits as commodity prices tend to be less correlated with stocks and bonds. These funds give retail investors easy access to commodities as an asset class, compared to direct trading of futures, which requires solid capital. The lowered transaction costs through the fund structure also improve returns. Some of the largest commodity index funds track popular indices like the S&P GSCI or Bloomberg Commodity Index.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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