The economy of India is growing at a fast pace. With domestic product growing at over 6% year-on-year, the financial markets of the country are an opportunity for investors to make good returns on their money. Thus, with the increase in financial awareness, investors are looking for lucrative options to invest their money and get handsome returns.

Apart from basic instruments like savings accounts or fixed deposits, more and more investors are now turning to capital markets where they invest in equity or debt of various companies. Capital markets provide an opportunity for these investors to earn high returns while building long-term wealth. But, the commodity market is also growing rapidly.

In India, commodity trading is not very well known due to the lack of investor education about it, but it is becoming a hotbed of a lot of investments. Investors looking for diversification and stable returns are investing in commodities through commodity exchanges.

Investing in commodities such as gold or wheat provides the right kind of diversification for a portfolio and also hedges some risk because commodity prices have been shown to be less volatile than other instruments such as stocks.

Basics of the commodity market

The Securities and Exchange Board of India governs the commodity trading activity in India since 2015 when the Forward Markets Commission merged with it. Forward Markets Commission was the erstwhile regulator of the commodities market. As of now,  India has 22 commodity exchanges where investors can buy and sell commodities or related instruments.

Some of the major Indian commodity exchanges are:

  1. National Commodityand Derivatives Exchange – NCDEX
  2. National Multi CommodityExchange – NMCE
  3. Ace Derivatives Exchange – ACE
  4. Indian CommodityExchange – ICEX
  5. The Universal CommodityExchange – UCX
  6. Multi CommodityExchange – MCX

All exchanges offer commodity trading but one needs a Demat account which can be opened with a service such as the National Securities Depository Limited (NSDL). The functions of a Demat account include holding your securities (commodities and contracts, in this case) in an electronic or ‘dematerialised’ form for easy retrieval and reconciliation.

Once you have a Demat account, you will need access to a broker’s trading terminals to be able to place and execute orders for commodities on the exchanges.

Steps to trade

As an investor, you can buy and sell a whole variety of commodities on the exchanges. The range available to trade is as varied from gold to renewable energy.

Following are some of the categories of commodities that are available for trade:

  1. Agriculture: grains, pulses such as corn, rice, wheat etc
  2. Precious metals: gold, palladium, silver and platinum etc
  3. Energy: crude oil, Brent Crude and renewable energy etc
  4. Metals and minerals: aluminium, iron ore, soda ash etc
  5. Services: energy services, mining services etc

Through an exchange, one can place an order for any of these and the price of these commodities fluctuates through the day depending on the demand, supply and volumes of trades in that particular commodity.

Commodity trading instruments

One of the best ways to trade in commodities is through a futures contract. A future commodities contract is an agreement between a buyer and a seller where they both agree to exchange a certain quantity of a commodity for a pre-agreed price at a pre-decided date in the future.

It is important to remember that the price and date are not allowed to be altered once the futures contract is in place.

The gains from the contract will be based on the future movement of the price of the commodity.

Let’s look at an example to understand this better.

For instance, consider that gold is priced at Rs 72,000 per 10 grams right now. And an investor decides to buy a futures contract for the same which expires after 30 days and it is priced at Rs 73,000. Now, the buyer has agreed to buy 10 grams of gold at Rs 73,000 after 30 days from the seller of the futures contract irrespective of its market price on that day.

If the market price of gold on the day of the expiry of the contract is Rs 75,000, the buyer of the contract will gain on his investment as he could now technically buy gold at Rs 72,000 from his futures contract and sell it for Rs 75,000 in the open market. Hence, this is a profit for him which will be credited to his account.

Types of contracts

However, not all futures contracts are the same. These contracts in the commodity markets can be either:

  1. Cash-settlement futures or
  2. Delivery based contracts

While the example given above was of a cash-settled futures contract where no actual exchange of physical gold took place but a delivery-based contract will require the physical commodity to be exchanged between the two parties.

Those entering into a futures contract must indicate their preference for the settlement type because it can’t be changed once the contract period has expired.