What are Commodities: Basics of Commodity Markets and Trading

Key takeaways/ Quick Knowledge Gain:
 

• Commodities are raw materials that are traded internationally, such as gold, oil, wheat, and coffee.
   
• There are two types of commodity markets: spot (immediate) and futures (future date).
   
• Commodities are purchased and sold on the spot market for prompt delivery at the going rate.
   
• Price movements are influenced by supply and demand, weather, politics, and global trends.

Commodities are basic raw materials on which businesses and consumers rely every day, such as gold, oil, wheat, and coffee. 

Assume a small business owner needs 1,000 kg of wheat at ₹30 per kg to manufacture bread for their bakery. If wheat prices rise by ₹5, your cost will climb by ₹5,000 instantly. Consider the global gold trade, where even a single kilogram variation in pricing might result in millions of rupees in profit.

Let's meet!  Ramesh owns and maintains a trading business. Last month, he bought 100 barrels of crude oil for ₹5,000 each, totalling ₹5,000,000.

What is a commodity market?

A commodity market is a location where goods such as oil, gold, wheat, and coffee are purchased and sold. These markets assist producers, consumers, and dealers in managing risks and prices. For example, if a farmer believes the price of wheat will fall after harvest, he might sell a contract in advance to lock in today's price and avoid losses.

Commodity markets come in two main types:

• Spot markets: They include the instantaneous exchange of goods. For instance, a baker purchases 500 kg of wheat for ₹32 per kg to begin baking.

• Futures Markets: They involve the purchase or sale of commodities at agreed-upon prices in the future. A coffee importer may purchase 1,000 kg of beans next month for ₹150 per kg to avoid price increases.
   

This system makes it easier for everyone to plan ahead of time and avoid surprises as prices change.

Let’s suppose Ramesh purchases 1,000 kg of wheat at ₹30 per kg using a three-month futures contract. If the market price reaches ₹35 per kg, he chooses not to pay the higher price.

Purchasing wheat ahead of time saves Ramesh ₹5,000, highlighting the benefits of commodities futures for cost management and price protection.

How does commodity trading work?

Supply and demand are the primary drivers of commodity price movements. If there is a drought, wheat production may fall, sending prices higher. If additional mines open, metal availability increases, and prices may decline.

There are various players in commodity trading:

• Hedgers: These are individuals or businesses who wish to lock in pricing to avoid losses. For example, a wheat farmer may sell futures to set his selling price prior to harvest.
   
• Speculators: These are traders who aim to profit from price fluctuations by buying cheap and selling high, hence increasing market liquidity.

Prices vary regularly, making commodities trading both fast-paced and fascinating.

Example - Last year, Ramesh bought oil at ₹6,000 per barrel; prices rose to ₹6,500.

His stock value rose to ₹3,25,000, resulting in an untapped gain of ₹25,000. This highlights the influence of commodity price changes on business holdings.

Types of Commodities Traded:

The commodity market mostly deals with two categories
 

• Hard commodities are mined or extracted, such as crude oil, gold, copper, and natural gas.
   
• Soft commodities are agricultural or livestock products such as wheat, coffee, sugar, and cattle.

Example: A gold merchant purchases 100 grammes at ₹5,000 per gramme for ₹5,00,000. If the price climbs to ₹5,200 per gram, the value increases to ₹5,20,000, resulting in a ₹20,000 gain.

Treasure Hunt: Do you know commodity prices can change multiple times in a single day, depending on global news?

Why Do Commodity Prices Change?

Several factors affect commodity prices:

• Weather: A poor monsoon or drought reduces crop output and raises prices.
   
• Political Events: Wars and sanctions affect oil and metal supply chains.
   
• Global Demand: Rising demand from developing countries might cause prices to rise.
   
• Inventories: High stockpiles can lower prices, while low stocks can raise them.

Understanding these allows organisations to better plan purchases and sales.

For instance, a 10% decline in wheat production could result in a price increase from ₹30 to ₹33 per kg, costing a bakery an additional ₹3,000 for each 1,000 kg purchased.

Treasure hunts- Do you know that some futures traders never take actual delivery, but rather only trade for profit differences?

How Can Businesses Use Commodity Markets?

Businesses use commodity markets to manage risks and expenses. For example:
 

• A bakery buys wheat futures to lock in pricing before flour costs climb.
   
• A jeweller purchases gold contracts to ensure supply and prevent price increases.
   
• An aviation firm may purchase fuel futures to better budget its expenses.
   

Utilising commodity markets effectively can enhance company margins.

Example: Ramesh's bakery purchases 2,000 kg wheat futures at ₹32/kg for ₹64,000. When prices climb to ₹35/kg, he saves ₹6,000 over buying at the market cost later.

Conclusion

The markets for commodities, which are the essential building elements of industries, assist buyers and sellers in controlling costs and risks. Making informed decisions requires an awareness of how these markets operate, whether a bakery is securing wheat costs or a transportation company is protecting itself from rising oil prices. Prices are continuously influenced by supply, demand, and world events, so traders and companies must remain aware to succeed in this dynamic market.

FAQs on Commodity Trading 

1. How are margin requirements set in commodity trading?

Margin depends on the commodity's volatility and risk. Exchanges use historical price movements to generate initial and maintenance margins, which protect both parties from default risk.

2. Can I take physical delivery of commodities purchased through futures contracts?

Yes, some futures contracts offer physical delivery of the underlying commodity upon contract maturity, although the majority of traders settle for cash. Delivery terms vary depending on the exchange and product.

3. What role do regulators have in commodity trading?

Commodity exchanges are regulated to promote fair trading procedures, prevent manipulation, protect investors, and keep markets transparent and stable.

4. What is the typical settlement cycle for commodity trades?

The settlement cycle varies per commodity and exchange, although it typically covers from the same day (T+0) to a few days (T+2 or T+3) after the trading date. Futures contracts specify delivery dates and settlement terms.
 

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