Commodities Trading Online
Commodity futures can be traded online. Technology has indeed made it possible to trade commodities from the luxury of your homes. All you need is a good speed internet connection, a device with a RAM of more than 2 GB and the initial capital to trade the markets. Let me clearly specify, I am talking of trading the future commodity markets.
Trading the commodity markets in Delhi can be done physically or electronically. The physical market is the spot market for commodities whereas the market available online is the futures market for the same. Futures commodity markets basically refer to the electronic contracts traded on the exchange. Each contract has an underlying commodity and an expiry date. The basic difference between the spot and futures is the criteria of price and delivery. In the spot market, the transaction to buy or sell a commodity takes place at current price of the commodity. The delivery too is immediate. On the other hand, the future contract of a commodity is a standardized contract stating to buy or sell a specified quantity, of a specific quality at a pre-determined date in the future.
To engage in hedging or trading, a commodity trader in Delhi is required to pay an initial margin of around 5-8% of the total value of the transaction. This means that if 1 contract of Aluminum is bought or sold at INR 120/kg then the total transaction size would be INR 600,000 (since the market lot size of Aluminum is 5 MT per contract). The commodity trader in Delhi will be required to pay only around INR 30,000 (assuming an initial margin of around 5%) to execute a trade in the said contract.
Settlement of Commodities
So how does it all work? Let me first clear the air about the process of trading a contract. An investor trading commodities from Delhi could choose to take delivery once the contract expires or he could clearly mention that he does not want delivery and would choose for a cash settlement. Many may wonder what this means exactly? Let’s take it one step at a time.
If I’m a commodity trader in Delhi exposed to the risk of falling copper prices, then I would like to sell a Copper Futures Contract to hedge my outstanding risk. In such a scenario I would be using a future contract as a hedging instrument.
A future contract of copper has an underlying quantity of 1000 kgs. Let’s suppose the price of copper is 300/kg and I feel that it may fall to 275 in the coming month. I have the choice then to short/sell a future contract at the price of 300/kg. This is in simple language would mean that I have the obligation to sell 1000 kgs of copper at 300/kg when on the expiry date. Now one may wonder how this would be possible since I don’t have any copper to sell and I was just trying to hedge my portfolio risk.
There are two ways this could play out. One, the investor chooses that he will settle the contract with physical delivery and the other is that he chooses to liquidate his position. In the second option, a few days before the expiry date he would settle the contract by buying back the same number of contracts that he had initially sold. The gain or loss in the exercise would be settled as marked to market.
The second situation could be that at the delivery date I have not liquidated my position. In such a scenario I’m obliged to supply 1000 kgs of copper. In the case of base metals, such a scenario would result in the position getting squared off at the exchange auction rate of copper since delivery of 1000 kgs of copper isn’t feasible. Therefore the exchange will square-off my position at the rate decided at the time of square off. In case of Agro-commodities, if the contract is not squared off or liquidated then the holder of the contract is obligated to make the delivery (in case he had sold a contract). If the delivery can’t be made he is obliged to pay a penalty in the range of 5-10% of the total transaction size (not of the initial margin).
MTM: What it is and how it works?
For future contracts there is a concept of MTM that is used to negate counterparty risk. At the end of each day the position of the contract holders is Marked to Market. MTM is a mechanism by the virtue of which the exchange ensures that both parties do not default on their dues.
Let me explain this through an example. I’m a commodity trader working out of Delhi. I take a position in the market by selling a future contract that expires in a month. I had bought the contract of Aluminum at the rate say 120/kg. The lot size of Aluminum is 5 MT or 5000 Kgs. Now at the end of day 1 the price moves up to 122/ kg. This means the counterparty of the contract owes me INR 2/kg or INR 10000 for the contract. This INR 10000 has to be paid by the counterparty to his broker at the end of the day. In my account, INR 10000 would be credited. If I choose to liquidate my position here, I would end up with a profit of INR 10,000. I choose to hold on and not liquidate.
Now let’s move to day 2, the price of Aluminum crashes to 119. The price fell by INR 3 from the previous day. This time, I am required to give a margin of INR 15000 to the broker and the same is credited to the counterparty. This is functioning of MTM which minimizes counterparty risk.
Commodity Exchanges in India
There are 3 major exchanges in commodities that provide opportunities to trade in commodities from Delhi. Namely, they are Multi Commodities Exchange of India (MCX), the National Commodities and Derivatives Exchange (NCDEX) and the National Multi Commodity Exchange (NMCE). These are national exchanges and one can only trade on these through an intermediary (Broker).
The MCX is the largest in the country in terms of turnover and participation. This is the exchange that focuses more on the Metals. Base Metals such as Aluminum, Copper, Nickel, Zinc and Lead are traded on the exchange. Out of the Precious Metals Gold and Silver Contracts are traded. In terms of Agro-commodities, 5 different contracts are traded (namely Kapas, Mentha Oil, Crude Palm oil, Cotton and Cardamom). Under Energy the focus is on Crude oil and Natural Gas contracts. NCDEX, on the other hand focuses more on the agro-commodities. It has a wider range of agro-commodities contracts as compared to the MCX.
To trade Commodities in Delhi, the first step for an individual should be to identify a Broker who would provide the technological platform to execute the trades. One must make sure the Broker has the relevant memberships to the exchanges.