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Tuesday, September 2, 2008

Commodities Trading

Commodities exchange

What does commodities trading involve? the how, what and were of the field :-

HAVE you ever given a thought to why the price of gold changes each time you go to buy ornaments? Or why the government keeps announcing hikes and cuts in diesel prices every now and then? These issues concern the common man, but the reasons behind them might not be comprehensible to the average person, who cannot do much, except, express pleasure or displeasure.

A commodity is defined as an article, product or material that is bought and sold. It can be classified as every kind of movable property, except actionable claims, money and securities.The prices of commodities such as precious metal, base metal, crude oil, energy and soft commodities like palm oil, coffee, etc are regulated and priced in international commodity markets, and it is these prices and fluctuations that get passed on to the ultimate consumer. In due course, several other exchanges were created in the country to trade in diverse commodities.


Circa 2007, we have certainly come a long way.The size of the commodities markets in India is quite significant, with 58% of the country's GDP being related to commodities. The Indian stock markets have seen an unprecedented growth in the last three years. The equity-space is also more specialised, as the risk and return, both stand to be high, with prices not being as related to fundamentals, as on sentiments, as compared to what most goods ought to be.

"Commodities actually offer immense potential to become a separate asset class for market-savvy investors, arbitrageurs and speculators, as in the case of commodities, fundamentals of demand and supply are far easier to understand than the equity markets," says Nitin Bhandari, a trader at one of India's leading commodity trading firms. Historically, too, pricing in commodities futures have been less volatile compared with equity and bonds. Currently, the various commodities across the country clock an annual turnover of over Rs 1,40,000 crore and with the introduction of futures trading, the size of the commodities market is likely to grow exponentially.

Over the last few years, the Indian government has allowed the setting-up of national commodity exchanges, similar to the BSE and NSE that would deal in commodity derivatives via an electronic trading platform The Forward Markets Commission (FMC) would regulate these exchanges. Among the prominent national commodity exchanges set up are the Multi Commodity Exchange (MCX), Mumbai, the National Commodity and Derivatives Exchange Ltd (NCDEX), Mumbai, the National Multi Commodity Exchange (NMCE), Ahmedabad and the National Board of Trade (NBOT), Indore. Resident individuals and corporates in India are allowed by the Indian government to trade commodity derivatives. However, the provision has not been extended to banks, funds and financial institutions in India so far.


Commodities are traded in two distinct forms, via over-the-counter (OTC) market and via the exchange-based market. The spot transactions in the commodity segment are over-the-counter markets and only those players are allowed to participate, who are involved with that commodity, for example, the farmer, processor, wholesaler, etc. Derivative trading in the commodity space, however, takes place through exchangebased markets with standardised contracts, settlements etc.

A commodity derivative is defined as a financial instrument, traded on or off an exchange, the price of which is directly dependant upon the value of the underlying commodity, or upon any agreed upon pricing index or arrangement. Derivatives involve the trading of rights or obligations based on the underlying product but do not directly transfer property.

"The oddity about commodity derivatives is that, unlike financial derivatives, where the financial assets to be exchanged are not bulky and do not need special facility for storage, commodities, due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Another irregularity in a commodity contract settlement is that the quality of asset can vary, which cannot happen in the case of financial derivatives," adds Bhandari.


There are typically three types of roles in this sector, which are:


Traders are the most important and highly paid resources in this sector. They not only look at the market movement, but also have to keep in mind each and every fundamental such as demand and supply, weather, government policies, and take decisions based on the same.


These individuals are usually highly skilled in economics and number-crunching and are specialists in specific sectors. They are the ones who provide in-depth and regular research to the traders, who then use the same to combine with their judgment and experience and make decisions on buying and selling.


Commodities can be traded on exchanges only if one has membership of these exchanges, which proves to be very costly and cannot be afforded by most individuals and corporates. Broking firms usually provide a platform for trading for the resident individuals, corporates and traders, and are able to trade on exchanges, as they are members of the same.

They have service teams, who take orders from clients, manage the order execution, settlement, paper-work etc. Now, with the Indian government taking away most of the restrictions on the commodity markets, it is time for the common man to take interest in these commodities and their markets, as it is expected to be the next rocketgrowth-story after the Indian equity markets.

Sunil Sharma


Dil Se Desi Group

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