Commodity Trading - Strategies and Tips

Commodity trading is a prominent trading segment in India with deep historical roots. Commodity trading through exchanges began in 1875 with the Bombay Cotton Trade Association. However, its roots can be traced back to the Vedic period.

The commodities market in India is valued at approximately US$998.03 billion. It is projected to grow by 1% each year. Experts expect it to reach US$1039 billion by 2028.

While this historical perspective is interesting, understanding the basics is crucial for anyone looking to begin commodity trading. Here is a brief insight into commodity trading for beginners.

What is Commodity Trading?

Commodity trading involves buying and selling items like gold, silver, oil, gas, and crops on exchanges like MCX and NCDEX. Commodity traders try to make money by buying and selling commodities when their prices go up or down. 

They can do this in the spot market or through derivatives like forward contracts, futures, and options. Traders use commodity trading to diversify investments and hedge against price fluctuations to reduce risk in their portfolio. 

Types of Commodities

The commodities market includes a variety of goods, categorized as hard and soft commodities. Here is a closer look at the different types of commodities.

• Agricultural Commodities

Agricultural commodities include products that are grown or harvested. This category includes grains like wheat, rice, corn, and other crops such as coffee, cotton, sugar, and soybeans. Farmers and producers trade these commodities to secure prices for their crops. Traders try to make money by taking advantage of price changes caused by seasons, weather, or supply and demand.

• Energy Commodities

Energy commodities are resources used to produce power and fuel. This category's most commonly traded energy commodities are crude oil, natural gas, and heating oil. These commodities are heavily traded worldwide and are considered vital for global economies. Various factors, such as geopolitical events, supply and demand dynamics, and technological advancements in energy production, influence the prices of these commodities.

• Metal Commodities

Metal commodities consist of both precious metals and industrial metals. Precious metals include gold, silver, platinum, etc. and are often seen as safe-haven investments, especially in economic uncertainty. Industrial metals, such as copper and aluminium, are essential for construction, manufacturing, and various other industrial processes. Prices of commodities in this category are affected by economic growth, industrial activity, and currency fluctuations.

• Livestock and Meat Commodities

This category of commodities is often considered an extension or ancillary to the agricultural commodities segment. Livestock and meat commodities include animals raised for meat production and related products. Examples in this category include live cattle, lean hogs or feeder cattle. Traders trade these commodities to profit from price changes influenced by feed costs, disease outbreaks, and consumer demand.

• Environmental Commodities

Environmental commodities are a newer category that includes items like carbon credits and renewable energy certificates. These are used in trading schemes to reduce greenhouse gas emissions and promote sustainable energy. The market for environmental commodities is expanding worldwide, including in India. More and more people are committed to going green and fighting climate change, which is driving this growth.

How to Trade Commodities?

Commodity trading is a popular trading segment in India and has gained huge participation over the years. So, the next question for beginners is how and where to begin commodity trading. Here are the essential steps. 

• Open a trading account with a registered broker and complete the KYC process to begin.

• Learn the basics of commodity trading and its nuances, such as the settlement process, factors affecting commodity prices, etc. 

• Select the commodities to trade based on your research and market conditions.

• Develop a trading plan that fits your risk tolerance and investment goals. Make sure you understand the trading strategies and risk management techniques. 

• Transfer funds in the trading account to support the selected trades and avoid penalties on account of shortfall. 

• Keep an eye on market trends to manage risks. Act to exit trades when reaching profit goals or to minimize losses.  

What Moves Commodity Prices?

Several factors, internal or external to a geographical space, influence commodity prices. A few top factors affecting commodity prices are mentioned -

• Supply and Demand: The most fundamental factor affecting commodity prices is the balance between supply and demand. Prices tend to fall when supply is high and demand is low. Conversely, when demand outstrips supply, prices rise.

• Weather: Weather can directly affect commodity prices, especially for agricultural commodities. Extreme weather like droughts, floods, and hurricanes can significantly impact. Such conditions can lead to poor crop yields, leading to higher prices due to limited supply.

• Economic Indicators: Macroeconomic factors such as inflation, interest rates, and GDP growth significantly influence commodity prices. For example, high inflation can increase commodity prices as the value of money decreases.

• Government Policies: Government policies and regulations, such as subsidies, tariffs, and trade policies, can directly impact commodity prices. Government rules, like limits on exports, can lower the amount of goods available worldwide, making prices for those goods go up.

• Market Speculation: Speculation is quite common in commodity markets. Traders and investors often speculate on future price movements, leading to price volatility. Speculative trading in large volumes can drive prices up or down based on market sentiment rather than fundamental factors.

What are the Differences Between Hard and Soft Commodities?

Commodities are primarily classified as hard commodities and soft commodities. Understanding these types of commodities is essential in learning commodity trading basics. Here is a brief explanation of the meaning of hard and soft commodities.

Hard Commodities

Hard commodities are natural resources extracted or mined from the earth, such as metals (gold, silver) and energy resources (crude oil, natural gas, coal). They are crucial for industrial processes, manufacturing, and energy production, requiring significant capital investment and long production cycles. Factors like geopolitical events, technological advancements, supply and demand dynamics, and economic growth influence the prices of hard commodities. Hard commodities serve as a hedge against inflation and currency fluctuations, making them appealing for long-term value preservation.

Soft Commodities 

Soft commodities are agricultural products like wheat, corn, rice, coffee, cotton, sugar or livestock like cattle and hogs. These commodities are grown or harvested with shorter production cycles and are subject to seasonal variations.

Weather conditions, seasonal cycles, pests, and diseases influence their prices. For example, droughts can reduce crop yields, increasing grain prices, while livestock diseases can disrupt meat supplies, driving prices up. Soft commodities are vital for daily consumption and directly impact food security in meeting consumer demand.

Commodity Trading Tips

The size of the commodity market in India is a testament to the increasing number of traders participating in commodity trading. However, if you are a beginner in this market then here are a few commodity trading tips that can ensure a smooth trading journey. 

• Learn about the commodity market and understand how prices are influenced by economic factors. 

• Start trading with extra money first. Once you have a solid trading plan and feel confident, you can trade with more funds to avoid financial problems.

• Diversify the commodity trading portfolio and use effective hedging strategies to minimise risk and capitalise on evolving market conditions. 

• Develop a solid trading plan with good risk management strategies, such as using stop loss or trailing stop loss orders. This will help you manage risk and stick to your trading goals. 

• Monitor commodity market trends by using tools such as charts and indicators. This will help you identify favorable times to make purchases and sales.  

Conclusion

Commodity trading is important in the financial markets. Traders use price changes to make money and protect against stock market risks. To succeed in commodity trading, it is important to understand the basics and use effective risk management strategies.