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Things to know before you start trading in commodities

Last decade there emerged a new avenue for retail investors and traders to participate: this was the new modified electronic platform of commodity derivatives. For those who want to diversify their portfolios beyond shares, bonds and real estate, commodities emerged as an alternative tool and one of the best option across the globe. Till some years ago, this wouldn't have made sense. For retail investors, they could have done very little to actually invest in commodities beyond gold and silver however the emergence of state of the art technology and methodologies it became possible to think beyond traditional asset class and invest or manage the risk in various other commodities like chana, oilseeds, crude oil and copper etc. in the futures market.

However, with the setting up of three multi-commodity exchanges in the country around 2003-04, market participants like traders, manufacturers, retail investors can now trade in commodity futures with or even without having physical stocks.

So first of all the question arises - what are commodities? And what are Commodity Markets?

In economics, a Commodity is a marketable item produced to satisfy wants or needs. In other words commodity is a raw material or primary agricultural product that can be bought and sold, such as copper or coffee. It include all raw or primary products are exchanged is called commodity market. Commodity markets can include direct physical trading and derivatives trading in the form of spot prices, forwards, futures and options.

Commodity Futures are contracts to buy/sell specific quantity of a particular commodity at a future date on an exchange platform. It is similar to the Index futures and Stock futures but the underlying happens to be commodities instead of Stocks and indices.

The Government of India permitted establishment of National-level Multi-Commodity exchanges in the year 2002 -03 and accordingly following exchanges have come into picture.

  • Multi-Commodity Exchange of India Ltd, Mumbai (MCX).
  • National Commodity and Derivatives Exchange of India, Mumbai (NCDEX).
  • National Multi Commodity Exchange, Ahmadabad (NMCE).
  • Indian Commodity Exchange (ICEX)
  • ACE Derivatives & Commodity Exchange Ltd.

However, there are number of regional commodity exchanges also functioning all over the country with one or two commodities in hand.

Why Commodity Trading?

Commodity trading can be done for various purposes out of which two are most important

1. Against the exposure towards physical trades -for risk management (Hedging)
Hedging is the practice of offsetting the price risk inherent in any cash market position by taking an opposite position in the futures market. A long hedge involves buying futures contracts to protect against possible increasing prices of commodities. A short hedge involves selling futures contracts to protect against possible declining prices of commodities.

2. Having no exposure in physical form - Investment & Speculation
Speculation is the practice of engaging in risky financial transactions in an attempt to profit from short or medium term fluctuations in the market value of a tradable good such as a financial instrument ex-commodity

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