Here's all you ever wanted to know about Commodity Futures

Most seasoned investors usually get mind boggled by the Commodity Futures segment of the Indian equity market. In an interview to CNBC-TV18, Kishore Narne of Motilal Oswal breaks down the complex subject of commodity futures.

Narne in detail explains how to go about commodity futures and what precautions are to be kept in mind before one becomes a full fledged investor. Narne also explain how one can successfully trade into bullion and how the metals fare among each other.
On what are the fundamental differences between the equity and commodities market, Narne says it is the mindset of the investors. "One will find a lot of volumes in commodity markets coming from upcountry rather than metro cities. Metro cities typically contribute lesser volumes. Upcountry, a lot of people feel comfortable trading commodities than the equities. They feel that probably understand chana much better than understanding Infosys Technologies," adds Narne Below is the edited transcript of Narne's interview to CNBC-TV18. Q: What all are the different commodities in which Indian investors can play the derivatives segment?
A: The entire market can be broadly divided into two major segments - agricultural commodities and non-agricultural commodities. Within non-agricultural commodities there are have commodities like precious metals, industrial metals and energy complex. These are typically broad based commodities.
In agricultural commodities there are grains which are typically the staples, softs like sugar and cotton and other exotic commodities like guar and spices. It includes a lot of things. Everything that is a tangible commodity can be traded.
As far as Indian commodity market's definition goes, anything which is raw in form and can be delivered, can only be traded. So, unlike the western counterparts where the Weather Futures, Rain Futures, other derivatives are traded which are non-deliverable, Indian market does not allow them. So, it is purely deliverable commodity market. Q: Across the basket which are the five most traded commodities?
A: Silver is the number one, followed by gold, copper, then crude oil and natural gas. These are the top five commodities basket. So, I think in India market is completely skewed towards these five commodities. About 75-80 percent of the Indian volumes happen in these. Q: When you are looking for a commodities exchange what should one be looking out for because one needs a contract which is liquid, where you can easily make a position, you will find a buyer or a seller at the opposite end as well. Where do you find a comprehensive list and how should you locate the place where you find liquidity for yourself?
A: Nearly 80-90 commodities are listed on Indian market and if I am not being very optimistic about that, one can probably find almost all the commodities. If you are a retail investor, the liquidity is not a big problem. The issue is that in the last bottom 10 of the commodities, spices and some of the smarter commodities like rubber and cardamom. If you are investor who is investing Rs 2-5 lakh investment, you will find enough liquidity and you will not find any problem in entering or exiting these commodities. Q: What are the key differences between equities and commodities?
A: The primary difference between these two market itself is that the investors are typically different. The mindset is completely different.
One will find a lot of volumes in commodity markets coming from upcountry rather than metro cities. Metro cities typically contribute lesser volumes. Upcountry, a lot of people feel comfortable trading commodities than the equities. They feel that probably understand chana much better than understanding Infosys Technologies.
For him, he looks at chana, goes to the mandi. He trades this day in and day out, so he feels much more connected. Because he has that habit of trading commodities, he also trades in gold and silver irrespective of whether he knows something about them or not.
The predominant difference is that there is a very high amount of leverage in commodity markets. Secondly, most of the commodities have different expiry cycles and different months of trading. Agricultural commodities are traded 9-10 months out of 12 months.
There are two months which do not have contracts; typically these are the harvest months. So, when one is trading in agricultural commodities he should be aware of when the crop is sown, when the crop is harvested. It is like fundamentals in equities.
If one is trading gold, it is nothing but a Xerox copy of the COMEX contract. So, typically the expiries work on bimonthly basis. Gold and silver are bimonthly. There are six contracts in a year. There is no contract for every month.
For copper, it is a 12-month contract, so every month there is a contract. Even for industry metals like nickel, zinc, led, every month there are new contracts. The expiry is also different. For few commodities like mentha oil, the 31st of every month and for gold and silver the last working day of the previous month is typically its expiry.
Most of the agricultural commodities are 20th of the month. There are concepts like staggered delivery. In agricultural commodities, the last 15 days before the expiry, any day you can get a delivery. So, as a buyer one should be aware that any point of time one might get a delivery and one can be asked to pay the 100 percent amount of commodity and the investor will get a commodity in his/her demat account.
If one is not interested, then he should rollover and get out of this position and go to the next month. So, the investor should take care of these basic things before turning an investor in commodity market. Q: For a financial investor what are the broad things that he needs to take care of and how easy is this market to manage if your sole agenda is to bet on a commodity, make profit and exit?
A: One common thing that a lot of investors come and say is I want to make money in gold or I want to make money in crude oil. I think it is something like saying that I want to make money in Infosys or Reliance Industries. The investor should be looking at the whole market as a perspective. He comes to equity market. He tries to say that I will invest X amount of money into consumer durables. I will invest X amount of money into telecom. There is a sector-wise differentiation or he will say that I will invest in Index 30 stocks, something like a portfolio or something like that, but in commodities unfortunately people say that I want to make money out of natural gas itself which becomes extremely difficult. If you are trading the same commodity every day or on a daily basis your success rate of making money will go down.
My suggestion is concentrate or believe in the opportunity, not in the commodity. Divide your money. Probably you can say that at this point of time chana is looking much better than natural gas. So probably you have nothing to do with chana, neither natural gas. You are a financial investor. You are looking for a profit. So you can see chana prices going up because of so and so reason, so you have an open interest (OI) built up or you have various derivatives data which are available. So the opportunity is more important than the commodity.
Spreading your money into various commodities is extremely essential here and keeping your leverage in control. Commodity markets tend to provide you that extra leverage. So a lot of times it acts as a double-edged sword and goes against you as well. A lot of times people look at the positive side of the leverage and they forget about the negative side and they end up making huge loss and complain that commodity markets are bad. Q: If there is an investor who allocates Rs 1 lakh for an investment in commodities should he go out and purchase commodities worth Rs 1 lakh or does there have to be Rs 25,000 investment - how does he manage it?
A: The first thing that one should remember is with Rs 1 lakh margin, it is not the capital one can buy. If someone is buying gold at 5 percent margin at the exchange, one has 20 times leverage. So, Rs 1 lakh worth of investment gives you exposure of Rs 20 lakh. One should be very much aware that your risk or your profitability is on Rs 20 lakh, not on Rs 1 lakh. If Rs 20 lakh worth of commodity moves by 1 percent let us say it is almost Rs 20,000 so your Rs 1 lakh will be down or up by 20 percent. It is always multiple times.
The same thing happens in equity derivatives also. But equity derivatives have higher margins. Let us say, 10 percent is the Nifty Futures and from there it goes up to 25-30-40 percent also in some stocks. But here it is at 5 percent and in some cases it goes up to 10-12 percent so we have higher leverage.
What happens is, when someone is investing, the investor has to look at the exposure not the investment. On Rs 1 lakh, one is willing to lose 10 percent of the money so the first thing the investor has to decide is how much I am willing to lose. One has to start with that. I am comfortable with losing Rs 20,000, that is 20 percent of my capital, that is my risk appetite so I can look for a return somewhere around 25 to 40 percent or 30 percent, whatever it is.
There is an objective of profitability and there is a risk parameter. Do I want to lose this entire Rs 20,000 in one single trade or I want to distribute into ten different trades? If one has to distribute it in ten different trades, per trade I have to lose Rs 2,000 so I need to buy a commodity which should be moving Rs 2,000 or less in a day, so my risk is under Rs 2,000. This means my stop loss should be somewhere in that range. So if the trade goes against me I will lose Rs 2,000 only and still have Rs 98,000 to trade the next day.
A lot of people what they do is, they calculate that okay I want to have 10 percent stop loss but this 10 percent on Rs 20 lakh which goes to 200 percent of their actual investment. They end up losing more money than what they invested, so it is more or less mismanagement of leveraging, mismanagement of capital allocation and mismanagement of risk management policy. I think these are the things that go wrong in commodities. Q: In which case the one thing that we were established that the investor has to ask not how much we want to make but how much am I willing to lose, how much can I tolerate, how much pain can I tolerate? If you had that Rs 1 lakh how would you advice the investor to go about building his position over the span of the year because two things that you have mentioned. One, the diversified portfolio, here the portfolio seems to be far more complex because there are commodities with different expiries. There are some which have a two month contract but not a single month contract. Some of them don't trade when there is harvest season - how would you advice them?
A: Let us say that I would like to lose 20 percent of the capital so my risk tolerance is Rs 20,000, so in a trade I should be putting not more than Rs 2,000 as stop loss. I need to distribute this among various commodities. If I am trading gold and silver - I buy gold and I buy silver, actually I am doubling my positions. Commodities move in the same direction so these are fundamentally the same, they are both precious metals, they react in the same way so I am doubling my risk.
I need to offset the risk through something else. I will trade gold but I will trade something else like copper which is an industry metal. The logic is if the economy is prospering, industry metals too should go up and the safe haven like gold and silver should come down so there is an offsetting risk advantage, one has to distribute in that way.
Secondly, one can distribute somewhat in agriculture commodities. Agricultural commodities are much more safer than most of the metals because one has an intrinsic value. A truck load of chana cannot go down by 20-30 percent in a day which is more or less possible in stocks. Most of the stocks, one can see a 10 percent movement in a day but none of the commodities move 10 percent even once in 4-5 years. That is one major advantage of commodities.
One needs to diversify this, one. Two, yes there are various maturities but your portfolio has to be reviewed almost every week. It is a weekly basis review of portfolio and it needs to be tracked on a daily basis. If one does not have that much time that one can spare half an hour to reposition yourself in the markets, one should not be in the commodity markets. Two, one should have enough buffer capital where one can pump in money for mark to market purposes.

So, one should never be 100 percent invested. My suggestion is that one should never be more than 50 percent exposed. So let us say one wants capital of Rs 1 lakh, one should never be utilizing more than Rs 50,000.