Why commodity trading can be an attractive asset class for retail investors

For retail investors, trading in commodities is much easier as it does not require the detail fundamental analysis that goes with stock picking. It is a case of pure supply and demand. If monsoon is good agriculture commodity tends to go down and if it is below normal their prices tend to grow. Likewise, hard commodities like metals if global economy is booming, their demand and prices tend to grow while if growth is subdued their prices tend to fall.

In short, there are few variables that need to be monitored for tracking a commodity. Since commodity cycles are of longer term they tend to trend longer as compared to equities. Further, since they are highly liquid markets, which are interlinked globally, it is difficult to manipulate them and makes it easy for traders to participate in it.

In India, trading is allowed through futures exchange and is closely and carefully monitored by market regulator SEBI after Forward Market Commission was merged with it. Today, there are three commodity exchanges that allow trading in commodities.

Here are some of the key features that can help a retail trader participate in the commodity markets.

For a retail trader who wants to participate in the commodity markets, it is as simple as opening a normal broking account with your local broker provided the broker is a member of the commodity exchanges. As volatility is low in commodities, the margin required to trade is also low. One can build up a position with a small margin of Rs 5,000.

Margin requirement is in the 5-10 percent range as compared to 30-40 percent in individual stocks in the equity markets. However, low margin is a double-edged sword. Just because it is small many traders tend to take a higher exposure and a sudden move in the opposite direction can not only wipe out the existing margin but it can also result in demand for more. Thus, risk management plays a more important part in commodities than it would in equities.

Unlike equities there is one parameter than a trader needs to remember. In equities, the unit of a futures lot is always the number of shares. For example, one lot of Reliance will comprise say 500 shares. But in case of commodities the unit changes depending on the commodity. It can range from kilograms to tonnes to pound to bushels and barrels. The trader needs to be aware of the unit of the commodity that he is trading.

Another factor is deliveries of goods purchased. In derivatives markets, there are generally very few deliveries across the world, but still investors need to know that deliveries are possible of the underlying goods. Exchanges allow cash as well as delivery settlements. Deliveries are generally preferred either by consumers or producers who had hedged their position in the market.

This brings us to the question of who are the players in the commodity market. Commodity markets mainly comprise hedgers, speculators and arbitrageurs. It is the last category of players who contribute the maximum volumes in the market. As global commodities are linked, it offers good opportunities for savvy players to arbitrage and speculate. There is, however, another leg of currency hedge that needs to be taken care of when taking arbitrage position. Arbitrageurs these days are normally algorithmic based and leaves very little room for a retail investor to capture.

Hedgers on the other hand are either producers or consumers who take a position in the market to lock their price risk. Thus, if a producer of say copper feels that prices are good in the futures market, he would sell it in the market to lock his price. If prices comes down after he creates a position, then he benefits from the fall in futures price, though he might realise less by selling in the physical goods in the cash market.

Similarly, if the price increases, the hedger would lose in the futures market, but this loss would be taken care of in the cash market when he sells the good on delivery.

Speculators are another big player in the commodity market. As mentioned earlier, the trader has a choice of taking a position based either on fundamentals or if he is adept with technical analysis he can use. Being liquid markets, technical analysis also works well in this market. The same rules and strategies of technical analysis that are used in equity markets can be used in commodities.

But tracking fundamentals is far easier as its demand-supply changes are miniscule in commodity markets as they are all developed markets with set suppliers and consumers. Key events like monsoon in growing case of agriculture commodities and overall economy growth for all other products can give a broad idea to get a view on the commodity.

Some of the biggest traders globally have made money in the market by trading commodities because of its nature of being relatively less volatile. A new trader can learn the trick of the trades much better in the commodity market than in equity markets.

(The writer is Executive Director of Trade Smart Online)