25 Jul 2018 19:49 IST

The nuts and bolts of commodity trading

Trading on the Multi Commodity Exchange is safer as non-agri commodities are easier to understand

The ongoing trade war between the US and China has hit commodity prices, particularly of base metals, over the last few months. In the global market, base metals are down 8-22 per cent, while there has been a fall of 3-16 per cent on the domestic front so far this year.

This kind of sharp volatility — whether up or down — is what traders thrive on, provided they are on the right side of the shift.

In India, trading in commodities can be done on two major exchanges — National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX). NCDEX primarily offers agri-commodities and MCX offers non-agri commodities.

The former is riskier to trade if one doesn’t have a deep understanding of the agri-market. Non-agri commodities are relatively easier to understand and trade. In this article, we take a look at what isrequired to trade on the MCX.

What’s on offer

The most actively traded commodities on the MCX can be classified under three categories: precious metals (gold and silver), base metals (aluminium, copper, zinc, nickel and lead) and energy (crude oil and natural gas). The trend in the global prices of these commodities influences their movement in the domestic exchange. So, it is important to track global commodity prices as well.

Gold, silver and copper move in tandem with their respective prices in the COMEX (formerly known as Commodity Exchange Inc). Base metals follow the trend in London Metal Exchange, and tracking crude oil and natural gas on the New York Mercantile Exchange makes it simpler to trade energy commodities on the MCX.

Mode of delivery

There are three delivery modes: compulsory, seller option or a combination of the two. As the name suggests, a compulsory delivery involves physical delivery of the commodity at the time of contract maturity. Gold and silver contracts come under this category.

Under the seller option deliverable contract, sellers can opt to do a physical delivery or not, on a specified date. The third mode is a combination of the previous two options. The physical delivery can be compulsory or optional (cash settlement). Barring gold and silver, all other metals and energy commodities come under this category and are mostly settled with cash.

There is a cut-off time, before the expiry date, to intimate the exchange of how the contract will be settled. This date and time vary across commodities and are available in the Settlement Schedule on the exchange website.

For example, the cut-off time to fix the delivery mode for the base metals contract that expires on July 31, is 6pm on July 26.

Contract specification

The lot size (minimum tradeable quantity) differs for each commodity. For instance, one lot of crude oil contract is equivalent to 30 barrels of oil, while one lot of zinc is equivalent to 5 tonnes. Similarly, the quotation values (the price displayed) on the exchange may differ from the lot size.

For instance, the value quoted for gold (₹29,850) is equal to 10 gm of gold while its lot size is 1 kg, and the value of silver (₹38,200) is for 1 kg and its lot size is 30 kg. So, one lot of gold is equal to ₹29,85,000 (lot size 1 kg – 29,850*100) and one lot of silver is worth ₹11,46,000 (lot size 30 kg – 38,200*30).

Capital requirement and cost

Do you need to cough up huge sums to trade in commodity futures? Yes, particularly when compared to equity or currency derivatives trading.

However, mini contracts, which reduce the cost of trading, are available. These are nothing but contracts of smaller lot sizes. For example, gold-mini is available with a lot size of 100 gm and silver-mini is available at a lot size of 5 kg.

A trader only needs margin money to take position in a commodity and need not shell out the full amount at the time of trading. Margin money is the minimum amount required to buy one lot in any commodity and it is about 5 per cent of the total contract value. So, a trader will require ₹1,49,250 as margin money to buy one lot of gold. Similarly, ₹14,925 is required to trade in one lot of gold-mini. However, in times of volatility, the margin money requirement may shoot up significantly and only traders with deep pockets should consider such trades.

Brokerage and commodity transaction tax (CTT) are costs involved in commodity trading. Given the bigger lot sizes when compared to equities, a CTT of 0.01 per cent is a major cost here.

Extended time

The commodity market is open for a longer duration — from 10 am to 11:30/11:55 pm — when compared to equity or currency markets, which are available only during the day. Since domestic contracts are linked to global commodities, price movements are usually smooth, and speculative activity is minimal. Such long trading hours and prices linked to international factors help avoid the occurrence of huge gap openings, which are frequent in equity and agri commodity markets.