What is Commodity trading?

Commodity trading is the buying and selling of contracts based on commodities like gold, crude oil, wheat, or cotton. Unlike stocks, where you own a part of a company, commodity trading involves derivative contracts linked to these tangible goods.

Think of it like this: when you trade commodities on stock exchanges in India, you're not actually buying physical barrels of oil or sacks of wheat to store at home. Instead, you're trading standardised contracts that represent these commodities. While physical delivery of commodities is possible in some cases, most retail traders deal with cash-settled contracts: when the contract expires, you simply settle the price difference in cash rather than receiving the actual commodity.

In this article, we'll focus on cash-settled commodity trading, which is what most individual traders participate in on Indian exchanges.

How does commodity trading work?

Commodity trading on Indian stock exchanges works through futures contracts, which are agreements to buy or sell a specific quantity of a commodity at a predetermined price on a future date.

Here's a simple breakdown:

The trading process:

• You trade standardised contracts on exchanges like MCX, NCDEX, NSE, and BSE. These contracts are linked to commodities but you're not physically buying or storing the actual goods.
• When you buy a commodity contract, you're taking a position on whether the price will go up or down.
• Most retail traders close their positions before the contract expires by taking an opposite position (if you bought, you sell; if you sold, you buy). This means you settle in cash: you receive or pay the profit or loss based on price movements, without ever handling the physical commodity.

Key components:

• Futures contracts: Standardised agreements specifying the quantity, quality, and delivery date of the commodity.
• Margin trading: You only need to pay a fraction of the contract's total value upfront (called margin), which allows you to control larger positions.
• Cash settlement: For most retail traders, contracts are cash settled, meaning you don't receive the physical commodity. Instead, you pay or receive the difference between your entry price and exit price. Physical delivery is available for certain contracts but is typically used by businesses that actually need the commodity, not individual traders.

Commodity exchanges

Commodity exchanges are organised marketplaces where commodities are traded in a regulated and transparent manner. These exchanges ensure fair pricing, standardisation, and proper settlement of trades.

In India:

• MCX (Multi Commodity Exchange): India's largest commodity exchange, established in 2003. It primarily deals with metals (gold, silver, copper), energy products (crude oil, natural gas), and some agricultural commodities.
• NCDEX (National Commodity & Derivatives Exchange): Launched in 2003, focusing mainly on agricultural commodities like wheat, soybean, cotton, and spices.
• NSE (National Stock Exchange): While primarily known for equity trading, NSE also offers commodity derivatives trading. It provides trading in various commodities including metals and energy products.
• BSE (Bombay Stock Exchange): BSE also offers commodity derivatives trading alongside its equity market operations, providing access to various commodity contracts.

Globally:

• COMEX (Commodity Exchange): Part of the CME Group, known for trading precious metals like gold and silver.
• NYMEX (New York Mercantile Exchange): Focuses on energy commodities such as crude oil and natural gas.
• LME (London Metal Exchange): The world's largest market for trading base metals like copper, aluminium, and zinc.
• CBOT (Chicago Board of Trade): One of the oldest exchanges, specialising in agricultural commodities like corn, wheat, and soybeans.

Regulatory oversight:

Just like SEBI regulates stock markets in India, commodity markets are also regulated:

• SEBI: Since 2015, SEBI regulates commodity derivatives markets in India, ensuring investor protection and market integrity. The Forward Markets Commission (FMC) previously regulated commodity markets before merging with SEBI in 2015.

Types of commodities

Commodities traded on Indian exchanges are generally classified into several main categories:

Metals

Precious metals:

• Gold: Used for jewellery, investment, and as a hedge against inflation.
• Silver: Has industrial applications in electronics, solar panels, and also serves as an investment.

Base metals:

• Copper: Essential for electrical wiring and construction.
• Aluminium: Used in transportation, packaging, and construction.
• Zinc: Important for galvanising steel and manufacturing.
• Nickel: Key component in stainless steel production.
• Lead: Used in batteries and construction materials.

Energy

• Crude oil: The most traded commodity globally, used for fuel and petrochemical products.
• Natural gas: Used for heating, electricity generation, and industrial processes.
• Agricultural commodities

Note: SEBI has suspended derivatives trading for certain agricultural commodities including paddy (non-basmati), wheat, chana, mustard seed and its derivatives, soybean and its derivatives, crude palm oil, and moong until January 31, 2025. Please check current regulatory status before trading in agricultural commodities.

Cereals and grains:

• Wheat, maize, barley, paddy (rice)

Pulses and oilseeds:

• Chana (chickpea), moong (green gram), soybean, mustard seed, castor seed, groundnut

Spices:

• Turmeric, coriander (dhaniya), cumin (jeera), black pepper, cardamom

Cash crops:

• Cotton, kapas (raw cotton), guar seed, guar gum

Oils:

• Soy oil, palm oil, castor oil, sunflower oil, cottonseed oil

What commodities can I trade on Kite?

On Zerodha's Kite platform, you can trade the following MCX commodity options and futures contracts:

Options contracts available:

Trading availability:

• You can trade only the current month's commodity options contracts on Zerodha.
• The next month's options contract becomes available for trading one day prior to the current month's contract expiry.
• Two months' options contracts are allowed for energy contracts (Natural Gas, Natural Gas Mini, Crude Oil, and Crude Oil Mini).
• You can use MIS (Intraday) for energy options contracts.
• MIS is blocked for all other commodity options contracts.
• For MCX futures, all three-month contracts are available for trading, and you can use MIS for these contracts as well.

Understanding lot sizes:

In MCX contracts, the lot size refers to the standardised quantity or volume of a specific commodity traded in a single contract. It represents the minimum quantity of the commodity you can buy or sell in a single transaction on MCX.

You can find the settlement type and last trading dates on this list.

Example: Gold contracts

1. The lot size for gold contracts on MCX is 1 kilogram, allowing you to buy or sell gold in multiples of 1 kilogram.
2. If you purchase one lot of gold contracts, you are transacting with 1 kilogram of gold.
3. If you sell one lot, you are selling 1 kilogram of gold.

Benefits of commodity trading

• Portfolio diversification: Commodities often move differently from stocks and bonds, helping spread your investment risk across different asset classes.
• Inflation protection: Commodity prices typically rise with inflation, protecting your purchasing power when the cost of living increases.
• Leverage opportunities: Margin trading allows you to control larger positions with less capital, potentially amplifying returns (though this also increases risk).
• Global exposure: Commodities are influenced by worldwide supply and demand, giving you exposure to global economic trends.

Common questions about commodity trading

Is commodity trading risky?

Commodity trading can be more volatile than stock trading due to factors like weather conditions, geopolitical events, and supply disruptions. The use of leverage also amplifies both potential gains and losses. It's important to understand these risks and trade within your risk tolerance.

Can beginners start commodity trading?

Yes, beginners can start commodity trading, but it's crucial to:

• Educate yourself about how commodity markets work.
• Start with small positions to understand market movements.
• Use proper risk management tools like stop-loss orders.
• Avoid over-leveraging your positions.

What's the difference between commodity trading and investing in commodity stocks?

When you trade commodities, you're trading derivative contracts based on those commodities (or contracts representing them). When you invest in commodity stocks, you're buying shares of companies that produce or deal with those commodities (like a gold mining company or an oil exploration firm).