A commodity is a product having commercial value that can be produced, bought, sold,
and consumed.
A derivative contract is an enforceable agreement whose value is derived from the
value of an underlying asset; the underlying asset can be a commodity, precious
metal, currency, bond, stock, or, indices of commodities, stocks etc. Four most
common examples of derivative instruments are forwards, futures, options and swaps/spreads.
Commodity future is a contract to buy or sell specific commodity, of a specific
quality, at a specific price, for a specific future date on the exchange.
A forward contract is a legally enforceable agreement for delivery of goods or the
underlying asset on a specific date in future at a price agreed on the date of contract.
Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of
goods, which are settled by payment of money difference or where delivery and payment
is made after a period of 11 days, are forward contracts.
Futures Contract is a type of forward contract. Futures are exchange traded contracts
to sell or buy standardized financial instruments or physical commodities for delivery
on a specified future date at an agreed price. Futures contracts are used generally
for protecting against rich of adverse price fluctuation i.e. hedging.
Futures prices evolve from the interaction of bids and offers emanating from all
over the country which converge in the trading floor or the trading engine. The
bid and offer prices are based on the expectations of prices on the maturity date.
In simple terms, long position is a net bought position.
In a spot market, commodities are physically bought or sold usually on a negotiable
basis resulting in delivery. While in the futures markets, commodities can be bought
or sold irrespective of the physical possession of the underlying commodity. The
futures market trades in standardized contractual agreements of the underlying asset
with specific quality, quantity, and mode of delivery whose settlement is guaranteed
by regulated commodity exchanges.
As in capital markets, a commodity exchange is an association or a company or any
other body corporate that is organizing futures trading in commodities and is registered
with FMC (Forward Market Commission). Two major national level commodities exchanges
are Multi Commodities Exchange of India (MCX), National Commodities and Derivatives
Exchange of India (NCDEX).
Commodity Market in India is regulated by Forward Market Commission (FMC) under
the guidance of the Ministry of Consumer Affairs, Food, & Public Distribution.
The biggest advantage of trading in commodity futures is price risk management and
price discovery. Farmers can protect themselves against undesirable price movements
and decide upon cropping pattern. The merchandisers avoid price risk. Processors
keep control on raw material cost and decreasing inventory values. International
traders also can lock in their prices
Hedging means taking a position in the futures or options market that is opposite
to a position in the physical market. It reduces or limits risks associated with
unpredictable changes in price. The objective behind this mechanism is to offset
a loss in one market with a gain in another.
Arbitrage is making purchases and sales simultaneously in two different markets
to profit from the price differences prevailing in those markets. The factors driving
arbitrage are the real or perceived differences in the equilibrium price as determined
by supply and demand at various locations
It is a document issued by a warehouse indicating ownership of a stored commodity
and specifying details in respect of some particulars, like, quality, quantity and,
some times, indicating the crop season. The original depositor or the holder in
due course can claim the commodities from the warehouse by producing the warehouse
receipt
Yes, the identifier is called as ICIN. Depending on the type of commodity, grade,
validity, expiry date, name & location of warehouse, the exchanges allot ICIN to
each commodity. ICIN differs from exchange to exchange.
Commodities have predefined lot sizes (set by the respective exchanges as per existing
regulation) where current price of a particular commodity, for selected expiry,
is shown in contract information available & rate units differ for different commodities.
The standard unit based on which the price of the contract is quoted for trading
is called quotation or base value. E.g. for gold contract, the quotation or base
value is 10 grams while it is 1 kg in case of silver on MCX.
It is the quantity of a commodity specified in the contract as tradable units. The
lot size is different for each commodity. The details about lot sizes / delivery
lot can be obtained from the respective exchanges’ website. Each contract has a
lot size and a delivery size, which are not the same; in the case of gold, the lot
size on the NCDEX is 100 gm while the delivery size is 1000 gm. If a person wants
to enter into a delivery settlement for gold, he will have to enter into a minimum
of 10 contracts or multiples thereof. Market participants are required to negotiate
only the quantity and price of the contract, as all other parameters are predetermined
by the exchange. Please note the trading/delivery lot varies from exchange to exchange.
The cost-of-carry of a commodity is the sum of all the costs including interest,
insurance, storage costs, and other miscellaneous costs. Usually, the commodity
futures price in the exchange is the spot price plus cost-of-carry.
Basis is the difference between the spot price of an asset and the futures price
of the same asset underlying. The spot price is the ready price prevailing in the
physical commodity market while the futures price is the price of any specific contract
that is prevailing in the exchanges where it is traded
It is the minimum percentage of the contract value required to be deposited by the
members/clients to the exchange before initiating any new buy or sell position.
This must be maintained throughout the time their position is open and is returnable
at delivery, exercise, expiry or closing out.
It is the extra margin imposed by the exchange on the contracts when it enters the
concluding phase i.e. it starts with tender period and goes up to delivery/settlement
of trade. This amount is applicable on both the outstanding buy and sell positions
Mark-to-market margins (MTM or M2M) are payable based on closing prices at the end
of each trading day. These margins will be paid by the buyer if the price declines
and by the seller if the price rises. This margin is worked out on difference between
the closing/clearing rate and the rate of the contract (if it is entered into on
that day) or the previous day's clearing rate. The Exchange collects these margins
from buyers if the prices decline and pays to the sellers and vice versa.
The contract enters into the tender period a few days before the expiry. This enables
the members to express their intention whether to give or take delivery.
It is the rate at which the contract is settled on the expiry date. Usually it is
the average of the spot prices of the last few trading days (as specified by the
exchange) before the contract maturity.
Spread is the difference between prices of two futures contracts of the same underlying
commodity. Futures market can be a normal market or an inverted market. If the price
of the far month futures contract is higher than the near month one, then it is
referred to as “normal market”. On the other hand, if the price of a far month futures
contract is lower than the near month one, then the situation can be referred to
as “inverted market”.
In most commodities and financial derivatives market, the term refers to buying
contracts maturing in nearby month, and selling the deferred month contracts, to
profit from the wide spread which is larger than the cost of carry.
In most of commodities and financial derivatives market, the term refers to selling
the nearby contract month, and buying the distant contract, to profit from saving
in the cost of carry.
Rolling over of hedge position means the closing out of existing position in the
futures contract and simultaneously taking a new position in a futures contract
with a later date of expiry.
A calendar spread means taking opposite positions in futures contract of the same
commodity with different expiry dates. It is also known as an intra-commodity spread.
It is a process of settling a futures contract by payment of money difference rather
than by delivering the physical commodity or instrument representing such physical
commodity (like, warehouse receipt). In India, most of the future trades are cash
settled.
Yes, like equity markets, commodity market has circuit breakers. Exchanges have
circuit filters in place. The filters vary from commodity to commodity but the maximum
individual commodity circuit filter is 6 per cent. The price of any commodity that
fluctuates either way beyond its set price limit will fall in circuit breaker category.
A. Credit risk: Credit risk on account of default by counter party: This
is very low or almost zeros because the Exchange takes on the responsibility for
the performance of contracts
B. Market risk: Market risk is the risk of loss on account of adverse movement
of price.
C. Liquidity risk: Liquidity risks is the risk that unwinding of transactions
may be difficult, if the market is illiquid
D. Legal risk: Legal risk is that legal objections might be raised; regulatory
framework might disallow some activities.
E. Operational risk: Operational risk is the risk arising out of some operational
difficulties, like, failure of electricity, due to which it becomes difficult to
operate in the market.
A settlement takes place either through squaring off your position or by cash settlement or physical delivery. Squaring off is taking a opposite position to the initial stance, which means in the case of an original buy contract an investor would have to take a sell contract.
An investor who intends to give or take delivery would have to inform his broker of the same prior to the start of delivery period. In case of delivery, a warehouse receipt is provided. Delivery is at the option of the seller; a buyer can take delivery only in case of a willing seller. All unmatched/rejected/excess positions are cash settled; all open positions for which no delivery information is submitted are also cash settled. Under cash settlement, the difference between the contract price and settlement price is to be paid or received.
In online commodity trading, client can not go for delivery & all positions are cash settled.
While trading in commodities, with any registered broker, client has to pay certain charges (apart from margin requirements for trading) which are as follows:
- Brokerage
- Servicetax
- EducationCess
- Exchange Transaction Charges
- Stamp Duty
- Commodity Transaction Tax (CTT)