Similar to any other market, the commodities market is either a physical or a virtual space where interested parties can trade commodities at present or future dates. The economic principles of supply and demand dictate the price.
How Does a Commodity Market Work?
Commodities markets allow producers and consumers of commodity products to gain access to them in a centralized and liquid marketplace. These market actors can also use commodities derivatives to hedge future consumption or production. Speculators, investors, and arbitrageurs also play an active role in these markets.
Certain commodities like precious metals have been considered a good hedge against inflation. A broad set of commodities as an alternative asset class can help diversify a portfolio. Because the prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.
In the past, commodities trading required significant amounts of time, money, and expertise and was primarily limited to professional traders. Today, there are more options for participating in the commodity markets.
While you get higher leverage with commodity trading, the risk associated with trading in commodities is also higher as market fluctuations are common.
Types of Commodity Market:
Typically, commodity trading occurs either in derivatives markets or spot markets.
1)Spot Markets-
A spot market is a financial market where financial instruments and commodities are traded for immediate delivery. Delivery refers to the physical exchange of a financial instrument or commodity with a cash consideration.
2)Derivatives Markets-
Derivatives markets in India involve two types of commodity derivatives: futures and forwards; these derivatives contracts use the spot market as the underlying asset, group of assets, or benchmark. A derivative is set between two or more parties that can trade on an exchange or over the counter.
The main difference between forwards and futures is that forwards can be customized and traded over the counter, whereas futures are traded on exchanges and are standardized.
What is a Commodity Futures Contract?
The commodity futures contract is the agreement that a trader will buy or sell a certain amount of their commodity at a pre-decided rate at a specific time. When a trader purchases a futures contract, they are not required to pay the full price of the commodity. Instead, they can pay a margin of the cost, a predetermined percentage of the original market price. Lower margins mean one can buy a futures contract for a large amount of a precious metal like gold by spending only a fraction of the original cost.
Commodity futures can hedge or protect an investment position or bet on the underlying asset’s directional move. Many investors confuse futures contracts with options contracts. With futures contracts, the holder must act. Unless the holder unwinds the futures contract before expiration, they must either buy or sell the underlying asset at the stated price.
Commodity futures can be contrasted with the spot commodities market.
Participants of commodity market:
Speculators:
Speculators drive the commodity market, along with hedgers. By constantly analyzing the prices of commodities, they can forecast future price movements. For instance, if the prediction is that the prices will move higher, they will buy commodity futures contracts. When the prices seem to increase, they can sell the contracts above higher than what they bought them for. Similarly, if the predictions indicate a fall in prices, they sell the contracts and buy them back at an even lower price, thus making profits.
Since they are not interested in the actual production of goods or even taking delivery of their trades, they mostly invest through cash-settlement futures, which provide them with substantial gains if the markets move according to their expectations.
Hedgers:
Manufacturers and producers typically hedge their risk with the help of the commodity futures market. For example, farmers will have to face a loss if prices fluctuate and fall during harvest. To hedge the risk of this happening, farmers can take up a futures contract. So, when the prices fall in the local market, the farmers can compensate for the loss by making profits in the futures market. Inversely, a loss in the futures market can be compensated for by making gains in the local market.
Commodities are also used as a hedge against inflation. As commodities’ prices often mirror the inflation trends, investors often use them to protect their funds in times of rising inflation, as the losses due to inflation can be offset by the rise in commodity prices.
Investing in commodities
Depending on the commodity type, traders can find different ways to invest in commodities. Because commodities are physical goods, there are four major ways to invest in commodities.
1. Direct investment: Investing directly in the commodity
2. Futures contracts: Using commodity futures contracts to invest in the commodity
3. Commodity ETFs: Buying shares of ETFs (Exchange-Traded Funds)
4. Commodity shares: Buying shares of stock in companies or organizations that produce commodities.
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