How to Start Commodity Trading: A Comprehensive Guide

In the last several years, commodity trading has witnessed a growing number of participants in India. It is considered one of the most popular short term investment options along with  equities and currencies.

Since it is still in a developmental stage, many still need to learn how to begin investing in commodities. It is something which requires skill, knowledge and hard work.

The following is a comprehensive guide describing how to start commodity trading and its methods and strategies. 

What Is Commodity Trading? 

Understanding commodities is essential for explaining the concept of commodity trading. The raw materials and physical resources employed in manufacturing finished goods are known as commodities. Any item that can be moved and traded falls under commodities, excluding money.

Trading of commodities takes place on spot markets or exchanges. In these markets, trades of physical commodities are settled instantly. On the other hand, you can also participate in commodity trading via derivatives like futures and options. These are financial contracts executed at a certain date at a standardised price.

Their pricing is determined by supply and demand, two fundamental economic principles.

Commodity and stock prices are usually negatively correlated. Therefore, it is advantageous to use them as hedging instruments during times of market turbulence. But aside from this, commodity trading has a lot of other advantages. Commodity trading offers greater portfolio diversity.

There are two different categories of commodities on the market. These include both hard and soft commodities. Below is a description of them.

• Hard Commodities: These serve as the building blocks for producing more complex goods. Iron and coal are some examples of hard commodities that are further processed to make other goods.
• Soft Commodities: On the other hand, soft commodities are those that you may use right away. Food items used in their natural state, such as rice and cotton, are examples of soft commodities.

Types of Commodities Available in the Markets

Before learning how to start commodity trading, it is crucial to learn about the various types of commodities. Hard and soft commodities can be separated into several categories. The grouping is as follows:

Hard Commodities

• Energy Items: Bulk traded energy goods include gasoline, crude oil, natural gas, uranium, coal, etc. With these resources becoming more scarce over time, the demand for them has increased. It is important to note that their value can be significantly impacted if alternative energy sources like wind and solar replace them.
• Metals and Minerals: These include both precious metals like gold, platinum, and silver as well as heavy-use metals like aluminium, iron, copper, etc. Due to their reliability and easily transferable value , precious metals are preferred by investors during periods of significant market instability, inflation, or currency devaluation.
• Environmental Goods: These include things like carbon credits and clean energy sources like hydro, wind, and solar power.

Soft Commodities

This includes products such as sugar, rice, cocoa, wheat, cotton, oilseeds, and others. Since these items rely on the season, their value is erratic. As a result, one can benefit from them by utilising their limited availability.

Some of the most traded commodities include billions of gold and silver and crude oil. Apart from these, cotton, corn and wheat are also highly traded.

How to Start Trading Commodities?

Before diving into the basics of commodity trading, investors understand the markets, commodities and economic principles which determine the prices of commodities. As a trader, one must also learn the analytical skills required for trading.

Apart from what is mentioned above, there are a few steps you should follow to start trading in the commodity market in India. They are described in detail below.

Step 1: Understand the Market and Commodity Exchanges

Before starting your trade, know about the various commodity exchanges operating in India.  The three major exchanges in India are listed below.

• Multi Commodity Exchange of India (MCX)
• National Multi Commodity Exchange of India (NMCE)
• National Commodity and Derivatives Exchange (NCDEX)

Step 2: Choosing a Reliable Broker

After learning about the various commodity exchanges, selecting a reliable broker registered with the Security and Exchanges Board of India (SEBI) is crucial. 

This is important since the broker is the one who will take care of your trading account. They help you ensure a smooth transaction flow and adhere to best operational practices.

There are numerous factors you should consider while choosing a broker. One of the significant factors is their trading platform’s efficiency and the services provided on it. Apart from that, you should also  consider their experience and brokerage fees into account.

Step 3: Opening a Commodity Trading Account

After choosing a reliable broker, you must open a Demat and trading account. To apply for an account, you must  fill in a form providing personal  details about yourself, such as age, income, etc.

After analysing the given information,, the broker will decide on whether to approve the opening of your Demat account.

Once approved, you can instantly start trading from your trading account. 

Step 4: Making an Initial Deposit

After opening a Demat account, you must make a small initial deposit to start trading. It is required to deposit 5 – 10% of the contract value of a commodity, which is known as the initial margin.

Suppose the initial margin for trading a precious metal is ₹5,000. This would be 10% of the trading price of the metal. As a trader, you must also maintain a maintenance margin, to ensure you have enough cushion when  the market is adversely affected.

Step 5: Making a Trading Plan

After all the processes are completed to set up a trading account, you should devise a trading strategy suited to your needs. This helps one understand  his/her financial capabilities, risk tolerance and trading style.

Trading plans vary from trader to trader, and one style cannot suit all. You can take help of the various technical and fundamental tools along with other resources provided by your broker to gain an understanding of the market and devise some plans.

With a combination of the services provided by the broker’s trading platform and the trading plan created, you are ready to begin commodity trading.

Different Methods to Trade in Commodities

While learning how to start commodity trading, it is crucial to be aware of its various methods. The different ways of trading commodities are described below.

• Physical Trading

This is one of the most popular commodity trading methods . For instance, you can purchase gold or silver from jewellery stores. This is a  traditional approach to investing in high-value commodities. However, the transaction costs are high, and the physical commodities need to be stored safely.

• Futures Contracts

Futures are derivatives which are financial contracts where one party must buy or sell a particular commodity at a specific price on a specific date. One requires a brokerage account for futures trading.

The price and dates in futures contracts cannot be modified as these are standard contracts for all. The profits are based upon future price movements of the commodity. It is one of the most common methods of commodity trading.

• Commodity Stocks

Another way to trade commodities is by purchasing stocks of commodity manufacturers/dealers. For instance, if you invest in the stocks of a  steel company, the stock price will follow the price of steel. This helps you to take an indirect exposure to the commodity while reducing the risk as a stock’s price is also influenced by other factors compared to investing in a commodity.

• Commodity ETFs, ETNs and Mutual Funds

There are numerous ETFs (Exchange-Traded Funds), ETNs (Exchange-Traded Notes) and mutual funds that invest in commodities. For instance, if you want to invest in gold, you can opt for gold ETFs or even Sovereign Gold Bonds. There are no physical storage issues since the units are stored in your Demat account.

• Commodity Pools

These are private funds which help in commodity investment. However, they are not available to the public and traders must be approved for investment. In addition, they often have high management costs.

Various Strategies for Commodity Trading

As stated in the steps of how to start commodity trading, devising a trading strategy is very important. Different traders rely on different strategies since a single strategy  cannot work for everyone.

You must  analyse various factors, such as financial capabilities, risk profile, profit goals, etc., to map out a trading strategy. The following are some helpful tips that will help you create a commodity trading strategy.

• Continuous Learning

To become a skilled trader, you must keep gaining insights into commodity trading. Therefore, it would be best to learn  how traders work and basic concepts such as futures, options, margins, resistance levels, etc.

• Technical Analysis

Each commodity depicts different technical attributes which are vital for a trader to know for him/her to profit from a trade. These include volume, open interest, chart patterns, etc .

• Understanding Commodity Frequencies

It is essential to take note of commodity frequencies. While some commodities are traded throughout the year, others are seasonally traded.

For instance, bullion of gold and silver is traded throughout the year. On the other hand, corn is traded during the harvesting season.

• Portfolio Diversification

As a trader, you should never invest all your funds in one asset. It is essential to diversify your portfolio to balance out the losses incurred from underperforming assets.

• Discipline and Consistency

You should be disciplined to  become a successful trader. Patience and consistency are essential while trading. Also, the resilience to stay in the market despite downfalls and learnings from past mistakes helps one become successful as a trader.

Final Word

Commodity trading can be highly beneficial if you are clear on the basics and assess your risk tolerance correctly. Two important benefits it provides are portfolio diversification and a hedge against inflation. The above information teaches how to start commodity trading in India.

Frequently Asked Questions