What is a commodity?

A commodity is a product having commercial value that can be produced, bought, sold, and consumed.

What is a Derivative contract & what is Commodity future?

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.

What is the difference between spot market and futures market?

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.

What is a Commodity Exchange?

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 SEBI (previously, 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).

Who regulates the commodity exchanges in India?

Commodity Market in India is regulated by SEBI (previously, Forward Market Commission (FMC) under the guidance of the Ministry of Consumer Affairs, Food, & Public Distribution.

What are the benefits of futures trading in commodities?

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.

What is hedging?

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.

What is arbitrage in commodity markets?

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.

Is an ISIN number also allotted to commodity like in equities?

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.

Unlike equities where rate is per share basis, does the commodities market have different rate units for different commodities?

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.

What is a lot Size? Do the trading & delivery lot sizes differ from each other?

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.

What are the various elements in cost-of-carry for a commodity?

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.

What is the meaning of Basis?

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.

What is meant by basis risk?

Generally, the spot price of a commodity and future price of the same underlying commodity do not change by the same amount during the life of the futures contract. This uncertainty in the variation of basis is known as basis risk.

What is “Contango” in commodity trading?

Contango means a situation, where futures contract prices are higher than the spot price and the futures contracts maturing earlier. It arises normally when the contract matures during the same crop season. In a well-integrated market, Contango is equal to the cost of carry viz. Interest rate on investment, loss on account of loss of weight or deterioration in quantity etc.

What is initial margin?

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.

What do you mean by delivery period margin?

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.

What is Mark-to-market (MTM)?

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.

What is meant by the term “tender period”?

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.

What is due date rate?

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.

What is spread?

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”.

What is rolling over of hedge positions?

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.

What is meant by calendar spread?

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.

What do you mean by convergence of futures price with spot price?

This refers to the tendency of difference between spot and futures contract to decline continuously, so as to become zero on the date on maturity.

What is novation?

Some Clearing Houses interpose between buyers and sellers as a legal counter party i.e., the clearing house becomes buyer to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of clearing house committing a default. Clearing House puts in place a sound risk-management system to be able to discharge its role as a counter party to all participants.

What is Cash Settlement?

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.

Can I take delivery of the commodity? If yes, how can I do the same?

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 or companies cannot go for delivery & all positions are cash settled.

What are the costs involved in trading of commodities?

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
  • Service tax
  • Education Cess
  • Exchange Transaction Charges