An An Introduction Introduction

totoCommodity Commodity

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Commodities is life!! Trading in commodities is

heterogeneous It’s a different asset class Underlying assets are tangible

Commodity Exchanges

Highly Commodities Traded

BULLIONS: Gold (100gms,1kg, 3kg), Silver(5kg, 30kg, 150Kg)

BASE METALS: Steel, Nickel, Tin, Copper, Zinc, Aluminium

SPICES: Pepper, Red Chilli, Jeera, Turmeric, CardamomENERGY & Gas: Crude Oil, Brent Crude Oil, Natural Gas OIL & OIL SEEDS: Castor Seeds, Mustard Seed, Mustard

OilFIBRE: Kapas, CottonPULSES: Yellow Peas, MaizePLANTATIONS: Cashew Kernel OTHERS: Guar Seed, Gur, Sugar M200, Guargum, Mentha Oil etc.

Reasons to trade in commodities

Portfolio diversificationNo counter party riskHigher leverageContract sizes meeting individual needs and

requirementsHedging the price risks

Hedgers Consumers – refineries, food processing

companies Traders Producers – farmers

Speculators Brokerage houses Retail investors Commodity spot trader Institutional proprietary traders

Arbitrageurs Brokerage houses Commodity spot trader

Benefits to Investors

Big money spinner

Attractive valuations compared to capital markets

Effective Instrument for Hedging

Diversification tool, for investors to park their money

ASSET

CL. RT AS

ON

04/09/08

MKT LOTCONTRACT

VALUE 1% GAIN

1% GAIN in

Rs. Term PROFIT

GOLD (1kg) 11600 100 1160000 1% 116 11600

GOLDM(100gms) 11700 10 117000 1% 117 1170

SILVER 20000 30 600000 1% 200 6000

SILVERM 20075 5 100375 1% 200.75 1003.75

CRUDE 4854 100 485400 1% 48.54 4854

NATURAL GAS 323 500 161500 1% 3.23 1615

COPPER 320 1000 320000 1% 3.2 3200

Monday to Friday Agricultural commodities: 10.00 a.m. to 5.00

p.m.

Gold,Silver,Crude oil,Brent crude oil,Furnace oil,, and Metals (ferrous & non-ferrous eg.Copper,Nickel,Tin, Aluminium & Steel) 10.00 a.m. to 11.55p.m..

Saturday (agri commodities) 10.00 a.m. to 2.00 p.m.

Holidays notified in advance

Illustration

Trading in physical gold Trading in gold derivatives

Involves paying of the entire cost of the gold transacted

Involves paying a small amount of 5-7% as margin of the entire cost of the gold transacted.

Costs incurred for safe keeping of gold

ZERO costs

Cumbersome to avail of the best price opportunities in market

Standardized pricing across India

MCX

Multi Commodity Exchange of India (MCX), an independent and demutualized Exchange, is India’s leading multi-commodity trading platform with a Pan-India online infrastructure.

Headquartered in Mumbai, MCX is led by a team of senior industry professionals, with extensive business and operations expertise.

Multi Commodity Exchange of India (MCX), India's first multi-commodity, online exchange launched its operations in November 2003.

A highly scalable, ‘distributed architecture’ based trading platform, built on Microsoft® technology using the Microsoft .NET Framework is in place for the exchange.

The exchange provides: Connectivity through VSAT & Internet. Real Time price and trade information dissemination Robust risk management system and controls.

MCX (Contd.) The Exchange has been promoted by Bank of India, Bombay

Bullion Association, Bombay Metal Exchange Ltd., Canara Bank, Corporation Bank, FTIL, Pulses Importers’ Association, Solvent Extractors’ Association, State Bank of India and Union Bank of India.

MCX currently offers futures for over 50 commodities. Of these eight commodities viz. Gold, Silver, Crude, Natural Gas, Soy oil, Guar, Kapas and urad account for almost 95% of the trade on this exchange. Peak one way turnover of the exchange has crossed Rs. 12,000 crores.

MCX is the first Commodity Futures Exchange in the world to have launched “Steel Futures Contract”

MCX is the fastest growing exchange in the world (UNCTAD Report). It also ranks second (next only to NYMEX) in trading on natural gas futures (volumes traded). Natural gas futures were listed for trading on MCX platform in July 2006.

NCDEX National Commodity & Derivatives Exchange Limited (NCDEX) is a professionally managed online multi commodity exchange promoted by ICICI Bank Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE).

NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a bouquet of benefits, which are currently in short supply in the commodity markets. The institutional promoters of NCDEX are prominent players in their respective fields and bring with them institutional building experience, trust, nationwide reach, technology and risk management skills.

NCDEX is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956 and has commenced its operations on December 15, 2003.

NCDEX…Contd

NCDEX is a nation-level, technology driven de-mutualized on-line commodity exchange with an independent Board of Directors and professionals

NCDEX is the largest exchange in the world for trade in agro-commodity futures .

NCDEX is located in Mumbai and offers facilities to its members in more than 450 centres throughout India. The reach will gradually be expanded to more centres. 

NCDEX currently facilitates trading of forty five, commodities -Cashew, Castor Seed, Chana, Chilli, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oi, Rice, Rubber, Sesame Seeds,  Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red Maize & Yellow Soybean Meal.  At subsequent phases trading in more commodities would be facilitated.

Future Of Commodity Markets

In 4 years the average daily turnover of MCX has reached more than 25,000 Crores

World Over the Commodity Markets are 10 times bigger than the Equity Markets

Possibility of MFs & FIIs to be allowed in the Commodities market, thereby increasing liquidity and depth in the market.

STOCK & COMMODITY STOCK & COMMODITY MARKETS – A COMPARISONMARKETS – A COMPARISON

Stocks V/S Commodities

Quite often, stock markets and stock exchanges are compared with commodity markets and commodity exchanges.

Derivatives of stocks and commodities are also compared and common man is led to think that both are similar except that the underlying asset is different.

This is far from true. Stocks and stock futures are indeed completely different from commodities and commodity futures.

Basic Difference

Stock/Share certificate is a paper / document which gives you a part of the ownership of the company.

Commodity Futures contract is also a paper / document; but does not give you ownership of any company but only the commodity that is the subject of the contract.

Speculation in shares need not lead to any social upheavals. It only affects the players in the market!!

Excessive speculation / volatility in commodity futures do have social implications since major part of the tradable commodities are agro-commodities.

Independent Alternatives!

Stocks and commodities are two independent asset classes.

They do not necessarily rise or fall in tandem!

Recent past is a conclusive proof. MCX and NCDEX saw only a marginal increase in volumes last 6 months while the stock market was sharply down.

Volumes On Commodity Exchanges

FIIs, FDI and Mutual Funds / Hedge Funds likely to be allowed to invest in Commodity futures.

Permission might be granted to them for trading initially only in Bullion and Crude futures.

Options likely to be allowed this year in the winter session of Parliament.

All these measures are expected to boost the volumes on commodity exchanges further.

Commodity MarketsCommodity Market Turnover

• 4 national commodity exchanges in India with

trading allowed in 102 commodities

• Commodity turnover grew by INR 30% in 2008 -

09

• India is anticipated to be one of the most

dominant global players in the commodities

markets as it is among the largest producers and

consumers of several commodities.

• India to become Hub of Global Trading in

Commodities which promises to be a $ 900

billion opportunity

• Commodity Futures volumes is expected to grow

by 15.4% annually(according to FMC chairman)

• MCX India, established in 2003, is India’s largest

commodity exchange and the world’s second

largest silver and third largest gold exchange

• NCDEX, only two and a half years old, is Asia's

third-largest commodities exchange after Tokyo

and Shanghai and the 14th-largest in the world.

Source: Hindu Business Line

Key Facts

Key FactsCopper Turnover

0

500000

1000000

1500000

2000000

2500000

3000000

Jan-07

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Oct-07

Nov-07

Dec-07

Jan-08

Feb-08

Mar-08

Apr-08

May-08

Jun-08

Jul-08

Aug-08

Sep-08

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Securities V/S Commodities

Security of a particular type (Equity share, debenture, bond, etc.) has the same face value and its holders have such rights and obligations as are prescribed by the rules of the company or the governing authority. One unit of security does not differ from another of the same type in terms of its face value and characteristics.

Commodity futures are completely different. The underlying asset is a commodity. Each commodity may have several grades / varieties and each lot in a grade may vary from another in the same grade!!

Commodities may have different usage for different holders and hence utility and intrinsic value would be different for different users. Quality may deteriorate due to improper handling, storage and transportation.

Stock Markets V/S Commodity Markets

A commodity exchange is not a physical market. Physical markets for commodities are spread throughout the country. In comparison stock exchanges are very few and mostly located in metropolitan cities with some terminals for trading in other areas.

Stock prices are essentially determined at central places or stock exchanges. Commodity prices in total contrast, differ widely from location to location with their quality characteristics and preferred usage. Unlike spot security price, there is no single unique cash price quotation for a commodity which will be valid throughout the country. Prices of most commodities, especially those of agro-commodities, also change seasonally.

Equity V/S Commodity Futures

Unlike equity futures which all expire on the last Thursday of the month of the contract, expiry dates of commodity futures depend on the underlying

Unlike equity futures that are all cash settled, commodity futures can be either cash or delivery settled

Similarity in Equity & Commodity Futures

Just like equity futures, traders can speculate, hedge and arbitrage using the same strategies

Like equity futures, the commodity futures can be squared at any time till the expiry date

Risks And Hedging Them!

In view of the unavoidable variations in prices of commodities, participants in the market face much larger risks than those holding or buying securities.

In commodities, not only traders / merchants but also processors and manufacturers, importers and exporters are required to enter into deals for forward purchases / sales to ensure regular supplies and sales. Hence, the need for an active futures market for efficient reference pricing and effective risk management is far more in commodities than in securities.

Most of the investors in securities do not require any hedging facility since they are mainly looking for dividends for regular income or appreciation in value!

Futures and options market in security derivatives provides an avenue for speculation to traders and professional speculators without benefiting long investors in any way. In total contrast, commodity markets do provide an avenue for hedging risks. Commodity futures market is thus primarily a hedging market and not a market for delivery.

Price Discovery Price discovery by futures market has a basic role to perform in commodity

markets than in securities markets. Commodity Futures prices serve as reference prices for physical market transactions in forward contracts. Securities futures prices have no such role.

Price discovery is not that consequential to security market operators. A sharp increase in prices is merely a “feel good” factor. But market functionaries in commodities are always keen to know true equilibrium of prices determined by the demand – supply factors. These prices help them in preparing their production and distribution plans.

A sharp rise in prices of commodities is a cause of concern for the Government and the people at large. A sharp rise is not good for farmers either! It distorts the true picture and may lead to imports and distort cropping pattern. Transparent price discovery system is therefore a must for commodities and commodity futures help achieve this.

Price discovery is of immense importance in commodity markets. The factors determining the prices of securities are not many (supply is almost fixed, demand varies with the financial performance of the company, general market expectations, etc.), while factors affecting commodity prices are far too many!!

While demand for securities is mainly for investment and speculation, the demand for commodities could be for inventories and consumption also.

Pricing Structure

Pricing structure of stocks is simpler vis-à-vis that of commodities. Irrespective of the company, the tradable lots, face value of shares etc. remain the same.

Pricing structure of commodity futures is much more complex: - Each commodity is quoted in different units and

increments. - The trader in a commodity market has to thus study the

contract specifications for every commodity carefully not only for one commodity exchange but also for other commodity exchanges even for the same commodity!

Ideally, a trader should know: How contracts are quoted? What are the units? What the minimum

and maximum tradable quantities are? What is the initial margin? Has any special margin been levied on the day of trading? What is the maximum volatility permitted for each commodity? What are the standard specifications for each of the commodities?

Limited/Short Life Span

Unlike shares, commodity futures have expiry date. In case of stocks, there is no life span barrier.

Thus you can afford to wait and hold the shares as long as you want to ensure that you are not booking losses.

This is not possible in commodity future’s trading. Futures contracts are valid for a month or for a few months. At the expiry, the owner has to necessarily take the possession of the commodity mentioned in the contract or the owner has to square off his / her position before the futures contract enters the delivery period.

Limited life of contracts also makes it difficult to undertake long term price forecasting.

Lower Margins

This is perhaps the most important difference between shares and commodity futures.

All the commodity futures contracts require initial margin to be paid by the participant. These margins are different for different commodities. However, they usually range between three to ten percent only. The participant can thus leverage his investment to a great extent.

In case of shares, the investor has to pay the entire amount upfront. Even if the participant is dealing in stock futures, the initial margin paid is quite high compared to the commodity futures.

Time Frame Is Short

Since the leverage in case of commodity futures is quite high, it is necessary to watch the developments on price front meticulously and frequently – almost on a continuous basis.

In case of stocks or stock futures, the analysts would like to look at the long range scenario whereas in case of commodity futures this is not possible due to the pre-determined life span of the contract

Stock analysts may be able to talk about where the market will be in five to six months from now whereas the commodity futures analyst would like to assess where the market would be in the next few weeks rather than months.

Timing Is Important

Timing is of utmost importance in case of commodity futures. Ascertaining the direction of market is no doubt important; but ascertaining the entry point is more important in case of commodity derivatives. If the timing of the entry or exit is not planned properly, the results could be disastrous!

Broad Market Averages

Stock market players give considerable importance to movement of stock market averages such as Standard and Poor’s 500 Stock Index, BSE Index, Technology Index, etc. This is in fact, a starting point for any study or analysis of movement of prices of stocks.

In case of commodity futures, there are few indices like Weather index, Commodity Research Bureau (CRB) Futures price index. Though these indices are used to some extent in anticipating the overall direction of the commodity markets, they are hardly given as much importance as the stock market averages by the participants in the market.

Use Of Technical Indicators

All technical tools were originally developed for analysis of stock price movements. Though these can be used in case of commodity markets, the usage so far in commodity markets has been limited.

It is a common knowledge that chart patterns in futures on commodities do not get formed as completely as they do in case of stock prices.

Sentiment Indicators

Participants in the stock market make extensive use of sentiment indicators and “Flow of Funds” analysis.

Sentiment Indicators monitor the performance of various operators like Mutual Funds, Floor Specialists, etc.

Flow of funds analysis refers to the cash positions of the large groups of investors such as Banks, Mutual Funds, Financial Institutional Investors (FIIs), FDIs, etc.

These indicators are not used in commodity Futures – particularly in Indian context since Banks, FIIS, etc. are not allowed to trade in commodities’ futures as yet!!

In Short!!

S. No.

Commodity Futures Stock Futures

1. Pricing structure cannot be uniform sincequantity, quality, units, etc. are different

fordifferent commodity contracts. Price

structureis thus complex.

Price structure is simple and uniform.

2. Contracts have expiry dates and hence they

have limited life span.

No expiry dates for stocks.

3. Lower margins required for trading – usually

less than 10% and hence, the leverage is very

high.

Immediate payment / delivery and hence higher

or no margins

4. High risks due to high leverage Comparatively low risks due to limited or noleverage.

5. Time frame at traders’ disposal is shorter due

to short life span of contracts and hence quick

decisions are required.

Time frame is adequate. Traders could wait if the

situation is not favorable for buying / selling.“Buy and Hold” strategy can work.

6. Time is of essence since it can “make” or“break” the players depending on “right”

or“wrong” entry time.

Situation is similar except in severity.

Commodities Affect All!

Stock prices if manipulated can do harm to only the participants (Buyers/Sellers) in the market. They neither affect third party directly nor do they have any social implications.

Contrary to this, any manipulation in prices of futures contracts in Commodity markets can directly have a bearing on the spot market prices and create artificial shortages of the concerned commodity in the market. This can cause excessive volatility in the prices of the commodity and harm the social fabric of the country since commodities are invariably products of mass consumption.

Thank youlets Begin