Commodities are inseparable from our lives. From the food we eat to the metals we use, all are the gifts called Commodities. Everyone buys and consumes commodities in one way or the other. But do you know that you can also trade in commodities? Nah? Well, you can.
In today's article, let's understand everything about commodity trading, an underrated investment option among retail investors.
What is a Commodity?
You may know about commodities. In case you don't know, commodities are raw materials or agricultural products that can be bought and sold in the market. For every economy, they are considered the building blocks. Just like debt and equity, they are traded on different commodity exchanges all over the world.
They are classified into the following broad categories:
- Agricultural goods like cotton, food crops, and many more
- Energy fuels like crude oil, coal, and fossil fuels
- Metals, including precious metals like silver, gold, and platinum
- Livestock products like eggs
The commodities differ from each other. But they are considered equal for trading as long as they fulfil the set quality standards.
Now that you have a brief idea about commodities let's look at commodity trading.
It is rightly said, "Concentrating the investments MAKES you rich. But diversifying them KEEPS you rich." That is why investing in commodities is an appropriate option for investors to diversify their portfolios.
Generally, the commodity prices are inversely related to stock markets. When the stock market goes down, the prices go up. So, investors can get good returns and cover up their losses during a stock market crash if they invest in commodities. It also reduces the risk of market volatility.
If you think that you can invest in commodities only by buying them, you are misled! Here are the different ways to invest in commodities.
Like stocks, commodities are traded through derivatives (futures and options) as well. A futures contract is a legal contract to buy or sell the commodity at a predetermined price at a specified time in the future. The buyer has to buy it at the agreed price at that time, irrespective of the market price. Similarly, the seller has to sell it to the buyer under the same conditions.
It helps to ensure the safety of profits to the farmers in the case of food grains. But he has to forego the additional profits in case the commodity prices increase.
Besides these traders, there are other types of traders known as speculators. They follow an opportunistic approach. They enter into a futures contract without the intention of executing it! Now you may be wondering if it is unethical from their side.
Before reaching any conclusions, let's know their entire strategy.
In times of inflation, commodity prices increase. So, commodities become an attractive investment option to get massive returns. What's more, there is significant leverage in a future contract. For example, a trader can buy Rs 5000 of commodities by investing just Rs 1000! It helps to get high returns. So, that actually makes proper business sense, right?
At the same time, there is a significant risk. As you know, the higher the return, the higher the risk.
That is why options contracts are popular in the commodities market. Here, you have the right to execute the contract on its due date. If the price does not move in the expected direction, all you will lose is the premium paid on the contract!
You would be amazed to know that you can invest in commodities through stocks! You can do it by investing in stocks related to that commodity. E.g., If you want to invest in energy fuels, you can buy shares of IGL or BPCL. In the stock market, the risk is comparatively lower, besides the liquidity of investments. And all the information about the company is available publicly. It helps in making informed decisions.
But the stock price may be affected due to other factors as well. It may not have the desired impact on investments.
Commodity ETF and ETN
As mentioned above, there are specific exchanges where commodity trading takes place. In India, the most popular exchanges are the Multi Commodity Exchange (MCX) and National Commodity and Derivatives Exchange (NCDEX). You can invest in ETFs and ETNs to get benefits from price fluctuations. ETFs track the prices of a particular commodity group in an index. ETNs are unsecured debt securities that mimic the price fluctuations in a commodity.
But they are not much preferred by the investors. It is so because the movement in the prices may not reflect in the underlying ETF. Moreover, ETNs have a credit risk as they are unsecured.
Mutual and Index Funds
Some mutual funds invest in companies related to a commodity. It gives benefits of professional management, diversification, and liquidity. But the management fees may be high, which may eat your returns.
Physical Investment in Commodities
Although there are many ways to invest in commodities, some investors may use the traditional investment method, i.e., purchasing the commodity physically. Generally, it is done in the case of precious metals, as the per-unit cost is expensive. Other commodities require a proper infrastructure for storage. After all, what is the point of buying food crops in bulk when they can get rotten?
But modern investment methods have become more attractive. Like people can invest in gold bonds to earn nominal interest, besides capital appreciation. Also, there is less risk of theft, which may be present in physical investments.
The bottom line
It is a wise strategy to diversify your portfolio, which includes investing in commodities. It is an apt investment option in case the stock market movement is not as per your expectations. It has immense potential to earn decent returns, but it comes at a higher risk.
To mitigate the risk, you can invest in futures and options. If you don't want to invest directly, you can invest in companies dealing in commodities or mutual funds. Some investors follow the conventional method of physical purchase. But it may not be feasible in current times due to modern options available.
In the end, remember that stock price can go to zero (in extreme conditions). But it is not in the case of commodities, as these are real things. So, don't hesitate to invest in commodities.
Acknowledge your goals, chalk out a proper strategy and invest in a suitable mix of assets.