Commodity Trading
Commodity and Futures trading in india
Indian markets have recently thrown open a new avenue for retail investors and traders to participate: commodity derivatives. For those who want to diversify their portfolios beyond shares, bonds and real estate, commodities is the best option.
Commodity trading in India has a long history. In fact, commodity trading in India started much before it started in many other countries. However, years of foreign rule, droughts and periods of scarcity and Government policies caused the commodity trading in India to diminish. Commodity trading was, however, restarted in India recently. Today, apart from numerous regional exchanges, India has three national commodity exchanges namely, Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX) and National Multi-Commodity Exchange (NMCE)[1]. The regulatory body is Forward Markets Commission (FMC) which was set-up in 1953.
Beginners Guide to Commodities Futures Trading in India
Commodities offer immense potential to become a separate asset class for market-savvy investors, arbitrageurs and speculators. Retail investors, who claim to understand the equity markets may find commodities an unfathomable market. But commodities are easy to understand as far as fundamentals of demand and supply are concerned. Retail investors should understand the risks and advantages of trading in commodities futures before taking a leap. Historically, pricing in commodities futures has been less volatile compared with equity and bonds, thus providing an efficient portfolio diversification option.
Untill some months ago, this wouldn’t have made sense. For retail investors could have done very little to actually invest in commodities such as gold and silver — or oilseeds in the futures market. This was nearly impossible in commodities except for gold and silver as there was practically no retail avenue for punting in commodities. However, with the setting up of three multi-commodity exchanges in the country, retail investors can now trade in commodity futures without having physical stocks!
In fact, the size of the commodities markets in India is also quite significant. Of the country’s GDP of Rs 13,20,730 crore (Rs 13,207.3 billion), commodities related (and dependent) industries constitute about 58 per cent. Like any other market, the one for commodity futures plays a valuable role in information pooling and risk sharing. The market mediates between buyers and sellers of commodities, and facilitates decisions related to storage and consumption of commodities. In the process, they make the underlying market more liquid.
Currently, the various commodities across the country clock an annual turnover of Rs 1,40,000 crore (Rs 1,400 billion). With the introduction of futures trading, the size of the commodities market grow many folds here on.
Where do I need to go to trade in commodity futures?
You have three options – the National Commodity and Derivative Exchange, the Multi Commodity Exchange of India Ltd and the National Multi Commodity Exchange of India Ltd. All three have electronic trading and settlement systems and a national presence.
Useful resources/links
National Commodity and Derivatives Exchange
National Multi-Commodity Exchange
About NCDEX
NCDEX Limited is an on-line nation-wide, multi-commodity, de-mutualised commodity exchange with strong institutional shareholding. NCDEX has seven national level institutions as its shareholders: CRISIL Limited (earlier known as the Credit Rating Information Services of India Limited), ICICI Bank Limited, Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD), National Stock Exchange of India Limited (NSE) and Punjab National Bank (PNB), Indian Farmers Fertilizers Co-operative Limited (IFFCO).All these institutions are reputed entities in their respective fields and NCDEX leverages their expertise to realize its potential in the commodity space. NCDEX commenced trading on December 15, 2003 and offers trading facilities on a robust trading platform through its trading and clearing members spread across over 127 centres in the country.
How do I choose my broker?
Several already-established equity brokers have sought membership with NCDEX and MCX. The likes of Refco Sify Securities, SSKI (Sharekhan) and ICICIcommtrade (ICICIdirect), ISJ Comdesk (ISJ Securities) and Sunidhi Consultancy are already offering commodity futures services. Some of them also offer trading through Internet just like the way they offer equities. You can also get a list of more members from the respective exchanges and decide upon the broker you want to choose from.
What is the minimum investment needed?
You can have an amount as low as Rs 5,000. All you need is money for margins payable upfront to exchanges through brokers. The margins range from 5-10 per cent of the value of the commodity contract. While you can start off trading at Rs 5,000 with ISJ Commtrade other brokers have different packages for clients.
For trading in bullion, that is, gold and silver, the minimum amount required is Rs 650 and Rs 950 for on the current price of approximately Rs 65,00 for gold for one trading unit (10 gm) and about Rs 9,500 for silver (one kg).
The prices and trading lots in agricultural commodities vary from exchange to exchange (in kg, quintals or tonnes), but again the minimum funds required to begin will be approximately Rs 5,000.
What do I need to start trading in commodity futures?
As of now you will need only one bank account. You will need a separate commodity demat account from the National Securities Depository Ltd to trade on the NCDEX just like in stocks.
What are the other requirements at broker level?
You will have to enter into a normal account agreements with the broker. These include the procedure of the Know Your Client format that exist in equity trading and terms of conditions of the exchanges and broker. Besides you will need to give you details such as PAN no., bank account no, etc.
What are the brokerage and transaction charges?
The brokerage charges range from 0.10-0.25 per cent of the contract value. Transaction charges range between Rs 6 and Rs 10 per lakh/per contract. The brokerage will be different for different commodities. It will also differ based on trading transactions and delivery transactions. In case of a contract resulting in delivery, the brokerage can be 0.25 – 1 per cent of the contract value. The brokerage cannot exceed the maximum limit specified by the exchanges.
Taxes in India are levied by the Central Government and the State Governments. Some minor taxes are also levied by the local authorities such the Municipality or the Local Council.
The authority to levy a tax is derived from the Constitution of India which allocates the power to levy various taxes between the Centre and the State. An important restriction on this power is Article 265 of the Constitution which states that “No tax shall be levied or collected except by the authority of law.”[1]Therefore each tax levied or collected has to be backed by an accompanying law, passed either by theParliament or the State Legislature.
Interesting document on google :
http://www.fiaasia.org/downloads/FIAIndiaTransactionTaxLetter408.doc.
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FUTURES TRADING ON NATIONAL, DEMUTUALISED,
MULTI COMMODITY EXCHANGES
8.1 Conventional commodity trading in India is of spot or ready delivery nature under which the delivery of goods and the full payment of value of the goods at the price settled between buyer and seller is to be made either immediately or within a specific period after entering into agreement. Nafed has so far been undertaking its business activities in the domestic market through above mentioned spot contracts in which delivery of the stocks confirmed through sales confirmation letter is effected within a period of seven days (extendable upto 21 days) after receipt of full payment.
8.2 A futures contact is a binding, legal agreement to buy (take delivery) or sell (make delivery of) a commodity. The terms of a futures contract are standardized by type (corn, wheat etc), quantity, quality, and delivery time and place. The variable portion of the contract is the price, determine at the time of trade in a process called price discovery that takes place on trading floor.
8.3 Features of Commodity Futures:
Organised
Commodity Futures contracts always trade on an organized exchange e.g. NCDEX, MCX, NMCE, NBOT etc.
Standardised
Commodity futures contracts are highly standardized with respect to quality, quantity and delivery date, all being predetermined.
Eliminates Counter party Risk
Commodity Futures exchanges use-clearing houses to guarantee that the terms of the futures contract are always fulfilled thus eliminating risk of default by the other party.
Facilitates Margin Trading
Commodity futures’ trading is done on margins. The investor only deposits a fraction-roughly 4 to 8% of the total value of the contract. This facilitates taking leveraged positions and generate higher returns.
Closing a Position
Commodity futures positions can be easily closed. The trader has the option of making or accepting physical delivery. Else the position can be closed by placing an order of equal quantity in the reverse direction i.e. a sell position can be squared of by a “buy” order and vice versa.
f) Regulated Market Environment
Forward Contracts (Regulations) Act 1952 is the regulating Act for commodity forward and futures trade in India. The Act has a three-tier system of control:
Govt. of India
The Forward Markets Commission
The recognized and registered associations.
The Forward Markets Commission is a statutory body under the administrative control of Ministry of Civil Supplies, Consumer Affairs and Public Distribution. Its main functions are:
Advise GOI regarding recognition of associations.
Monitor forward markets and take necessary actions.
3. Collect and publish information regarding trading and conditions for commodities to which the Act is applicable.
Inspect the accounts of recognized exchanges.
g) Market Participants
An efficient market for commodity futures requires a large number of market participants with diverse risk profiles. Ownership of the underlying commodity is not required for trading in commodity futures. The market participants simply need to deposit sufficient money with brokerage firms to cover the margin requirements. Market participants can be broadly divided into following categories:
Hedgers: They are generally the commercial producers and consumers of the traded commodities. They participate in the market to manage their cash market price risk. Commodity prices are volatile and their participation in the futures market allows them to hedge or protect themselves against the risk of losses from fluctuating prices.
2. Speculators: They are traders who speculate on the direction of futures price with the intention of making money. Thus for the speculators, trading in commodity futures is an investment option. Most speculators do not prefer to make or accept deliveries of the actual commodities, rather they liquidate their positions before the expiry date of the contracts.
3) Arbitrageurs: Sometimes due to market inefficiencies, differentials across different markets exist. For example, the futures rate for a particular contract month may be higher than the sum of spot rate and carrying cost. Arbitrage would then involve simultaneous buying in the spot market and selling on the futures exchange. Arbitrage keeps the prices in different markets in line with each other. Usually such transactions are risk free.
The fluctuations in commodity prices represents both, a risk and a potential for profit. The hedgers transfer this risk by foregoing the associated profit potential. The speculators assume this risk in the hope of realizing profits by predicting price movements. The arbitrageurs make the process of price discovery more efficient.
8.4 Types of Futures Markets
Normal Futures Market
A normal futures market is one where the price of nearby contract is less than the price of distant futures contract.
Inverted Futures Market
In an inverted futures market, the price of the near contract is greater than the price of distant contract.
8.5 The concept of Basis in commodity futures
Basis defined: The difference between the local spot price(cash price) and the relevant futures price of a commodity is called thecommodity basis.
Basis = Spot Price-Futures Price
Theoretically, the futures price and the spot price are related in the following manner:
Futures Price=Spot Price + Cost of Carry
The basis depends upon the local spot market price and so it reflects the local market conditions. It is affected by the following factors-
-Local demand and supply
-Storage costs
-Profit margins
Contango: The market is said to be in contango when the price of a futures contract is higher than the prevailing spot price. This is typically expected to happen when arrivals of particular agricultural commodity are continuing in the market.
Backwardation: The market is said to be in Backwardation when the price of a futures contract is lower than the prevailing spot price. This is typically expected to happen when we are moving from lean to peak season.
Whether the market is in contango or Backwardation, as the futures contract approaches the expiry date, the spot and futures prices converge.
Short and Long positions: In simple terms, long position is a net bought position and Short position is net sold position.
8.6 Economic Benefits of Commodity Exchanges:
Benefit to farmers: In the absence of a proper price discovery mechanism, farmers bear the brunt of price instability during peak arrival period. With futures market, the price fluctuation cushion taken into account by buyers is minimum and thus maximum benefit is passed on to the farmers provided right price information is available to farmers. Cooperatives can play a very vital role in providing market determined price information available from futures market, which can also serve as a very important basis for production decisions.
Price Discovery and Hedging: Futures trading provides a mechanism for the discovery of prices in the future, facilitating production, processing, storage and marketing decisions. It also allows stockists to hedge against price risks associated with procuring and holding of stocks.
Improvement in quality: The existence of exchange warehouses with grading facilities and requirement of tendering commodityhaving standard specifications creates a strong incentive for the producers for upgrading qualities acceptable to the exchange warehouses.
Facilitates access to credit: In view of the inherent price volatility of agricultural commodities and lack of proper post harvest management tools, banks/credit societies are reluctant to offer loans to growers/traders. The hedging mechanism of a futures exchange ensures proper valuation in terms of price discovered for the produce and thus it minimizes the risk of producers/traders.
8.7 How to trade in Commodity Futures
With the setting up of nation-wide commodity exchanges, a new avenue has been opened up for Nafed. These exchanges have electronic trading and settlement systems making it easy to trade in commodity futures. These exchanges are:
National Multi-commodity Exchange of India (NMCE) (www.nmce.com)
Multi-Commodity Exchange (MCX) (www.mcxindia.com)
National Commodity & Derivatives Exchange (NCDEX) (www.ncdex.com)
National Board of Trade (NBOT)
8.8 Trading in commodity futures comprises three simple steps:
a) Choosing a Broker
Each branch can choose one or more broker who are a member of the exchange the branches wish to trade in. Following factors should be kept in mind while choosing a broker:
Competitive Edge provided by the broker
Broker’s knowledge of the commodity markets
Credibility of the broker
Experience of the broker
Net-worth of the broker
Quality of broker’s trading platform
b) Depositing the margin
Margin requirements are of two types: initial margin and maintenance margin. The maintenance margin is usually lower than the initial margin. The position is marked to market daily and any profit or loss is adjusted to the margin account. If the account falls below the maintenance margin, a margin call is generated from the broker for replenishment of the margin.
c) Access to information and trading plan
There should be access to prevailing prices on the exchanges as well as market information that can help predict price movements. Brokers provide research and analysis to their clients.
8.9 Steps for trading on the futures exchange
Register with a Trading Member (Broker) of repute and complete other relating formalities like opening a hedge account with a bank and DP account for demat deliveries.
Identify Items, which are being actively traded on the Exchange and their specifications and match with items on which the branch is active.
Prepare programme for trading on the futures exchange and take approval from concerned Divisional Head in HO.
The trading can be done by the branches through hedging (when the future price is more than the ex-godown cost + carrying cost upto contract month) and arbitrage.
Procure stocks at contract locations as per the quality standards prescribed by the Exchange, as far as possible given in eachcommodity contract to ensure that the branch is in a position to give deliveries if the eventuality arises.
Deposit Initial Margin for each commodity envisaged to be traded and the same has to be according to the amount planned for exposure.
Regularly monitor rates on the exchange and square off positions profitably.
Considering the price competitiveness, some on time purchases can also be considered.
Branches to build the database on the prices of various commodities for it’s own use as well as its dissemination among member cooperatives.
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