Dealing in commodities is an age-old profession. Ancient civilizations traded on a wide array of commodities ranging from spices, agricultural produce, livestock, gold, precious stones and so on. Commodity trading was an essential business since time immemorial. It is due to the dealing with commodities that the people from west started to explore the sea path to reach east.
What is a Commodity?
A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services.
The quality of a given commodity may differ slightly, but it is essentially uniform across producers. When they are traded on an exchange, commodities must also meet specified minimum standards, also referred to as a basis grade.
Example of commodities which are used as the mediums of exchange includes gold, silver, copper, salt, tea, peppercorns, decorated belts, shells, alcohol, candy, nails, cocoa beans, barley and so on.
Commodities linked to food, energy or metals play a very important role in the day to day activities of a common mans life.
For Example: If anyone drives a two-wheeler, then the rise in the crude oil prices will definitely have an impact on the individual.
Types of Commodities
Basically, commodities can be classified under the below mentioned four categories. They are:
• Metals - gold, silver, copper, platinum
• Energy - natural oil and gasoline, heating oil, crude oil
• Livestock & meat - live cattle, feeder cattle, lean hogs, pork bellies
• Agricultural - wheat, rice, cocoa, corn, soya beans, coffee, cotton, sugar
What is Commodity Futures? How does it work?
The term commodity futures refers to an agreement to buy or sell a raw material at a specific date in the future at a particular set price. The contract is for a previously set amount.
The buyers of commodities use the futures contract to fix the price of a commodity which they are going to purchase in future. It reduces their part of the risk, in the event of a rise in the prices of those commodities. On the sellers part, the use of futures guarantees that they will receive the agreed upon price at the time of sale and thus reduce the risk factor in case of a drop in the prices of commodities.
Margin & Its Types
To trade in a futures contract, you need to deposit a certain percentage of the total contract value with the exchange as a security deposit. This sum is known as 'Margin'.
The percentage can vary for different commodities and is decided by the exchange.
There are basically four types of margins -
• initial margin
• mark-to-market margin
• special margin
• delivery period margin
When a commodity trader opens a trading account with a broker, he or she is required to put down a capital sum to initiate a trade.
This acts as a collateral which allows the commodity trader to enter into the futures market. It is refundable at delivery, exercise, expiry or squaring off, depending on the profit or gain on the trade.
The initial margin must be maintained throughout the time that the position is open.
If the value of underlying commodity falls below the margin, you need to top up your account with additional margin to hold the particular commodity.
For commodity futures margins can be in the range 2-15% of contract value.
Mark-to-market, also called as M2M is the margin that is calculated on each trading day by taking the difference between the closing price of a contract on that particular day and the price at which the trade was initiated.
In other words, its the practice of crediting or debiting a trader's account based on the daily closing prices of the futures contracts he is holding.
Mark-to-market margin is calculated on daily basis to find out the profit or loss on the open futures position.
If there is a profit, the amount is transferred from the clearinghouse to your trading account by the broker, and in case of loss, the amount is transferred by the broker from your trading account to the clearinghouse.
For example, if one buys futures of Rs 5000 and its price fall to Rs 4500. Then s/he has to pay an M2M margin of Rs 500 to take the position in the future.
With a view to controlling price volatility and the breach of the daily circuit (the maximum permissible daily movement against the previous closing price on either side), Exchange has introduced the system of Special Margin.
The purpose of this margin is to control excessive speculation and to protect the interest of common traders and investors.
This will be applicable for all the traders who have an open position and they can't trade further unless this special margin amount is paid.
When the contract approaches delivery period i.e. last five days before the expiry date of the contract, the exchange requires the buyers and sellers to put additional margins.
Usually, it is 25 percent of the total contract value and is subject to change by the exchange. The delivery margin percentage is different for each commodity.