Lesson 4 of 9
There are several kinds of markets where the commodities are traded. Typically, the commodities which are meant to change hands physically for use in daily life like agricultural commodities are traded over the counter where the buyers and sellers meet to decide the price. These are usually the spot markets, where instant cash is used to physically exchange the commodities, which pass from sellers hands to users. However, given that most of the products traded in commodity markets have a large volume and need some storage space, it is noticed that spot markets for commodities are popular only for physical exchange of goods from one party to another for cash, where they may be of use for the buyer. The key issues surrounding the settlement in cash/ OTC spot commodities markets are the lack of clarity of contract size of commodities, for settlement, and the period involved, which may vary from two days to 45 days. Apart from same, the transaction costs in spot markets are also high, and the credibility of the buyers can not always be ascertained offhand.
In sharp contrast, forward markets and future markets are derived for trading of commodities in markets, with a view of ascertaining a future value of the same commodity, after keeping view of the demand, the geo-political factors, climatic conditions, fluctuation in currency and inflation and the supply available for the commodity. In forward markets, the settlement is done by physical delivery and payment is settled close to 6-7 weeks from carrying out the trade, but is done after backing the same with physical delivery and not merely by exercise of options and calls.
The most popular form of trading in commodity markets, from base metals, precious metals, oil and energy and agri-products, is carried out in the futures market, where the contract size of every lot of commodity is pre-determined, and the date of expiry of options and futures is also earmarked in advance, as per the exchange rules. In such cases, the commodities are traded in options and futures by paying some margins at the time of entering into contract in any commodity, and the exercise of options/ futures could be settled till the date of expiry of contract date, by the person who holds such a right by paying a premium for the time value in advance.
The date of expiry of contracts is always determined in advance by the relevant exchange, and the traders buy or sell options/ calls based on the forecast of the price they anticipate of the commodity by the date of maturity of contract. In most of the well regulated and advanced commodity markets, the mechanism works almost on lines similar to futures trading in the stock markets, and such contracts are matched on electronic basis. With time, the physical delivery of commodities have paved way for the futures trading in the commodity markets, and the exchange authorities monitor the system of collection of margins from traders, based on mark to market basis, after a base margin.
Usually, the traders themselves are involved in active trading in commodity markets in the products of their knowledge and interest. But at times, they may also act as brokers for other parties wanting to get the hedging done, to typically safeguard their main business line from risks. Apart from these classes, there are other traders, who like to take advantage of arbitrage between the price differences two different commodity exchanges operational in the same country, to make gains out of such wild movements of same commodities in separate directions in different commodity markets.
In India, the popular futures markets for commodity trading are MCX and NCDEX, and both of them even offer facilities of evening trading, to tune the local prices, in line with the major international markets with a time zone gap. Ever since the growing popularity of commodity exchanges in futures over the past two decades in our country, the number of products to have been permitted to be traded have been increasing gradually. The average daily turnover in commodity exchanges has noticed a significant uptrend over the past 10 years, since the increased retail participation and awareness on commodities.