Posted on May 03, 2019
Many investors and traders consider trading in commodities as Risky. The complexity and volatility of commodity markets dissuade people from investing in commodities. However, well-planned commodity trading can be beneficial for an investor's portfolio. So, before getting into the benefits of trading in the commodities, let's understand what are commodities, types of commodities and how the commodity market work.
What are commodities?
Commodities are tangible objects that originate on earth or within from earth such as gold, silver, copper, aluminium, wheat, soybeans, cotton, oil, etc. Commodities of the same category are considered fungible i.e. interchangeable with other commodities of the same grade regardless of who produced or farmed it.
For example, if mining companies in Karnataka and Maharashtra produces high quality copper. The copper produced by both mining companies is fungible as long as it receives the same grade. As an investor, it does not matter which mining company produced it as long as the quality of copper is same.
Types of commodities
Today, tradable commodities fall into the following four categories:
- Precious Metals (such as Gold, Silver, Platinum, and Palladium)
- Base Metals (such as Aluminium, Copper, Zinc, etc.)
- Energy (such as Crude oil Natural gas, Heating oil and Gasoline)
- Agricultural (including Soya bean, Soya oil, Wheat, Corn, Guar seed, etc.)
Trading in commodities can be a great way to diversify a portfolio beyond conventional securities - either for the long term or as a place to park cash during unusually volatile environment and/or bearish stock markets.
Benefits of Investing in Commodity Market
1) Diversification: Invest in a range of commodities to earn decent returns.
Commodities are an alternative investment avenue that diversifies one’s portfolio with decent returns, as they have low correlations with the returns of other asset classes.
Commodities are a different set of asset class having multiple correlations other assets classes like Equities, Bonds, Currencies, especially U.S. dollar, etc. Also are impacted by supply-demand fundamentals, natural calamities, climatic conditions, geo-political issues and some commodities like metals are considered to judge the global economic barometer.
For example, the prices of stocks fell sharply during a financial crisis; but gold was on rise in the same period. This is because investors ran for safe asset - gold. A diversified portfolio with a low relationship between its assets tends to have less volatile returns. Thus, investing in commodities assures diversification and improves risk-adjusted returns. However, during crisis period commodities like industrial metals and crude prices had plunged as well.
2) Profit from Inflation
Inflation usually occurs due to scarcity or an unusual rise in demand for the commodity or may be caused due to various other factors discussed above. Commodity prices usually go up during high inflation periods, leading to rise in prices of raw materials and or finished products.
Rising inflation causes depreciation in the value of the currency and also affects the value of stocks and bonds. Commodities, however, maintain their value during inflation. The increase in the demand for goods and services increases their price and in turn, boosts the price of commodities used to produce those goods and services.
3) Protection against Event Risk
Situations like natural disasters, wars, and financial crisis that can lead to devaluation of an investor’s assets are termed as ‘event risk’. Such unforeseen events and calamities negatively affect financial assets like equities. They may also increase the values of certain commodities like Agricultural commodities. For example, unseasonal rains may destroy standing crops; disruptions in the fuel supply, due to wars may increase crude prices.
4) Volatility & Liquidity
Liquidity describes the degree to which an asset can be promptly bought or sold in the market without inflicting the asset's price too much and volatility helps in keeping the futures and options contract liquid. Liquidity and Volatility are the two main advantages of commodity trading/ investment.
5) High leverage/ Low margin
High leverage: A particular commodity can be bought on the exchange by paying only a fraction of that value known as Margin. Moreover, the margins in the commodity futures and options market are lower than that in equity futures and options. For example: Commodity margins are usually 5-6% of the contract value i.e. Crude oil CMP4500, contract value Rs. 4,50,000/-, Margin required to trade Rs.22,500/-.
Less manipulation: Since most of the commodities (except for agricultural commodities) are internationally traded, they are less prone to rigging or price manipulation.
6) High Returns: Highly Volatile yet Profitable
Commodity prices are highly volatile as compared to the other asset classes like equities. Huge price swings could be seen based on events like Central bank meetings, economic projections, U.S. dollar moments, supply/ demand equations, etc.
For example, the undesired climatic conditions and lack of appropriate rains or excess rains could push up prices of soybeans and soybean oil, which are one of the most important commodities in the global marketplace. High price swings are an opportunity earn decent profits.
Conclusion
Investment in commodities may be considered as a risk; but as we said earlier that well-planned commodity investments/ trading can be beneficial for an investor's portfolio and we at Aditya Birla Money can help you in that.
So, in case you are looking to get started with commodity markets trading and investing, we can assist you in taking your next step forward. Share your basic details and we will get in touch with you soon! Click Here.