Ask Mint | Commodities futures: the win or lose arithmetic

Ask Mint | Commodities futures: the win or lose arithmetic
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First Published: Sun, Apr 12 2009. 10 58 PM IST

Updated: Sun, Apr 12 2009. 10 58 PM IST
Globally, the value of commodities futures contracts traded on commodity exchanges is many times more than the value of commodities actually produced. No surprise then that the Bank of International Settlements (BIS), in one of its studies (2007), pointed out that the value of exchange traded derivatives for precious metals such as gold exceeded 30 times the value of actual production of gold in 2005. That’s the beauty of how our commodity exchanges work: This hen always lays eggs bigger than its own size. But many newbies find the investment opportunities in a commodities futures market a bit perplexing.
Johnny: I also wonder, Jinny, what kind of job these commodity exchanges perform. I just hope they are not in the business of drilling holes into the ground to look out for new things.
Illustration: Jayachandran / Mint
Jinny: Well, you seem to be grossly unaware of the true potential of our commodity exchanges. Internationally, the volume of trade done on commodity exchanges is many times more than the volume of trade generated in the securities market. Many people worldwide have made their fortunes by simply trading in commodities. It’s time to wake up now; trading in commodities futures in India is also increasing by leaps and bounds. In the present fiscal ending March, the value of trading at commodity exchanges is likely to see a growth rate of between 30% and 40%. With that kind of growth rate, how long would it take for the market size to double?
Johnny: That’s a very optimistic picture, Jinny. But tell me now what commodity exchanges actually do.
Jinny: Commodity exchanges work just like our stock exchanges, but instead of trading in stocks and bonds, commodity exchanges provide a facility for trading in commodities futures. Commodities futures contracts are standardized derivative contracts for buying or selling the underlying commodity on a future date at a predetermined price. They provide an effective mechanism of price discovery and price hedging. For instance, if you want to purchase 100g of gold bar after three months but feel that the price of gold in the meantime is likely to go through the roof, then you can hedge your price risk by buying a futures contract for gold. Futures contracts remove uncertainty because you know in advance what price you have to pay to buy gold three months from now. You will, in fact, make a profit if the price of gold after three months moves higher than the price fixed under your futures contract, but you would lose money if the price moves lower. I hope you already know about this win or lose arithmetic of futures contracts.
Johnny: Well, I understand the arithmetic. But tell me, Jinny, if I were so concerned about the price going through the roof, then I could eliminate all uncertainties by simply buying gold now instead of buying a three months futures contract.
Jinny: That’s how it used to be when there were no markets for commodities futures. But you can make better use of your money now. There’s no need to buy if you don’t actually require the thing now; similarly, there’s no need to sell unless you really want to sell now. Waiting has its own rewards. If you buy gold now, you would be required to pay its full price, which means that your money would get unnecessarily locked for three months. To buy commodities futures, you need to pay only the initial margin, which is generally between 5% and 8% of the price that you have to finally pay. The rest of the money remains at your disposal. However, for the remaining period of your contract, you are required to bring in additional mark-to-market margin if the value of your contract really goes down. This ensures that you have to just take one bite at a time. Even if you have to lose money in commodities futures, you lose it slowly, day by day.
Johnny: What you said sounds interesting. But I don’t understand the trading mechanism of commodity exchanges.
Jinny: The trading mechanisms of commodities futures are similar to stocks. You can trade commodities futures online just like stocks through any trading member of the commodity exchange. For that you need to open a trading account with a broker and a demat account with a depository. Many stockbrokers also provide a facility to trade commodities, so you can start trading stocks and commodities futures side by side.
But before you actually jump, it would be better to do some more research. For instance, you need to find out which commodities are available for trading on the commodity exchanges. The list of commodities available for trading keeps changing. What are the fundamental drivers of price of the commodity you want to trade in? Different commodities have different fundamental drivers. What’s the settlement procedure? Most of the commodity futures are settled by cash but in some contracts the seller has the option of making physical delivery, and in some contracts physical delivery has been made compulsory.
Johnny: Thanks for alerting me, Jinny. Good research can help us avoid any nasty surprises.
What: Commodity exchanges provide an opportunity for trading in commodities futures.
Why: Commodity exchanges are useful because they provide an effective mechanism of price discovery and price hedging.
Who: Commodity exchanges in India are presently being regulated by the Forward Markets Commission (FMC).
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas fortheir weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Apr 12 2009. 10 58 PM IST