Why commodity trading makes sense?

Investors intuitively know that they must spread their investments across various assets as a core investment strategy. To attain this goal, they obviously need choices beyond stocks, bonds and bank deposits. Investing in commodities could just be the element to spruce of the portfolio of an investor.

Commodity trading not only provides an ideal asset allocation but also helps investors hedge against inflation and buy a piece of global demand growth. Moreover, in an era where the bank deposits provide a rate of return on investment which is even lower than the rate of inflation, investment in commodity trading is a good option one can look at.

Commodity trading is as complicated as any other investment, and requires as much, if not more research if you are not to make a total hash of it. Commodity markets thrive when economies grow and at present India is at the helm of a global economic boom. Soon, India will be an important contributor to global commodity trade. Given the existing circumstances, commodity trading is all the more lucrative.

The last two and a half years have seen the commodity market getting far more regularized in India, with three fully computerized exchanges operational now- the National Multi Commodity Exchange of India Ltd. (NMCE), the National Commodity & Derivatives Exchange Ltd. (NCDEX) and MCX.

The commodity trading operates as thus. At any point, there are three concurrent contracts starting from the 21st of each month. If you enter the market on, say, July 28, you can purchase three futures- the August future,the September future and the October future – each priced differently. But you pay only a margin amount which varies according to the commodity.

The increase or decrease in price is reflected in your margin account everyday. You stand to make huge profits if first, as the market always goes up, and second, the appreciation in the market is good enough to cover your rollover costs. At the end of the contract period (one-three months), you can withdraw your net profit and take a fresh position or buy a new contract. You can, though, terminate your contract before the due date, even on the day you take it.

If one was to pitch on gold at say Rs 10,000 for 10 gm and pick up a kilogram of gold for Rs 10 lakh, one would pay Rs 70,000 upfront i.e 7% margin. If the price goes up by Rs 2000 the next day, the difference of Rs 2000 is credited in ones account. Likewise, if the price falls by Rs 1000 the next day, one is left with only Rs 1000 profit.

Commodities allow a portfolio to improve overall return at the same level of risk. An investor who wants to take advantage of price movements and wishes to diversify his portfolio can invest in commodities. Investors must understand the demand cycles that commodities go through and should keep a watch on factors that affect this.

Commodity trading which is normally done in the form of futures throws up a huge potential for profit and loss. The risk aspect gets magnified as the information available on supply and demand cycles in commodity markets is not robust.