Commodity trading began in India in 2003 in the organised markets when MCX commenced trading in commodities. However, commodities have been in existence for a very long time. In fact, for over hundreds of years they have been around. Commodity trading has a slightly different tinge to it compared to traditional equity trading. The number of factors that impact the price and the trading view on a commodity are a lot more diverse and broad-based. Let us look to understand some basic commodity trading tips.
Important commodity trading tips to watch out for
• Commodities are essentially about demand and supply factors. In case of most agricultural commodities it is demand and supply factors that are most important. Normally a spurt in demand (like commodity demand from China) or a sudden shortage in supply can cause agri commodity prices to rise. These are the points you need to closely track to take a call on commodities.
• When it comes to commodities, currency variations are another important factor that influences the price of commodities. Since most of the commodities are denominated in US dollars, the value of the dollar index has an inordinate influence on commodity prices. Gold and oil are classic example. Both are very closely related to the value of the dollar since they are both dollar denominated.
• Keep an eye on inflation, always. Inflation is one of the key factors that influence the price for commodities. Normally reasonable inflation is a sign of a robust economy and that leads to a pick-up in demand for commodities. This is true for most agri commodities and metals. Inflation has been positive for most commodity prices, especially industrial metals.
• Keep a constant eye on global data flows. US and global data flows matter a lot. The macro data flows in the form of the Fed rate action, the jobs data, the production data, the PMI data for manufacturing and services, the stance of the central banks of nations all make an impact on commodity prices.
• Certain industrial commodities are influenced by bulk demand and supply. For example all industrial metal prices are impacted by Chinese demand which accounts for 50% of consumption. Similarly, OPEC actions and US inventory makes a difference to the price of crude oil. Gold is determined by demand from jewellers, ETFs and central banks.
• When you are trading in commodities there is a much higher element of leverage. We are referring to the margin that needs to be paid in this case. For example, if you take a long or short position in index futures, you have to pay around 10% margin (that means a leverage of 10 times) and you have to pay around 15% margin for stock futures (that means a leverage of 6.66 times). When it comes to commodities the leverage offered is much higher. Normally, the leverage is as high as 14-16 times in many cases.
• Trading commodities is all about trading the trend. Commodities follow larger cycles and sub-cycles. You will have bouts of volatility within these larger cycles. But you need to catch this trend and trade within the contours of this trend. A contrarian approach may work very well in case of equities but it may really not help you in commodities trading. Commodities are a lot more homogenous compared to equities and hence the key lies in catching the underlying trend and trade in the same direction.
• Significance of a stop loss gets enhanced in case of commodities for 2 reasons. Firstly, commodities are highly leveraged positions on low margins and hence strict stop losses are necessary to curtail your losses. Secondly, stop losses will ensure that you do not over expose yourself to any particular commodity. That will make your trading positions skewed in favour of few commodities substantially increasing your risk.
• Most traders indulge in commodity trading for the adrenaline rush. That is not a very smart thing to do. Don’t get carried away by the heat of the moment. When you are an aggressive trader, there is the temptation to over trade and try to recover your losses. That is not the way trading in commodities in practice. Ensure that you never get a margin call from the exchange and that means you need to manage risks very smartly.
• Trading equities, futures, options or commodities, is all about trading to a plan. When we refer to a trading plan we are talking about a set of rules that will act as a guide for your trading. You must set rules to the maximum exposure you will take to a particular commodity position. Also your trading plan must cover how much you are willing to lose in a trade, at different time intervals. Your trading plan must also very explicitly cover how you are going to conserve your capital and at what point will you shift largely into cash.
These are just some of the basic rules of commodity, but they can be a good starting point.