9 Common Myths

Rahul Oberoi/Money Today        Print Edition: May 2012

Money Today speaks to market players to clear the misconceptions around commodity trading.

1. COMMODITY TRADING IS FOR SPECULATORS
For years, commodity trading has been a part and parcel of the economy. Market participants, particularly hedgers, arbitrageurs and speculators, help in efficient price discovery and price-risk management.

"Speculators are an important link in the market. They can work only because someone is hedging their risk," says Naveen Mathur, associate director, commodities and currencies, Angel Broking.

Ashwin Vidhate, economist, NCDEX, says, "Trading in commodity futures is not different from trading in stock or currency futures. Speculation does not amount to gambling. Speculators are important market participants who inject liquidity and help hedgers transfer risk. The absence of speculators will mean fewer players in the market, making it difficult and expensive for participants to transfer risk."

Speculators are prepared to assume the risk which hedgers are trying to transfer in the futures market. Market experts say speculators add depth and liquidity to the market.

2. UNDERSTANDING THE MARKET IS TOO DIFFICULT
Many investors think the commodity market is difficult to understand. Vivek Gupta, head of research, CapitalVia Global Research, does not agree.

"All commodities are globally traded and the global-demand supply situation is widely known and available to anyone who reaches out for it. So, understanding commodities is not complex as it is basic economic factors and seasonal cycles that affect prices."

3. THERE IS NO ASSURANCE ON QUALITY OF COMMODITIES DELIVERED
Most exchanges put quality control measures in place to ensure that commodities delivered to their warehouses meet high quality standards. They also make efforts to ensure that only quality stocks are delivered to buyers.

Experts say commodities delivered within the final validity period are of standard grade and quality.

Dilip Bhatia, chief executive officer, Ace Derivatives and Commodity Exchange, explains, "The exchanges have well-established inspection and audit processes to ensure adherence to the highest standards in testing, assaying and storage of commodities, ensuring the quality of commodities delivered."

"The buyer also has the option of getting the stock examined for quality while taking delivery," he says.

4. COMMODITY MARKETS ARE TOO VOLATILE
Many investors see volatility as a big problem. They have to invest 4-10 per cent value of the commodity, far less than in stock futures. However, many do not know how to gain from such high leverage. Another problem is that they overtrade and use the margin to the hilt. Therefore, if prices rise a little, they can double their money, but if prices fall, they can lose all their money.

"Commodities are no more volatile than stocks if we remove the leverage," says Shariq Hoda, executive vice president-products, Religare Broking.

However, Harish Galipelli, head, commodities, JRG Securities, says, "The fact is that prices of derivatives are directly linked to prices in spot markets," Apart from this, unlike stocks, which can move by even 20 per cent in a single session, metal and energy contracts can rise or fall up to 6 per cent in a day. In agri commodities, the range is only 4 per cent.

5. COMMODITY EXCHANGES FUEL INFLATION
Commodity exchanges promote price transparency. Today, a copper wire manufacturer in Punjab can see the live international price of copper in London on his trading terminal. Similarly, a farmer in Haryana can know the current price of wheat in Delhi. By allowing wider participation, exchanges discourage cartelisation by local traders and associations and facilitate fair price discovery.

"By providing futures trading in far-month contracts, exchanges provide price signals to farmers, policy-makers and other value chain participants,"says Ashwin of NCDEX.

6. DIFFICULT TO MAKE MONEY IN COMMODITY TRADING
It is generally believed that most investors lose money in commodities futures. "This happens only when market participants do not trade with discipline and fall victimto greed and fear," says Mathur of Angel Broking.

For example, investors hold on to losses in expectation that prices will recover. In case of profits, they square off positions for the fear of losing the already earned money.

Professional guidance can help in such situations. Gupta of CapitalVia Global Research, says, "Professional traders make huge money for clients. They have spent time in understanding market movements and apply the right blend of technical and economic analysis. Many fund managers and hedge funds trade only in commodities and have a record of giving 20-30 per cent a year for more than a decade."

7. COMMODITY TRADING IN ONLY FOR LARGE TRADERS AND HIGH NET WORTH INVESTORS
This is not the case. As Dharmesh Bhatia, associate vice president-research, Kotak Commodities Services, puts it, "I do not think the commodity market is only for investors who have a lot of spare money. It is like any other derivatives market and any person can trade by paying a small percentage of the total value of the contract."

"In India's commodities markets, lot sizes are low and any retail investor can participate by paying a margin of 4-10 per cent," says Hoda of Religare Broking.

Big exchanges such as the Multi Commodity Exchange, the National Commodity and Derivatives Exchange, the National Multi Commodity Exchange and the Indian Commodity Exchange have several options for high net worth investors, companies and small investors.

For instance, the exchanges first launched gold contracts on 1 kg bars. Later, they introduced 100 gram, 8 gram and 1 gram contracts to attract small investors. Multi Commodity Exchange launched a 1 gram gold petal contract in 2011 with a 4 per cent margin requirement. So, one can invest as little as Rs 112 and take exposure of Rs 2,776 (the price of 1 gram gold on 28 March 2012).

8. DELIVERY OF COMMODITIES IS COMPULSORY
There is a common belief that anyone who buys commodity derivatives has to take delivery as well. Delivery is mandatory only in specific commodities and that too only if one keeps the position open after the delivery notice period.

There is compulsory delivery in commodities such as chana and gold. However, an investor cannot take delivery of crude oil and metals, as trades in these two commodities are cash-settled. Settling a futures contract by payment of price difference rather than delivery of the physical commodity is known as cash settlement.

Bhatia of Kotak Commodity Services explains, "It is not necessary to take delivery as long as the trader squares off his positions before the contract's expiry. Only commercial players like hedgers and arbitrageurs take delivery."

9. PRICES ARE EASY TO MANIPULATE
Most commodities that are traded are produced and consumed across the globe. As such, any person or a group of persons cannot easily manipulate prices. However, illiquid commodities can be easily manipulated, say experts.

Harish Galipelli, head, commodities, JRG Securities, says, "Price manipulation is possible only when production is concentrated in an area. It does not happen in essential commodities. Regulators and governments across the globe monitor prices of essential commodities and take measures whenever there is an attempt to manipulate the markets."

Mathur of Angel Broking says, "One cannot change a commodity's fundamentals. Commodity prices reflect demand-supply dynamics and thus operators cannot manipulate prices. Besides, commodities are traded worldwide and hence there is a minimal chance of manipulation by a handful of participants."




BACK TO SCHOOL

HEDGERS have an underlying interest in specific delivery or ready delivery contracts and use the futures market to insure themselves against adverse price movement.

SPECULATORS may not have an interest in ready contracts but seek opportunities in price movements. They assume risk which hedgers are trying to transfer in the futures market.

ARBITRAGEURS make simultaneous sale and purchase in two markets to gain from the price difference. They remove price imperfections in different markets.

FORWARDS CONTRACTS are for supply of goods and payment where supply of goods or payment or both take place after 11 days from the date of the contract or where delivery of goods is totally dispensed with.

FUTURE CONTRACTS are contracts in which quantity, quality, date of maturity and place of delivery are standardised and the parties to the contract only decide the price and the number of units to be traded. Bearing standardised, futures contracts are entered into through commodity exchanges.


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