Commodities trading protection against inflation

Budget 2007 has proposed several measures to curb rising prices in agricultural products. Commodities trading also provides protection against inflation.

By Tejas Bhope | Print Edition: March 22, 2007

Budget 2007 has proposed several measures to curb rising prices in agricultural products. Commodities trading also provides protection against inflation. MONEY TODAY explains the whys and hows:

Most people invest in debt, real estate and stocks. But in a scenario of rising inflation, returns from these assets erode. Inflation is however, ideal for commodity investors. Inflation generally occurs because commodity prices rise. If you can invest directly in the commodities, your returns will at least match the price rise. In fact, your returns may far exceed the inflationary impact.

Commodity trading has a long history in India. But various commodities were banned between 1962 and 1970 for fear of price manipulation. Trading was reintroduced in 2002 after a hiatus of almost four decades. It is regulated by the Forward Markets Commission (FMC).

The new age commodity exchanges are much more high-tech than traditional mandis. Commodity futures trading generates average daily volumes of about Rs 10,000-15,000 crore.

In a futures trade, you don’t pay full contract value
You pay a percentage of contract value called “margin”
Margin amount is decided by the exchange
The ratio of margin to the contract value is the “leverage”
Leverage amplifies both losses and gains
The higher the leverage, the greater the loss/gain
At end-of-day (E oD), gains or losses are marked to market at last price
Losses are collected from the margin deposited
Gains are added to margin
At expiry/settlement, all losses/gains are adjusted
However, these exchanges only offer futures contracts. Although it is possible to take delivery of a futures contract, if you wish to buy commodities in bulk, it is better to trade in spot markets.

A future contract is a financial hedge against price moves. It doesn’t tackle physical storage and handling issues. As an investor, the other limitation with futures contracts is short-term horizons. Futures contracts normally offer cover for three to six months. But, the returns, both positive and negative, from futures trading is high because of low margins and high leverage (see How Leverage Works).

In futures trading, standard contracts with pre-determined market lots and pre-set margins are offered. You deposit the margin, which is a small percentage of the contract value and take a long position (where you buy a contract) or a short position (where you sell). If you think prices are rising, take long positions and, if you feel prices are headed south, you opt for shorts.

The margins are set by the exchange and vary from commodity to commodity. In gold for instance, the margin is 4% so returns are amplified by a leverage of 25. That means a 1% change in price is equal to 25% change in returns.
Trading in commodities futures is similar to equity futures trading. Many brokers offer both equity and commodities futures. You must open a separate commodity trading account, with the same documentation (PAN, client-member agreement, photos, etc). The trading is dematerialised—contract notes are generated electronically.

Internet-based commodity trading is offered by a few brokers. Brokerage rates are around 0.03% of the contract value and reduce with higher volumes and on intraday trades. The cost of opening an account varies between Rs 350 and Rs 750. Brokers provide daily research reports, to help you make trading decisions.

Commodities trading is classified as speculative. Unlike equity trading, losses incurred in commodities trading can’t be written off against profits.The profit earned is taxed at the highest rate at which your income is taxed.

Commodities are governed by the Forward Contract Regulation Act, 1952 and this does not allow the use of options. Inter-exchange arbitrage is possible to exploit varying prices of the same contracts on two exchanges.

The other trading possibilities include calendar spreads where you buy say, the March contract and sell the April contract simultaneously to exploit a price difference.

For example, a March contract is trading at say Rs 106 while the April contract for the same commodity is trading at Rs 120. You might buy the March contract and sell April in the expectation that the difference will narrow. You would sell March and buy April if you thought the difference will increase. These are typical calendar spreads.

Different commodities have different market lots, which means complicated calculations. You must deal with quintals (100 kg), a bale (170 kg) or a carton (22.68 kg).

The margin is determined by the exchanges and depends on price volatility. At the end of each trading session, margin is recalculated and “marked-to-market”. More margin is collected if the position suffers a loss while gains are added on. The margin is lower if you are a seller.

Many commodities have yielded good returns in 2006-7 as inflation has risen across several groups of agri-commodities. As shown in the table Inflationary Returns the price of pepper on NCDEX has increased by 82% in the past 12 months while the price inflation of pepper according to the Wholesale Price Index (WPI) has been 72%. Actually, since the margin for pepper is set at 9.11% of the contract value, the return of 82% could have been multiplied by a leverage of 10.9 for a mind-boggling gain of over 900%.

Several commodities such as sugar, gur and Brent crude have negative returns in the same period. But a sophisticated trader could even exploit these by short-sales.

Apart from price and liquidity risk, political risk is also present. In January, futures contracts of tur and urad were banned. The Budget has suspended trading in wheat and rice futures, apparently in order to prevent speculative rise. Whether the ban will succeed in controlling prices is debatable. But it hurt traders by removing the hedging mechanism.

It requires research to pick the right commodity and trade in the right direction. But commodity trading offers high rewards and protection against inflation. So if you’re concerned about rising pepper prices, add some spice to your portfolio!

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