How Commodity Trading Works in India: A Beginner's Guide

Understanding how commodity trading works can helps Indian beginners to familiarize themselves with the gold, silver and crude oil futures markets and the futures markets of agricultural products, where contracts are traded through standardized agreements. Trading commodities in the derivatives market is not the same as buying a commodity in the shop next door. Participants in exchange-traded commodity derivatives take positions on the price movement of a commodity subject to the terms of the contract, margin requirements and rules of settlement.

Commodity derivatives in India are traded by members of recognized exchanges. MCX is popular for trading non-agricultural commodities like precious metals and energy products and NCDEX for agricultural commodities. Like stocks, the instruments available for trading on a commodity exchange can change, and traders should always check the latest contract available before taking a position. Expiry and settlement rules, use of margins, how to close positions and how to monitor positions and other aspects of commodity futures are explained in detail in this guide.

What Is Commodity Trading?

Commodity trading consists of buying and selling commodities or financial contracts linked to their prices. Commodities can include precious and industrial metals, energy and agricultural products. Traders can participate in the market for price risk management, speculation on price movements or implementing other market strategies. Unlike commodities, a derivative's value is correlated to an underlying commodity. However, trading a derivative does not equate to buying and storing the physical commodity.

For detailed information, please refer to InvestEdge360’s complete guide on commodity trading in India. If you wish to explore commodity investment opportunities available in the markets of gold, silver, and other exchange-traded commodities, you can open a commodity trading account with Motilal Oswal to gain access to a commodities trading platform with market opportunity, trading cost, and risk analysis.

Commodity Trading in India: Exchanges and Contracts

Exchange traded commodity derivatives are governed by the rules and the regulatory framework applicable to the securities and commodity derivatives market in India. Generally, the investor/trader accesses the market through a broker who is a trading member of the respective segment. The broker’s trading platform provides order access, and order and/or position information. The exchange and clearing corporation provide trading, risk management and settlement services.

MCX commodity trading

The Multi Commodity Exchange of India (MCX) has contracts in categories such as bullion, base metals and energy products. Some examples of well-known commodity categories include gold, silver, copper, crude oil and natural gas. The contract names, available expiries, trading sessions and contract specifications, among others, should be verified on the exchange’s website.

NCDEX trading

Agricultural commodity derivatives on the National Commodity and Derivatives Exchange (NCDEX) are well-known. Each agricultural contract may have specified quality grades, delivery centres, tender periods and delivery procedures. It is important to be familiar with these as an agricultural contract may have a settlement process that is different from a non-agricultural contract. Not all commodities are available for derivatives trading. Not all contracts may follow identical rules.

To understand account access for the agricultural derivatives segment, see the requirements described on the NCDEX trading account page. Access to a given exchange or contract may depend on the broker, client eligibility and the requirements of the given exchange.

How Commodity Trading Works: Step by Step

Step 1: Choose a commodity and understand its price drivers

Start by identifying the commodity you want to study. Prices may respond to different factors: precious metals can be influenced by global prices, currency movements, interest-rate expectations and demand for safe-haven assets; energy prices can react to supply, demand, inventory data and geopolitical events; agricultural prices may be affected by weather, crop output, stocks, imports, exports and government policies. These are examples of possible influences, not reliable short-term price signals.

Before considering a trade, understand what information is relevant to that commodity and whether you can monitor it. A product's familiar name does not make its derivative contract simple or low risk.

Step 2: Select the exchange and verify the contract

After choosing a commodity category and exchange, you need to verify the available contracts through your broker. The current contract specifications should be reviewed and analyzed rather than relying on a generics description of the commodity. You should analyze the following:

• Trading unit or lot size: This is the quantity represented by a contract.

• Quotation unit: This is the unit price is quoted by, which can be a specific amount per unit weight.

• Tick size: This is the minimum price movement.

• Expiry date: This is the date when the contract no longer trades on the exchange.

• Delivery and settlement terms: This specifies if the contract is cash settled or a deliverable contract.

• Quality and location terms: This is especially important when a contract involves physical delivery.

Understanding these specifications will help you assess your financial risk when taking a position in the commodity.

Step 3: Calculate the contract value

To calculate the contract value, we multiply the quoted price by the number of units in the contract, keeping in mind any unit and contract conversion. For example, let's say we have a hypothetical contract that represents 100 units and the quoted price is ₹500 per unit. In this case, the contract value would be ₹50,000. In reality, the actual unit, lot size and quotation conventions of a live contract may be very different from the above example.

This is important for the trader to understand because, in the case of contracts for difference, their exposure is for the full contract value. In this case, a small price move can result in a significant profit or loss compared to the margin paid.

Step 4: Open and fund an eligible trading account

A trading account is required to trade commodity derivatives. The account has to be with a broker offering the required segment of commodity, along with completed KYC, onboarding and margin funds or collateral. Just having an equity trading account does not mean that all commodity contracts are activated. Confirm segment activation fees, platform access and other requirements with the broker.

Read the broker’s tariffs and risk disclosures before trading. While trading contracts, the client is liable to pay the brokerage charges, exchange transaction charges, taxes and levies, and other service charges. Verification of the applicability and amount of each charge should be taken from broker and exchange’s current information.

Step 5: Understand margin before placing an order

What is meant by “commodity margin” is funds or eligible collateral required to support the derivatives position. In order to open a position, an exchange requires an “initial margin”. There can be other margins, depending on the contract, market conditions, concentration, volatility and closeness to expiry or delivery. Exchanges and clearing corporations may adjust requirements based on their rules.

Margin is not the maximum possible loss, and is not a down payment to purchase the entire commodity. It supports the obligations associated with a leveraged contract. If prices move against a position, additional funds may be required. If the trader does not fulfill a margin call, the broker can take several actions against the trader based on its policies, and other applicable rules.

Step 6: Place and confirm the order

Once you’ve assessed the risks and understand the contract, you will then be in a position to place your order. You will be required to specify the type of order (market or limit), the order price, number of lots, and order type. A market order is an order to buy or sell at the current best price in the market. A limit order is an order to buy or sell at a price that is at or better than the specified price. Not all limit orders are filled at the specified price. Orders may be filled at a worse price or not at all.

You will need to verify that the order status reflects what you expected. It may not be prudent to assume that an order has been fully filled just because you clicked a button. You will need to analyze the contract, the direction and quantity that was filled, and the average price at which the contract was filled, especially when similar contracts are listed.

Step 7: Monitor the position and mark-to-market obligations

Once a futures position is opened, one must monitor its fair market value, available funds, the use of margin, and time to expiry. A position in futures is subject to mark-to-market settlement. In the case of adverse price movements, the futures trader will be obligated to make a payment, and in the case of favorable price movements, the trader will be entitled to receive a payment, again, subject to the rules of the exchange and clearing house.

In an example, a long futures position is exposed to loss when the contract price falls, and a short futures position is exposed to loss when the contract price rises. Again, like any options or equity instrument, a futures position can lose value rapidly especially during market volatility. It is good practice to monitor broker alerts and exchange notices to maintain sufficient funds for the trade rather than to assume the original margin deposit will cover the trade.

Step 8: Close the position or prepare for expiry

A trader has the right, but not the obligation, to continue holding a position. One of the ways to cease holding a position is to place an order to close the position, assuming there is sufficient liquidity, given trading hours, and in accordance with any applicable rules. Generally speaking, long positions are closed by selling the position, and short positions are closed by buying the position. Profit and loss are determined by execution prices, settlement adjustments and costs.

Closing a position can remove certain obligations related to that position, and, if closing a position is desirable, a trader should confirm that the order has closed the position. Contract-specific cut-off times, and a broker’s square-off policy, if any, would be of importance. Do not wait to act until the last minute to learn a contract has a delivery or tender requirement.

Commodity Futures, Expiry and Settlement

A commodity futures contract is an agreement to buy or sell a particular quantity of a commodity in the future at an agreed upon price. Such contracts are of two types. The first type is used by commercial participants for managing their price risk. The second type is used by non-commercial participants for taking a view on price movements. The expiry and the settlement of a futures contract is governed by the rules of the exchange and the terms of the contract.

To know more about futures concepts, refer to SEBI’s investor education material on the commodity derivatives market. The important point for a beginner is that an exchange traded contract is a financial obligation governed by standardized rules. Thus, an exchange traded contract is not an informal promise to buy a commodity later.

Does every commodity contract require physical delivery?

No. Settlement depends on the terms of the contract. Many retail participants close out their positions before expiration, and some contracts provide for cash settlement. Other contracts may involve physical delivery, such as certain specified agricultural contracts, or other contracts whose rules require delivery. In contracts that provide for delivery, buyers and sellers may be required to meet delivery location, quality, documentation, pay-in/pay-out, time and other requirements and obligations, including applicable margins and/or charges.

A trader should never assume that every commodity derivative is cash-settled or that every trader has the option to take or make delivery. There are numerous variations, and eligibility may be restrictive. If a contract provides for physical delivery, failing to meet the requirements may result in added costs, penalties or other consequences under the applicable rules. Confirm the latest contract circular and broker instructions before the tender period or expiration date.

Physical Commodity Transactions and Derivatives

Both activities are linked but different. Buying physical gold from a seller, purchasing grain for a business or arranging a direct supply of crude-related products involves a physical transaction and has many other considerations (e.g. quality, transport and storage, payment and delivery terms, etc.). On the other hand, trading a futures contract means taking a position in a standardized derivative (traded on an exchange) and assuming the exchange’s clearing house’s defined settlement obligation.

• Physical transaction: the buyer and seller come to an agreement about commodity, payment, delivery and other contractual quality and logistical terms.

• Exchange-traded derivative: participants take a position in a standardized contract traded through an intermediary and settle through a clearing house as per the rules and procedures of the exchange and clearing house.

• Delivery-linked derivative: the contract may obligate the eligible buyer/seller to access the exchange's delivery procedure to fulfill the obligation in the event the position is still open at that stage.

It should be understood that the existence of a futures contract does not mean that a retail trader should expect a parcel of the commodity to arrive. Read the contract’s settlement and delivery terms and specifications before taking a position.

MCX vs NCDEX: What Should Beginners Check?

MCX and NCDEX are named after different categories of commodities, but the right contract for a participant depends on the product, current listing, contract rules and trading objective. MCX and NCDEX are not to be chosen based on their name only and contract specifications and practical conditions need to be compared.

• Check whether the exact commodity and expiry are listed.

• Look for lot size, tick size, quotation unit and expiry date.

• Check the trading sessions, special sessions and holiday variations.

• Check the settlement method and delivery centre, if applicable.

• Compare Current Margin requirements, Liquidity, Bid-Ask spread and other charges.

• Confirm that your broker has activated the required segment and contract.

Exchange Products and contract conditions can change. The latest official contract documents of the exchanges can be relied upon. Information pertaining to the contracts available on Social Media and other forums cannot be relied upon. SEBI’s Investor Education and Protection Fund (IEPF) Resources can be relied upon for understanding the risks involved in trading of Derivatives.

Key Risks of Commodity Trading

Commodity derivatives can be highly volatile. Global supply and demand, currency changes, geopolitical developments, weather, government policy and unexpected inventory or production data may cause sharp price movements. Leverage means that a trader can have exposure larger than the margin deposited, so losses may be substantial and can exceed the initial margin.

• Leverage risk: a small price movement can have a large effect relative to the margin deposited.

• Margin shortfall: adverse movement or increased margin requirements may mean additional funds are needed quickly.

• Liquidity risk: thin trading can widen spreads and make it harder to exit at a desired price.

• Expiry and delivery risk: failing to understand contract-specific procedures can create unexpected obligations and costs.

• Overnight and event risk: prices may move sharply while the trader is not actively monitoring the market.

• Cost risk: brokerage, exchange charges, taxes and other applicable costs reduce the net result.

Beginners should learn the contract mechanics before using leverage, avoid risking money they cannot afford to lose and consider whether they can monitor the position and meet possible margin calls. No trading method can guarantee profits.

Checklist for First Time Commodities Trader

1. Make sure your Broker is authorized for the commodity derivatives segment.

2. Take a look at latest contract specifications, understand lot size, price quotation and expiry.

3. Calculate the notional contract value and understand the effect of a price movement.

4. Know your initial margin, other margins and potential margin calls.

5. Understand order types, liquidity, bid-ask spread and trading hours.

6. Read the settlement method and determine whether delivery obligations may apply.

7. Know the broker charges, square off policy and margin shortfall policy.

8. Have a risk limit and plan to manage or close the position.

Conclusion

Understanding how commodity trading works in India involves learning about the underlying commodity, selecting the right listed contract, knowing its specification, meeting the margin requirement, placing and managing orders and understanding how the position is closed or settled. The most important aspect is understanding that contracts are not interchangeable. Lot size, expiry, margin and delivery rules change from contract to contract, and can change overtime.

Before trading, confirm the latest information from the exchange and broker, and use the official Investor education materials to augment your knowledge. Commodity Derivatives are leveraged products, and losses can occur quickly, therefore this document is educational and not personalized trading or investment advice.