How does trading in commodity futures compare with equity futures?
Sep 20, 2022
Equity futures are an efficient way to hedge market risks; however, commodity futures are the way to go for a more holistic approach and strategic risk distribution.
Stock futures and commodity futures can complement each other pretty well. Commodities are an asset class that offers the benefit of economic cycles. When an economy goes through a boom phase, the commodity future performs remarkably well. You can create a remarkable portfolio, assembling various commodity classes such as agro-commodities, bullion, base metals, and energy.
In India, commodities markets are essentially commodity futures markets. The spot commodity markets are still regulated by the respective state governments, not the commodity market regulator. On the contrary, the commodities futures market has a full-fledged exchange mechanism with standard contract sizes and expiry schedules, robust surveillance, and risk management systems. National Commodities and Derivatives Exchange of India (NCDEX) and Multi Commodity Exchange of India Limited (MCX) are the two exchanges/platforms for commodity futures markets/commodity trading.
Just like equity futures, commodity futures can be settled by squaring up positions or actual delivery. Suppose the trader is unwilling to take actual delivery. In that case, he needs to square off positions before expiry or roll over the same to next month before it goes into the delivery process.
Commodity futures offer several advantages for investors who want to diversify from equity futures. Here’s a quick look at some of them:
Commodity futures are an excellent hedging tool
Commodity futures are an excellent way to hedge positions because you can trade on margins here. This implies that a margin of 10-15% of the notional value of the commodity contract allows you to take a position more significant than you can afford. Commodity futures are also a hedge against inflation. High inflation leads to a rise in commodity prices in contrast to stocks and bonds that perform better with a lower inflation rate. This is why several investors turn to gold during phases of high inflation.
Commodities can be traded with extended market hours
In India, trading begins at 9 am for agro-commodity futures and continues until 5 pm on NCDEX. In contrast, for the international market, trading continues till 9 pm for agro-commodities such as cotton. For non-agro commodities like bullion, base metals, and energy contracts, trading continues till 11: 30 pm. The extended trading hours help investors capitalize on the advantage during extreme volatility in global markets.
Commodities help in diversifying the portfolio
Typically, stocks are closely related and have a positive correlation among themselves. In contrast, commodity prices have a negative (prices move in the opposite direction) or low correlation (weak relation) with stock prices, acting as a potent stock market hedge. Let’s say oil and stocks usually have a negative correlation, which means that oil prices are on the rise during a stock market downturn. Similarly, when the stock market is stronger, oil prices are lower. By including diverse asset classes in your portfolios, you can enjoy downside protection and upside potential.
Tracking the fundamentals in the commodity futures market is easier
Tracking the fundamentals in stock futures involves several factors. The internal position of the company and the broader macro factors contribute to their performance. On the other hand, it’s easier to track the fundamentals in commodity markets as demand-supply. The commodity prices move in tandem with the economy. An improving scenario signifies increasing consumption of raw materials, impacting the prices by pushing them higher. Similarly, weak economic growth has a negative impact on demand, thereby leading to lower prices.
Should you trade commodity futures?
Commodity futures trading is a high-risk, high-reward affair. Its performance depends on several global factors like demand-supply mechanism, currency fluctuations, and macroeconomic policies. Thus, it is important to closely track the global markets, as the Indian commodity market reflects the pricing fluctuations of global exchanges like NYMEX, COMEX, SHFE, and LME.
Commodity futures are a powerful tool for diversification and hedging, but to reap results, you need to understand the supply-demand dynamics of the global commodity market. Commodity trading involves speculation, thus, if you're just starting, lower your risk by limiting margin usage.