Learn commodity trading basics

What ARE Commodities?

Why fungibility matters: It allows standardized contracts and transparent pricing. You don't need to inspect "this particular wheat" vs "that wheat"—a Chicago wheat contract is a Chicago wheat contract.

Categories of Commodities

1. Energy: Crude oil, natural gas, gasoline, heating oil
2. Metals:
   • Precious: Gold, silver, platinum, palladium
   • Industrial: Copper, aluminum, zinc, nickel
3. Agricultural:
   • Grains: Wheat, corn, soybeans, rice
   • Soft: Coffee, cocoa, cotton, sugar
   • Livestock: Live cattle, lean hogs

Same metal category, opposite drivers.

How Commodity Trading Works

The Contract Structure

Example: One COMEX Gold futures contract =

• Commodity: Gold
• Quantity: 100 troy ounces
• Quality: Minimum 99.5% purity
• Delivery: Any business day in contract month
• Location: COMEX-approved vaults in New York

Why this specification? Before standardization, every gold trade required negotiation: "How pure? When? Where?" Standardization → liquidity → price discovery.

Spot vs. Futures

The relationship between them:

$F = S \cdot e^{(r + u - y)(T - t)}$

Where:

• $F$ = Futures price
• $S$ = Spot price
• $r$ = Risk-free rate
• $u$ = Storage costs (% per year)
• $y$ = Convenience yield
• $(T - t)$ = Time to delivery in years

Derivation from first principles:

1. Start with arbitrage-free pricing: If I buy the physical commodity today at spot price $S$ and sell a futures contract at $F$, I lock in a profit/loss.

2. Cost of carrying physical: Holding the commodity costs money:

   • Financing cost: I need capital $S$ for time $(T-t)$, which costs $S \cdot e^{r(T-t)}$
   • Storage cost: Physical storage at rate $u$ per year = $S \cdot e^{u(T-t)}$

3. Benefit of holding physical (convenience yield): Owning the physical commodity has value—manufacturers need it for production, you can't run a refinery on a futures contract. This benefit is convenience yield $y$.

4. No-arbitrage condition: $F = S \cdot e^{r(T-t)} \cdot e^{u(T-t)} \cdot e^{-y(T-t)} = S \cdot e^{(r+u-y)(T-t)}$

When is $F > S$ (contango)? When storage + financing costs exceed convenience yield. Common for gold (high storage, low convenience).

When is $F < S$ (backwardation)? When convenience yield exceeds carry costs. Common for oil during supply squeezes—refineries pay premium for immediate delivery.

Find: Theoretical 6-month futures price

Solution: $F = S \cdot e^{(r + u - y)(T-t)}$ $F = 4.50 \cdot e^{(0.03 + 0.05 - 0.02)(0.5)}$ $F = 4.50 \cdot e^{0.06 \times 0.5}$ $F = 4.50 \cdot e^{0.03}$ $F = 4.50 \cdot 1.0305$ $F = \$4.64 \text{ per bushel}$

Why each step?

• Step 1: Apply cost-of-carry formula
• Step 2: Plug in values (note: rates as decimals)
• Step 3: Combine exponent $0.06 \times 0.5 = 0.03$
• Step 4: Calculate $e^{0.03} \approx 1.0305$
• Step 5: Multiply to get futures price

Interpretation: The futures price is $0.14$ higher than spot because the net carry cost $(3\% + 5\% - 2\% = 6\%$ annual) over 6 months adds ~3% to the price. This is contango.

Trading Mechanisms

1. Futures Exchanges

• MCX (India): Gold, silver, crude oil, copper, natural gas
• NCDEX (India): Agricultural commodities
• COMEX (US): Metals
• CME (US): Energy, agriculture
• ICE (International): Energy, soft commodities

2. Spot/Physical Markets

• OTC (Over-The-Counter): Direct contracts between parties
• Bullion dealers: Physical gold/silver
• Commodity ETFs: Track spot prices without futures rolling (e.g., GOLD ETF)

Futures contract:

• Gold futures (MCX): 1 kg contract
• Gold price: ₹60,000 per 10g = ₹60,000 per kg
• Margin required: ~5% = ₹3,00,000

Physical gold:

• 100g at ₹60,000 per10g = ₹6,00,000 upfront
• No leverage

Why this step? Futures offer 20x leverage (5% margin = 1/0.05 = 20). A 5% gold price move =100% gain/loss on your margin.

The risk: If gold drops 3%, you lose ₹1,80,000 on a₹3,00,000 margin =60% of capital. Broker will issue margin call to deposit more funds or auto-liquidate.

Key Pricing Factors

$P_t = f(\text{Supply}, \text{Demand}, \text{Inventory}, \text{Speculation}, \text{USD strength})$

Supply factors:

• Weather (droughts, floods for agriculture)
• Geopolitics (OPEC decisions, sanctions)
• Production costs (mining, drilling)
• Technology (fracking unlocked US oil)

Demand factors:

• Economic growth (industrial metals)
• Seasonal patterns (heating oil in winter)
• Substitution (electric vehicles → less oil demand)

Inventory levels:

• High inventory → oversupply → lower prices
• Low inventory → scarcity → higher prices + backwardation

Why the spike?

1. Strong emerging market demand (China, India)
2. Weak dollar (oil priced in USD)
3. Speculation (hedge funds piling in)
4. Supply fears (Nigeria unrest, hurricane season)

Why the crash?

1. Demand destruction: Global financial crisis → recession → less oil consumption
2. Deleveraging: Hedge funds forced to sell meet margin calls
3. Inventory build: Weak demand → storage tanks filled → contango

The same commodity, 78% drop in 5 months. Commodities amplify macroeconomic cycles.

Common Mistakes

Why it's wrong:

1. Commodities are pro-cyclical: They boom in economic expansions (demand rises) and crash in recessions (demand falls), regardless of inflation.
2. Inflation type matters:
   • Demand-pull inflation (strong economy) → commodities rise✓
   • Stagflation (weak economy + inflation) → commodities mixed
   • Deflation → commodities crash despite being "physical"

Example: 2015-2016 commodities crashed 30% despite ongoing QE and inflation fears, because China's growth slowed (demand factor dominated).

Steel-man: The mistake conflates long-term inflation protection (over decades, gold tracks CPI) with short-term trading (where cyclical demand dominates).

Fix: Trade commodities based on supply-demand cycles, not just inflation. Gold is the exception (monetary asset), but crude oil, copper, wheat follow economic cycles first.

Why it's wrong: Futures contracts expire. If you don't close before expiry, you must:

1. Take physical delivery (you need storage, quality grading, logistics)
2. Roll to next contract (sell expiring, buy next month)

Rolling costs (contango/backwardation):

• Contango (next month $F > S$): You sell low, buy high → lose money on roll
• Backwardation (next month $F < S$): You sell high, buy low → gain on roll

Example: Oil ETF (USO) lost 30% in 2020 despite oil stabilizing, because it kept rolling in steep contango—every month paying more for the next contract.

Fix:

• Trade actively, close before expiry
• Use commodity ETFs only if you understand their rolling strategy
• For long-term: consider mining stocks or physical metal (gold)

Risk Management in Commodities

$\text{Contracts} = \frac{A \times R\%}{\text{Contract Value} \times \text{Expected \% Move}}$

Why? Limits loss to $R\%$ of account on expected adverse move.

How many contracts?

Maximum loss allowed: $10,00,000 \times 2\% = ₹20,000$

Per contract loss at 5% move: $22,50,000 \times 5\% = ₹1,12,500$

$\text{Contracts} = \frac{20,000}{1,12,500} = 0.178 \approx 0$

Conclusion: The position is too large for this account. You'd need ₹56,25,000 to safely trade even1 contract with 2% risk and 5% stop.

Why this matters: Commodity futures have large contract sizes. Small accounts either:

1. Trade mini contracts (if available)
2. Trade commodity ETFs
3. Accept higher risk per trade (dangerous)

Why Trade Commodities?

1. Portfolio Diversification Low correlation with stocks/bonds. In2022, stocks fell 18%, bonds fell 13%, but energy commodities rose 40%.

2. Inflation Protection (Long-term) Physical goods maintain purchasing power over decades.

3. Economic Cycle Plays

• Early expansion: Industrial metals (copper, aluminum)
• Late expansion: Energy (oil, gas)
• Recession: Precious metals (gold as safe haven)

4. Leverage Opportunities Futures offer high leverage for directional bets (with comensurate risk).

Remember: "Farmers raise COWS for Gold" → all major commodity groups.

Connections

• Futures-and-options-basics - Commodity futures are type of derivative
• Portfolio-diversification-strategies - Commodities as alternative asset class
• Understanding-market-volatility - Commodities exhibit high volatility
• Technical-analysis-for-trending-markets - Commodities trend well
• Currency-markets-and-forex - USD strength affects commodity prices
• Global-economic-indicators - GDP growth, PMI drive commodity demand

But what if I want to make sure I can buy a chocolate bar from you 3 months from now? We can make a deal today: "In 3 months, I'll buy your chocolate bar for ₹12." That's a futures contract.

Why would I pay ₹12 instead of ₹10? Because:

1. You have to store the chocolate for 3 months (costs money to keep it fresh)
2. You could have sold it today and used that₹10 to earn interest
3. But also, having chocolate available is useful—if there's a chocolate shortage, you're lucky to have it!

If storage costs more than the convenience of having chocolate, I pay more (₹12). That's contango. If chocolate is super scarce and everyone wants it now, I might pay less for future chocolate (₹9) because having it today is way more valuable. That's backwardation.

Now imagine instead of chocolate, it's oil, gold, or wheat. Companies need these to run factories, jewelers need gold for ornaments, bakers need wheat for bread. The prices go up and down based on:

• How much is available (supply)
• How many people want it (demand)
• What's happening in the world (wars, weather, economy)

Trading commodities means buying and selling contracts for these real things. It's riskier than stocks because:

1. A drought can destroy wheat supply overnight
2. You're using leverage (controlling₹10 lakhs with just ₹50,000 margin)
3. Contracts expire—you can't just "hold forever"

But it's also a way to make money from real-world events, not just company performance.

Flashcards

#flashcards/stock-market

What is a commodity and what makes it different from a stock? :: A commodity is a raw material or primary agricultural product that is fungible (interchangeable). Unlike stocks which represent company ownership, commodities represent tangible physical goods whose prices move based on supply-demand of the physical world, not corporate earnings.

What are the three main categories of commodities? :::1) Energy (crude oil, natural gas), 2) Metals (precious like gold, industrial like copper), 3) Agricultural (grains, soft commodities, livestock).

Define contango vs backwardation :: Contango: futures price > spot price (F > S), occurs when storage + financing costs exceed convenience yield. Backwardation: futures price < spot price (F < S), occurs when convenience yield exceds carry costs, indicating tight supply.

Concept Map

Hinglish (regional understanding)