We all have heard of trading in the cash market versus trading in the futures market in equities. But did you know that there is a similar distinction with respect to commodities too? You can buy commodities in the spot market as well as the futures market. For example, you can either buy cotton in the spot market and take delivery or you can buy cotton in the futures market and decided before the settlement date whether to take delivery or not. Remember, in the spot market there is no choice because delivery is compulsory. If you have bought cotton in the spot market then you need to have funds to take the delivery of cotton. Similarly, if you have sold cotton then you need to have the cotton inventory available with you to give the delivery.
Taking delivery and giving delivery in the equity market is quite simple. In the old days, this was done by endorsing the share certificates with a transform form. But in the modern demat era, giving and taking delivery of equities has become a lot simpler as it merely involves a debit or credit to your online Demat account. Spot commodity markets are, however, a lot more complex. For example, if you bought cotton in the spot market then you need to take delivery of physical cotton. Of course, the process is substantially simplified as the spot transaction can be done with the help of warehouse receipts. In this case, the cotton bales in an authorized warehouse will be evaluated by an assayer and an auditor will issue the certificate of value and the existence of the cotton in the premises. Based on these Warehouse Receipts, the spot transaction can be concluded and settled and the actual delivery can happen after that as it involves physical movement
Spot transaction is immediate but futures transactions pertain to a future date
That is the basic difference between a commodity spot market and a commodity futures market. But the spot name is actually a misnomer. Since spot delivery is not possible practically, the seller is actually given 5-7 days time to complete the execution and honouring of the contract. That is because the entire process of delivering the commodity at the prescribed spot involves formalities and compliance requirements apart from the actual physical movement. Commodity futures pertain to a specific settlement date in the future. Normally, futures expire each month and at any point of time traders have access to trade in 5-6 monthly futures. Volumes are normally focused in the near month only.
Commodities futures are less dependent on geography
This is a very important distinction between spot and futures commodity markets in the Indian context. For example, chillies are produced in Andhra Pradesh, Pepper and Cardamom is produced in Kerala, pulses are produced in Madhya Pradesh while sugar is produced in Maharashtra and UP. In the spot commodity market it is either not possible or not economically feasible to transport these commodities over long distances. Hence spot markets tend to be more limited to geographies. In such cases, futures market can be more useful. Commodity futures are largely region agnostic. Since commodity futures trading is essentially online, you can buy and sell commodity futures sitting anywhere in India. Hence, unless you actually intend to take physical delivery, commodity futures offer a better way of participating in commodities market.
There is a difference in settlement and regulation too
There is a very important distinction to understand here. While the SEBI (formerly FMC) regulates the commodity futures business in India, the commodity spot markets are not regulated by SEBI. They come under the direct purview of respective state governments. The SEBI does not regulate the spot markets of commodities in any way. Even it terms of settlement, they are slightly different. For example, commodity futures transactions on the MCX and the NCDEX are settled by the exchange clearing corporation with appropriate safeguards, risk management and trade guarantee. The spot market on the other hand is an OTC market and hence the settlement takes place on the base of broadly agreed upon rules and principles. There is no institutional mechanism for settlement of spot transactions.
Futures prices and spot prices differ and they tell a story
Normally, futures price tend to quote at a premium to the commodity spot price. In technical parlance that is called the cost of carry. When you buy cotton futures deliverable at a future date, there is additional cost in terms of blocking funds and storage costs that the seller has to incur. That goes into the calculation of the cost of carry. There are also other reasons for the gap. When there is heavy selling in the futures due to speculative reasons, it is likely that the futures price goes below the spot price. Similarly, when there is too much speculative buying interest in the commodity futures, it tends to widen the carry. Normally, when the carry widens, arbitrageurs enter the market and iron out these spreads.
Remember, commodity futures are leveraged products
When you take a position in, say gold futures, you pay a margin of just 3-4%. That effectively means that you get 25 times leverage. With a margin of Rs.1 lakh, you can take positions in the commodity futures with a notional value of Rs.25 lakhs. That is not possible in the spot market. Leverage works both ways. When the position is profitable the profits get magnified by the leverage. At the same time, in the event of losses the loss also gets magnified by leverage.
The crux of the matter is that commodity futures offer you a simple and elegant way of participating in commodity markets. That is unless you want to actually take physical delivery!