Commodity markets have made rapid strides in terms of volumes and open interest in the last decade since they have been traded actively. For too long equities and debt were the principal investment avenues for people. With the advent of commodity futures, commodities have emerged as a distinct asset class where individual can actually participate through the market mechanism. Why it is that commodity have emerged as a distinct asset class and what are the unique features that should make commodities interesting for investors? Of course, when we talk of commodities we are talking with specific reference to commodity futures.
Why are commodities emerging as a distinct asset class?
The first big advantage with commodity futures is the benefit of leverage. What do we mean by leverage? When you take position in commodity futures, you only pay a small margin to initiate the position. The margin normally consists of a combination of SPAN margin and an extreme loss margin. In case of commodity futures this is normally around 5-6% which gives the trader a leverage of nearly 20 times. Thus, even with a small margin investment, one is able to take a position in commodities.
Commodity futures are extremely liquid. At least major commodities like crude oil, gold, silver, mentha oil, cardamom, nickel, zinc, copper are all extremely liquid. Getting large transactions executed is quite simple and does not involve too much of impact cost. Unlike physical commodities, these commodity futures are standardized and can be held purely for investment purposes. Commodity futures allow you to participate in commodities without bothering to take physical delivery; making it cheaper and more convenient.
Commodities act as a good inflation hedge. Why does this happen. Normally commodities are part of most inflation indices. For example, the inflation index has an agricultural component and also a non-agricultural component. It is possible to participate in the rise in price of these commodities through futures. Hence it becomes an automatic hedge against inflation. In fact, among various asset classes commodities offer the closest hedge against inflation.
When investors allocate money they look at factors beyond returns. One such attribute is diversification. What do we mean by diversification? You do not want your entire portfolio to be similar in nature as the entire portfolio will underperform if the conditions are unfavourable. By adding commodities the overall portfolio gets diversified as commodities have a low correlation with equity and debt. Also as an asset class, commodities tend to follow distinct cycles, which make them a good diversifier of risk.
Standardization of contracts is another major advantage of commodity futures. Unlike equities, commodities are heterogeneous products with sub –classification on the basis of type, quality, grade, purity etc. By standardizing these into similar baskets, commodity future simplifies the entire process of trading commodities into one simple algorithm. Also when you trade commodities through the futures route, you do not have to worry about physical delivery, holding, demurrage etc. You can just participate in the price movement.
Commodity futures are traded on an electronic exchange where prices are determined in a transparent manner through the forces of demand and supply. Traders in commodities know exactly the price at which their order is getting executed and that transparency makes the entire process a lot simpler and democratic.
Commodity futures are executed on an exchange where the clearing corporation actually guarantees each and every transaction. Virtually, the clearing corporation acts as the counterparty for every transaction and hence counterparty risk is eliminated. This is in contrast to the opaqueness and risks in a forward market.
Commodity futures can also be used as a lead indicator for taking trading decisions in equities. For example, Sterlite and copper prices tend to move in tandem and the commodity price tends to precede the stock price. There is a similar relationship between Titan and gold prices. Similarly, there is a positive correlation between the price of crude and the stock price of stocks like ONGC and Oil India. Such relationships can be leveraged upon.
There is another very important advantage in commodities that is not appreciated by a lot of trader. Most of the key commodities like gold, silver, nickel, copper, tin, aluminium etc are denominated in US$. As a result they tend to have a negative relation with the dollar. So effectively when you buy commodity futures you are short on the dollar and when you sell commodity futures, you are long on the dollar. This is more so for commodities where the domestic price is set based on international prices.
Commodity futures offer the benefit of simplicity and diversification to traders. For traders and investors used to traditional avenues like equity and debt, commodity markets offer an attractive alternative.