Before getting into the nitty-gritty of trading in commodities, you need to understand one basic thing. Commodities markets in India are essentially commodity futures markets. The spot commodity markets are still under the regulation of the respective state governments and the commodity market regulator does not control or regulate the commodity spot markets. (The Indian commodity markets were formerly regulated by FMC, which was later merged into SEBI. So effectively, SEBI is the regulator for the Indian commodity futures market too). With the regulator now permitting the introduction of commodity options on the commodity futures, there is one more SEBI-regulator commodity trading product that is available for traders. What are the special benefits to the customer by trading in commodity futures (in MCX and NCDEX)
Commodity markets bring an institutionalized approach to commodity trading
This is one of the main advantages of trading in commodity futures. You have a full-fledged exchange mechanism. That means; you have standard contract sizes, standard expiry time-tables, comprehensive surveillance systems and foolproof risk management systems. All this reduces the risk of trading in commodities. Contrast this with the market for OTC commodity futures. You do not have a centralized clearing mechanism and no guarantee that trades will be executed and honoured. Secondly, contracts are tailor-made for individual needs and hence it can become illiquid in the absence of the counterparty having a balancing requirement. The commodity exchange mechanism overcomes these basic challenges of the OTC commodity markets.
Holds an edge over spot markets as trading can be done on margins
The big difference between the commodity spot market and the commodity futures market is that in commodity futures you can actually trade on margin. That means by paying a margin of 8-10% of the notional value of the commodity contract, you can take a much larger position than you can afford. This is extremely useful for someone who is looking to hedge their position. For example, if you are looking to receive a consignment of Zinc after 3 months and are looking to protect against the risk of a rise in prices then you can buy 3-months Zinc futures today by paying a small margin and the contract can be reversed when the actual consignment is received. That way by paying a small margin you can protect against the price risk of Zinc.
Traders can trade without worrying about counter party risk
In a sense the market mechanism in case of commodity futures is akin to that of stock futures. When you trade through the stock exchange or the commodity exchange the exchange clearing corporation guarantees each trade executed on the exchange. Effectively, the clearing corporation becomes the counter party for each trade. So if A is the buyer of gold and B is the seller of gold, then both A and B actually trade with the clearing corporation as the counter party. But how does the exchange guarantee each trade? The exchange has the broker margins to fall back upon. It is precisely for this reason that the clearing corporation holds something called the Trade Guarantee Fund (TGF) which they can fall back upon in the event of making good any transaction. This makes the entire process of trading, clearing and settlement a lot safer.
Commodity futures can actually devolve into actual commodities
In the equity derivatives market, all transactions are necessarily settled only in cash. There is nothing like delivery of shares against the futures. So if you are holding futures of Tata Steel, you can go to the exchange on the expiry date and ask for the delivery of shares of Tata Steel equivalent to the futures. That facility is not available in stock futures. They have to be necessarily settled only in cash with the profits being credited and losses being debited to the account of the traders. It is here that commodity futures are slightly different. In the commodity markets, you can actually demand delivery of physical commodities against your long futures positions. Similarly, a trader holding short futures position can actually deliver equivalent quantity of the commodity. Of course, the member is required to provide all prior delivery intimation to the exchange and also affirm to the exchange that all the requisite delivery formalities have been complied with. This makes the commodity futures more of a genuine hedging market. Companies and traders with long/short exposure to respective commodities can actually hedge their risk through the commodity markets.
In a way, the commodity futures contracts are exactly like the contract in stock futures and stock futures in the sense that they operate within a regulated market mechanism which lays great focus on managing risk. The difference is that commodity futures can actually provide a platform to hedge your commodity risk since it permits delivery against settlement. With the SEBI permitting institutional investors like Foreign Portfolio Investors (FPIs) to participate in commodity futures and options in a big way, one can expect greater depth and liquidity in the commodity futures markets in the months to come. That could be the icing on the cake!