What Are Commodity Derivatives - Meaning, Benefits, and Basics Explained

Trading in the stock market comes in various types. You can go for the primary markets or secondary markets, or even the equity market and commodity market. But when it comes to the securities that trade, there are futures, options, derivatives, and more. One such great option is the commodity derivatives. 

The commodity derivatives' meaning is quite simple. It is one where the derivative services the value from the underlying commodity in which it trades. But the question is, why is this important, and why should you consider the same? 

Well, if you are also looking for an answer to the same, then read this guide. Explore everything you need to ensure you trade well. 

What Are Commodity Derivatives?

Commodity derivatives are financial contracts. These contracts get their value from the underlying commodity. These commodities can be hard or soft commodities. The most common commodities include gold, silver, crude oil, natural gas, agricultural products, and base metals.

By doing so, the traders can not just manage the price risk but also earn better from price changes. This plan helps to gain protection against sudden price swings. Here, the trader does not buy or sell the actual commodity, but deals in contracts that track its price movement.

Traders and investors use them to take positions based on market expectations. In India, such contracts are actively traded on platforms like the National Commodity and Derivatives Exchange, which provides a regulated and transparent market.

Features of Commodity Derivatives

Commodity derivatives are financial contracts that are linked to physical commodities. These contracts are traded on regulated exchanges like NSE and BSE. Traders participate by paying a margin amount instead of the full contract value. This makes them more accessible to a larger group of traders.

But when it comes to trading, certain features make them stand out from the rest. The most common features that you should know about are as follows:

• Can be easily traded on the stock exchanges.

• Works based on the underlying commodity.

• Designed to offer you transparency and better outcomes.

• Follows the margin-based trading format.

• Works perfectly for all traders.

• It can be helpful for hedging and trading purposes.

Types of Commodity Derivatives

Commodity derivatives are classified based on how the contract is structured and settled. Each of these types is unique and offers a purpose that syncs with the market participants. This will be based on goals like risk protection or even short-term trading. The common types to know are as follows:

1. Futures Contracts

Futures contracts are the simplest in nature. These are the ones where there is an agreement to buy or sell a specific commodity. It is set at a predetermined price on a fixed future date. These contracts are standardized and traded on exchanges. This ensures that there is liquidity and price transparency. They are commonly used by farmers, manufacturers, and traders to hedge price risk or take market positions.

2. Options Contracts

Options contracts give the buyer the right, but not the obligation, to buy or sell a commodity at a set price before or on a specific date. The buyer pays a premium for this flexibility. Options help limit downside risk while allowing traders to benefit from favorable price movements.

3. Forward Contracts

Forward contracts are customized agreements. These are also between two parties to buy or sell a commodity at a future date and price. These contracts are not traded on exchanges. These are usually settled privately. They are often used by businesses that need tailored contract terms.

4. Commodity Swaps

Commodity swaps are agreements. These are the ones where two parties exchange cash flows based on commodity price movements. These contracts are mainly used by large companies and institutions. This helps them to manage long-term price exposure rather than short-term trading.

Pros of Commodity Derivatives

Commodity derivatives offer several benefits for both businesses and individual traders. While they surely help reduce the uncertainty, there are other benefits as well. The most common ones to know are:

• Helps manage and hedge price risk.

• Better price discovery system in the market.

• Enables trading with lower capital through margins.

• Helps with portfolio diversification. 

• Allows profit opportunities in rising and falling markets.

Cons of Commodity Derivatives

While useful, commodity derivatives also involve risks that need careful consideration. Some of the most common risks that you should know are:

• High price volatility increases risk.

• Leverage can magnify losses.

• Requires strong market knowledge.

• Global, local, and natural factors impact the prices.

• Regulatory changes can impact trading positions.

How Commodity Derivatives Work

Commodity trading is quite simple. It follows a series of steps which, when taken in the proper manner, can ensure that you take the right trading call. Just like when you buy and sell a share, you analyse the market; the same thing needs to be done here. The trades are settled through regulated exchanges by SEBI, which makes trades effective. 

The steps to follow are as follows:

Step 1: Selecting the Commodity

The trader chooses a commodity such as gold, crude oil, or wheat based on market view or business need.

Step 2: Choosing the Contract Type

The trader selects a futures or options contract. The choice will be based on the analysis of the expiry date and contract size.

Step 3: Paying the Margin

Instead of paying the full value, the trader deposits a margin amount, which is a small percentage of the total contract value.

Step 4: Price Movement and Settlement

Profits or losses are adjusted daily based on price movement. On expiry, the contract is settled in cash or delivery, depending on contract terms.

Example of Commodity Derivatives

Assume a trader expects gold prices to rise. Gold is currently trading at Rs. 60,000 per 10 grams. The trader buys one gold futures contract at this price. The margin required is Rs. 6,000.

If the price rises to Rs. 62,000, the trader gains Rs. 2,000 per 10 grams. If the price falls to Rs. 58,000, the trader incurs a loss of Rs. 2,000. The profit or loss depends entirely on price movement, not physical ownership.

Conclusion

Commodity derivatives help traders with price risk and improve market efficiency. They allow traders, businesses, and investors to take positions with no need to hold physical stock.

When used correctly, these instruments support hedging, price discovery, and portfolio balance. But it is important to manage these well, as there is high volatility as well. And if you wish to start trading right, consider Rupeezy. Connect with experts, get all the tools, and trade well every day.

FAQs

What are commodity derivatives in simple words?

Commodity derivatives are contracts. These are ones whose value depends on the price of commodities like gold, oil, or crops.

What is the main purpose of commodity derivatives?

The main purpose is to manage price risk. This allows trading based on future price movements.

Are commodity derivatives risky?

Yes, they involve price volatility and leverage. This can lead to losses if not managed properly.

Who should invest in commodity derivatives?

They are suitable for informed traders, hedgers, and businesses with commodity price exposure.

Where are commodity derivatives traded in India?

In India, commodity derivatives are traded on regulated exchanges such as the National Commodity and Derivatives Exchange.