MUMBAI: With one of the biggest bull runs still on in India, stories of riches made in no time trading shares have percolated down so much that even the paanwalas have started trying their luck in the stock market. On the other hand investing into commodities has still not picked up owing to a lack of awareness about this asset class.

So, how to start trading in commodities? It is possible to trade in commodities by investing in commodity futures. As in the case of equity, one has to have a trading account with a commodity broker to trade in commodities. The first step involves getting hold of an account opening form which costs Rs 50. Other than this, some of the brokers charge, account opening charges and transaction and processing charges, leading to the cost of opening a trading account going up. These charges vary across brokers.
Unlike stock exchanges, commodity exchanges do not mandate a demat account. However, for delivery purposes, a demat account is needed. There is an annual maintenance charge that an investor has to pay for a demat account. This charge varies from Rs 250- Rs 1,000, depending on the brokerage an investor chooses. Trading and demat accounts can be opened with any exchange-approved intermediary as in the case of stocks.

Other than this, like in case of equity, there are trading charges as well. Brokerages usually charge anything between 0.01%-0.04% on non-delivery trades and 0.08%-0.30% on deliver-based transactions.

After having completed the formalities, the individual can start trading. Let’s take the example of a wholesale wheat merchant who has just bought 100 kg of wheat for Rs 950. Due to a stock pile up at his warehouse, the merchant is compelled to clear the existing stock first. This means he will have to hold back this new lot of wheat. Going by the average pace of despatches, he hoped to clear the existing stock and sell the new lot by December 20. At the same time, he feared that by then, wheat prices may drop below the current market price of Rs 1,100 per quintal. Here is where commodity futures come in.

Now, say wheat futures for December 20 delivery are trading at Rs 1,115 per 100 kg. What he will do is, enter into a future contract in which the counterparty to it promises to buy his wheat stock at Rs 1,115 on December 20. By this, the merchant has assured that he remains unaffected by the probable fall in wheat prices by locking into a safe price in the futures market. This is called hedging.

Now, there are two possibilities. Either wheat prices in the physical market on December 20, fall below Rs 1,100 (the current market price) or rise above it. In the first case, if it falls to say Rs 950, the merchant makes a profit of Rs 165 (Rs 1,115- Rs 950) as he would still be selling his product at a price higher to its actual price in the market, while the counter party stands to make a loss of the same magnitude as he would have to buy the product for Rs 1,115 while its actual price is Rs 950.

In the second case, if the wheat prices rise to say Rs 1,200 on December 20, while the merchant’s profit is limited to Rs 165, the counterparty stands to gain Rs 85 per quintal. This is because the counterparty bought the wheat at Rs 1,115 per quintal when it was quoting at Rs 1,200 per quintal in the market. The counterparty in this case takes the delivery of wheat and hence needs to have a demat account.

Further, he will also have to pay for warehousing charges. As this example shows, hedging risks arising out of uncertainty of future price movements is the real objective of commodity derivatives, though it serves other uses too.

Now imagine a US-returned Indian who decides not to work anymore. He has no option but to sit and watch his savings depreciate in value due to frequent withdrawals and an ever-climbing inflation eating most of the interest earned on it. Bored of this, he decides to convert his savings to investments by trading in gold futures.

At the opening, the December future for Gold is quoting at Rs 9,100 per 10 gm and the January future is at Rs 9,200 (spread or a difference of Rs 100). As the day progresses, he notices the prices of gold futures for December, January and February deliveries turning volatile and decides to make use of it. When both gold December and January dipped to Rs 9,080 and Rs 9,195 respectively, he buys Gold December and sells Gold January.

Now, he stands at a positive spread of Rs 115, which is not his profit, as his positions are still open. So to exit no strings attached, he has to reverse his positions, that is, buy Gold January and sell Gold December.  Later on the day, when both Gold December and Gold January rose to Rs 9,105 and Rs 9,210 respectively, he reversed the position with a negative spread of Rs 105. Hence he exits the market with a profit of Rs 10 (Rs 115-Rs105). Here, the individual just reverses his initial position, and there is no delivery of gold involved, and so he does not require a demat account