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Commodities for
Beginners
Kotak Commodity services LTD.
Welcome to the world of Commodities. Unkown to most of us
commodities have been a part of our day to day existence since ancient
times. It is also one of the finest investment avenues available. The
wheat in our bread, the gold in our jewellery, the cotton in our clothes etc
are all traded across the world in major exchanges.
We've divided this book into simple and insightful sections. We start with
introducing you to Commodity Futures along with providing you insights
into a Commodity Futures contract. We take you down memory lane
starting with a brief history on Commodity trading and end with the
modern day exchanges. An efficient market requires large number of
market participants. We shed light on various categories of market
participants.
Our section on Commodities Futures explains to you the reasons that
make investing in commodity futures an attractive preposition. You can
also leaf through invaluable information on the types of future markets
that exist. Flip through the pages to discover what exactly is the concept
of basis in commodity futures. We will also give you insights into how to
trade in Commodity Futures in India.
So, if you feel the need for clarity on various aspects of Commodity
trading , reach for this book. And remember, help is just a page away.
Commodities for Beginners
Kotak Commodity services LTD.
DISCLAIMER
ACKNOWLEDGEMENTS
This material (prepared by Kotak Commodity Services Ltd) should
not be construed as an offer to sell or a solicitation of an offer to buy
any commodity or commodity derivative, where such an offer or
solicitation would be illegal. We are not soliciting any action based on
this material. It is for the general information of readers. It does not
constitute a personal recommendation or take into account the
particular investment objectives, financial situations or needs of
individual clients. Before acting on any advice or recommendation in
this material, clients should consider whether it is suitable for their
particular circumstances and, if necessary, seek professional advice.
The contents of this book do not in any way reflect the views of the
publisher - Web Fusion, nor are such views endorsed by Web Fusion.
You shall not in any manner deem such information as emanating
directly or indirectly from us. Web Fusion and Kotak Commodity
Services Ltd assume no liability and/or responsibility, of any nature
whatsoever, for any inaccuracy or errors in the contents of this book or
for action taken by readers on the basis of information provided for in
this book. Further, neither Web Fusion nor Kotak Commodity
Services Ltd are under any obligation to update the information
contained in this book after the date of publication of the book.
We would like to thank the sponsors - Kotak Commodity Services Ltd
for providing the material for this book.
Kotak Commodity Services Limited (KCS) is one of the premier
commodity derivative brokerage firms in India. It is promoted by the
Kotak Family, which has a history of over 75 years of commodity
trading in India.
KCS commenced activities in commodity derivatives in 2003, when
the 2 commodity derivatives exchanges viz. Multi Commodity
Exchange of India (MCX) and National Commodity and Derivatives
Exchange (NCDEX) threw open their trading platforms for trading.
KCS is a member of both the exchanges and is well regarded as a
major player in a basket of commodities.
KCS primarily deals on behalf of clients in both exchanges. It trades in
a variety of commodities in both exchanges. The more active
commodities include tur, urad, chana, gold, silver, copper, guar,
wheat and steel. It also trades, on behalf of its clients, in other
commodities, which are traded on the two exchanges.
Further, KCS is a very active player in promoting delivery of
commodities in both exchanges. KCS delivers and receives delivery
of large quantities of commodities such as tur, urad, sugar and gold. In
fact, KCS is one of the proponents of the retail delivery based gold
products offered by the MCX and NCDEX. KCS also offers a variety of
structured products to its clients on a customized basis.
KCS is an Introducing Broker to a leading Futures Commission
Merchants in the overseas markets. Through these relationships,
About Kotak Commodity Services Limited
About Kotak Commodity Services Limited
KCS assists clients, who are otherwise permitted under Indian
regulations, to open accounts for trading in international markets.
KCS is one of the few brokers who offer this service in India.
Kotak Commodity Services Limited has 60 branches all over India
and over 400 associates who offer its services through the length and
breadth of the country. It has over 160 employees working in its
offices and its dealing room is open from 9 am to midnight, offering
services to clients throughout the market hours.
About Kotak Commodity Services Limited
Dear Readers,
Welcome to the exciting world of commodity trading. Till now, we have
been used to commodities as articles of some kind of use or the other,
whether for consumption or for decoration. Now we are getting the
chance to look at commodities in a different light.
We have carefully prepared this book to give the reader a sense of the
commodity markets. But before embarking on a perusal of the book,
we request the reader to give us an opportunity to describe the
market, the opportunities thereon and the pitfalls to avoid.
The commodities markets where the reader is participating is
basically a derivatives market. Essentially derivatives are instruments
whose price behaviour is dependant on the price behaviour of the
underlying instrument, in this case commodities. However, there are
many areas in which derivatives are different from the commodity
itself. Firstly, unlike a physical commodity, you cannot look at or feel a
derivative. For some of us, there might be a feeling of incompleteness
without a physical sense of the commodity. Secondly, there is usually
a difference between the price of the derivative and the price of the
Introduction to the exciting
world of commodities
Introduction to the exciting
world of commodities
underlying. This difference can be broken down into a number of
factors, which the book will endeavour to. It is necessary for the
reader to have at least a basic knowledge of this difference. Finally,
the concept of leverage. It is necessary to remember that derivatives
positions are essentially leveraged positions. This means that for
every unit of money, you can take a position whose value is more than
one unit. Leverage helps a client in making more money from a
position. At the same time, it sometimes results in the client losing a lot
more money than if he had not leveraged himself. A reader who keeps
these points in mind usually finds himself in a much better situation
than someone who does not.
A word for our friends who wish to take directional calls in the market.
Please remember the two basic principles of trading:
1. Ride your profits.
2. Cut your losses.
Usually, most of us do it completely the other way round. We ride our
losses in the expectation that the prices will reverse in our favour and
cut our profits! This is absolutely the wrong thing to do if you are
trading the markets. Please remember that all our calls cannot go
right and therefore we must cut our losses and preserve our capital, if
we want to continue to participate in the markets. Else, you might find
yourself out of the market, before you begin to make any money!
We now come to why you should consider participating in the
commodities markets. Most of us participate in the debt income and
equity markets. The risk reward equations in both these markets are
Introduction to the exciting world of commodities
quite different. Most of us would consider debt as low risk, low reward,
whereas we would consider equity as high risk, high reward. This
raises an interesting question. Should we look at other markets, which
give us a moderate risk, moderate reward pay-off? If the reader is
clear that he wants to, then commodities markets are there for him.
Commodities fall somewhere between debt and equity in both risk
and reward. Also, some commodities (not all!) have a negative co-
relation with the other two markets mentioned by us. Hence they act
as a sound diversification mechanism for the investor. For these
reasons, the reader should seriously consider looking at the
commodities markets.
Having decided to participate in the commodities markets, the reader
will now come to the next logical question. Which is, what does he do
in the commodities markets? The reader can do many things, starting
from taking simple directional calls (speculator) to hedging his
exposure in other markets (hedger) to arbitraging between markets
(arbitrageur) to participating in physical markets or structured
products (investor). The reader is left to understand his own risk
profile and decide what he wants to do.
Thank you and wishing you a very happy and rewarding time in the
commodity markets.
Kotak Commodity Services Ltd
Introduction to the exciting world of commodities
Content
Chapter 1
Chapter 2
Chapter 3
Chapter 4
Chapter 5
Chapter 6
Introduction to Commodity Futures .................
6Brief history of commodity trading ................6Commodity futures contract ...........................6Market participants ..........................................
Commodity Futures as an Investment Avenue .............................................
Types of Futures Markets ...................................
6Normal futures market ....................................6Inverted futures market ...................................
The Concept of Basis in Commodity Futures
6Basis defined ...................................................6Strengthening / Weakening of basis ...............6Hedging and basis ..........................................
How to Trade in Commodity Futures in India .................................................................
Dematerialization ................................................
Glossary of Terms ..............................................
6Step One : Choosing a broker ..........................6Step Two : Depositing the margin ....................6Step Three : Access to information and a
trading plan ......................................................
6Entities in dematerialization ..........................6Process flow in dematerialization ....................6Process flow in commodity futures trading ........
13
23
29
33
33
14
16
18
29
30
35
36
39
45
49
40
41
39
464647
INTRODUCTION TO COMMODITIES
FUTURES
CHAPTER 1
Unknown to us the commodities that have always been a part of our
day-to-day existence are also one of the finest investment avenues
available. The wheat in our bread, the cotton in our clothes, our gold
jewels, the oil that runs our cars, etc; are all traded across the world in
major exchanges.
Over the ages, commodities have been the basis for trade and
industry. They have spurred commerce, encouraged exploration and
altered the histories of nations. Today, they play a very important role
in the world economy with billions of dollars of these commodities
traded each day on exchanges across the world.
Commodities today have become an attractive investment vehicle. In
the current investment scenario, it is increasingly getting difficult for
individuals and institutions to create a well-balanced investment
portfolio. With uncertainty in interest ratio, it is tough for the investor to
beat the ever-rising inflation. Averse to being over exposed to equity
markets, the investors are left with limited choices… Well no more!
13
Chapter 1
Introduction to Commodity Futures
Introduction to Commodity Futures
Introduction to Commodity Futures
Introduction to Commodities Futures
Trading in commodities futures has a long history. Though the modern
trade in commodity futures could trace its origins back to the 17th
century in Osaka, Japan, there is evidence to suggest that a form of
futures trading in commodities existed in China 6000 years earlier.
Organized trading on an exchange started in 1848 with the
establishment of the Chicago Board of Trade (CBOT).
The first milestone in the 125 years rich history of organized trading in
commodities in India was the constitution of the Bombay Cotton Trade
Association in the year 1875. India had a vibrant futures market in
commodities till it was discontinued in the mid 1960's, due to war,
natural calamities and the consequent shortages.
The advent of economic liberalization helped the cause of laying
emphasis on the importance of commodity trading. By the beginning
of 2002, there were about 20 commodity exchanges in India, trading
in 42 commodities, with a few commodities being traded
internationally.
Commodities futures contracts and the exchanges they trade in are
governed by the Forward Contracts (Regulation) Act, 1952. The
regulator is the Forward Markets Commission (FMC), a division of the
Ministry of Consumer Affairs, Food and Public Distribution.
In 2002, the Government of India allowed the re-introduction of
commodity futures in India. Together with this, three screen based,
.Recent Developments in India
Brief History of Commodity Trading
14
15
Chapter 1
nation-wide multi-commodity exchanges were also permitted to be
set up with the approval of the Forward Markets Commission. These
are:
1. National Commodity & Derivative Exchange .
This exchange was originally promoted by ICICI Bank, National
Stock Exchange (NSE), National Bank for Agriculture and Rural
Development (NABARD) and Life Insurance Corporation of
India (LIC). Subsequently other institutional shareholders have
been added on. NCDEX is popular for trading in agricultural
commodities.
2. Multi Commodity Exchange .
This exchange was originally promoted by Financial Technologies
Limited, a software company in the capital markets space.
Subsequently other institutional shareholders have been added
on. MCX is popular for trading in metals and energy contracts.
3. National Multi Commodity Exchange of India .
This exchange was originally promoted by Kailash Gupta, an
Ahmedabad based trader, and Central Warehousing Corporation
(CWC). Subsequently other institutional shareholders have been
added on. NMCE is popular for trading in spices and plantation
crops, especially from Kerala, a southern state of India.
In terms of market share, MCX is today the largest commodity futures
exchange in India, with a market share of close to 70%. NCDEX
follows with a market share of around 25%, leaving the balance 5% for
NMCE.
(www.ncdex.com)
(www.mcxindia.com)
(www.nmce.com)
A commodity futures contract is a commitment to make or accept
delivery of a specified quantity and quality of a commodity during a
specific month in the future date at a price agreed upon when the
commitment is made.
Commodities traded in the commodity exchanges are required to be
delivered at the contracted price, ignoring all the changes in the
market prices. Both the participants (Buyers & Sellers) are allowed to
liquidate their respective positions by way of cash settlement of price
between the contracted and liquidated price, no later than the last
trading session of the specified expiry date.
An effective and efficient market for trading in commodities futures
requires:
Volatility in the prices of the underlying commodities.
Large numbers of buyers and sellers with diverse risk profiles
(hedgers, speculators and arbitrageurs).
The underlying physical commodities to be fungible, i.e. they
should be exchangeable.
!
!
!
Commodity Futures Contract
Introduction to Commodities Futures
16
17
Chapter 1
.Features of commodity futures
1. Organized:
Commodity Futures contracts always trade on an organized
exchange, e.g. NCDEX, MCX, etc in India and NYMEX, LME,
COMEX etc. internationally.
2. Standardized:
Commodity Futures contracts are highly standardized with the
quality, quantity, and delivery date, being predetermined.
3. Eliminates Counterparty Risk:
Commodity Futures exchanges use clearing houses to guarantee
that the terms of the futures contract are fulfilled. The Clearing
House guarantees that the contract will be fulfilled, eliminating the
risk of any default by the other party.
4. Facilitates Margin Trading:
Commodity Futures traders do not have to put up the entire value
of a contract. Rather, they are required to post a margin that is
roughly 4 to 8% of the total value of the contract (this margin varies
across exchanges and commodities). This facilitates taking of
leveraged positions.
5. Closing a Position:
Commodity Futures positions can easily be closed by placing an
offsetting or opposite trade. Care should be exercised to ensure
that the offsetting trade in placed in the same contract. Else there
would be two open positions.
6. Regulated Markets Environment:
Futures markets are closely regulated by government agencies,
e.g. Forward Markets Commission (FMC) in India, Commodity
Futures Trading Commission in (CFTC) USA, etc. This ensures
fair practices in these markets.
7. Physical Delivery:
Actual delivery of the commodity can be made or taken on expiry
of the contract. Physical delivery requires the member to provide
the exchange with prior delivery information and completion of all
the delivery related formalities as specified by the exchange.
An efficient market for commodity futures requires a large number of
market participants with diverse risk profiles. Ownership of the
underlying commodity is not required for trading in commodity
futures. The market participants simply need to deposit sufficient
money with brokerage firms to cover the margin requirements. Market
participants can be broadly divided into hedgers, speculators and
arbitrageurs.
Hedgers:
They are generally the commercial producers and consumers of
the traded commodities. They participate in the market to manage
their spot market price risk. Commodity prices are volatile and
their participation in the futures market allows them to hedge or
protect themselves against the risk of losses from fluctuating
!
Market Participants
Introduction to Commodities Futures
18
19
Chapter 1
prices. For e.g. a copper smelter will hedge by selling copper
futures, since it is exposed to the risk of falling copper prices.
Speculators:
They are traders who speculate on the direction of the futures
prices with the intention of making money. Thus, for the
speculators, trading in commodity futures is an investment option.
Most Speculators do not prefer to make or accept deliveries of the
actual commodities; rather they liquidate their positions before the
expiry date of the contract.
Arbitrageurs:
They are traders who buy and sell to make money on price
differentials across different markets. Arbitrage involves
simultaneous sale and purchase of the same commodities in
different markets. Arbitrage keeps the prices in different markets
in line with each other. Usually such transactions are risk free.
The market functions because of the differing risk profiles of the
market participants. The fluctuation in commodity prices
represents both, a risk and a potential for profit. The hedgers
transfer this risk by foregoing the associated profit potential. The
speculators assume this risk in the hope of realizing profits by
predicting price movements. The arbitrageurs make the process of
price discovery more efficient.
!
!
COMMODITIES FUTURES AS AN
INVESTMENT AVENUE
CHAPTER 2
Commodity futures are globally recognized to be a part of every
successful and diversified investment portfolio. The fact that the
returns from most of the commodities in the last 53 years from 1951 to
2006 have been higher than the global inflation rate, establishes that
investments in commodity are an effective hedge against inflation.
Some of the reasons that make investing in commodity futures an
attractive preposition are described below:
Leverage:
Commodity Futures trading is done on margins. The investor only
deposits a fraction of the value of the futures contract with the
broker to cover the exchange specified margin requirements. This
gives the investor greater leverage and thus the ability to generate
higher returns.
Liquidity:
Unlike investment vehicles like real estate, investments in
commodity futures offer high liquidity. It is equally easy to both buy
and sell futures and an investor can easily liquidate his position
whenever required. There is also another advantage of being able
.
.
23
Chapter 2
Commodity Futures as an Investment Avenue
Commodity Futures as an Investment Avenue
Commodities Futures as an Investment Avenue
to use the profits from a trade elsewhere, without having to close
the position.
Diversification:
Investments in commodity markets are an excellent means of
portfolio diversification. For example, gold prices have historically
shown a low correlation with most other asset prices (such as
equities) and thus offer an excellent means for portfolio
diversification.
Inflation Hedge:
As the commodity prices determine price levels and consequently
inflation, investing in commodity futures can act as a hedge
against inflation.
Physical Gold
Physical Gold is a product by which retail and high net worth
investors can take investment positions in dematerialized physical
gold using the futures market. In this product, the investor can hold
physical gold, in a safe deposit vault approved by the exchange,
which is reflected in the investor's demat account. The main
features of this are:
Liquidity
Assurance of purity
Transparency of rates
Safety
.
.
.
!
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24
25
Chapter 2
These features have attracted a large number of clients to the product
since its introduction. Many brokers offer a full package of services
associated with the Physical Gold contract, including acting as
commission agent to take care of sales tax / VAT related issues.
Commodities traded in Commodity Exchanges.
Large numbers of commodity are traded on commodity exchanges in
around the world. The commodities are classified on the basis of their
use and consumption. Further classification is based on the
characteristics of the commodity.
Some of the commodities traded on various futures exchanges are as
follows:
Foodstuff
Coffee
Sugar
Cocoa
Maize
Rough rice
Soybean
Wheat
Sunflower Oil
Barley
Orange Juice
.
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Commodities Futures as an Investment Avenue
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Precious Metal
Gold
Platinum
Palladium
Silver
Industrial Metals
Copper
Lead
Zinc
Tin
Aluminium
Nickel
Recycled
Energy
Crude Oil
Natural Gas
26
TYPES OFFUTURES MARKETS
CHAPTER 3
The futures market for a commodity can be normal or inverted.
A normal futures market is one where the price of the nearby contract
is less than the price of the distant futures contract. This is illustrated
by the figure below, which shows the prices of gold futures in a normal
market. The more distant the contract month, the higher is the
contract price, in a normal market. The price difference between the
futures contracts of different months is due to the cost of carry. The
cost of carry is the cost incurred in carrying a commodity to some
future date. It includes interest, insurance and storage costs. This is
logically what should happen for all contracts since cost of insurance,
interest and storage will be a finite positive number.
29
Chapter 3
Types of Futures Markets
Types of Futures Markets
Normal Futures Market
Types of Futures Markets
In an inverted futures market, the price of the near contract is greater
then the price of the distant contract. As shown in the figure below, the
more distant the contract, the lower is the price.
An inverted futures market is seen when there are short term supply
disruptions, resulting in shortages.
Inverted Futures Market
30
8840
8860
8880
8900
8920
8940
8960
8980
Feb Apr Jun Aug
Normal MarketP
ric
e (
Rs
/10
gm
) (G
old
)
88208840886088808900892089408960898090009020
Feb Apr Jun Aug
Pri
ce
(R
s/1
0 g
m)
(Go
ld)
Inverted Market
THE CONCEPT OF BASIS IN
COMMODITY FUTURES
CHAPTER 4
The difference between the local spot price (cash price) and the
relevant futures price of a commodity is called the commodity basis.
Basis = Spot price - Futures price
For example, if the spot landed price of gold in March is Rs.
9450/10gm and the April gold futures price is Rs. 9400/10gm, then the
basis is Rs. 50/10gm (9450-9400). The basis can be positive or
negative.
The spot price of a commodity is the prevailing cash price in the
market. The futures price is a representation of the market opinion of
the spot price of the commodity on some future date. Theoretically,
the futures price and the spot price are related in the following manner
Futures price = Spot price + Cost of carry
The cost of carry is the cost of carrying the commodity from the current
month to the month of delivery. This includes costs of storage,
33
Chapter 4
The Concept of Basis in Commodity FuturesThe Concept of Basis in Commodity Futures
Basis Defined
The Concept of Basis in Commodity Futures
insurance, interest etc. Thus usually, the price of a futures contract is
higher than the prevailing spot price. This condition is known as
Contango.
The actual difference between the spot and the futures price may be
different from the cost of carry and can vary based on the demand and
supply of the underlying commodity at current and expected levels in
the future. Thus it is possible for the futures price to be less than the
spot price. This condition is called Backwardation. For e.g. the copper
futures on NYMEX have mostly been in backwardation since the
1950's.
Whether the market is in Contango or Backwardation, as the futures
contract approaches the expiry date, the spot and future prices
converge.
The basis depends on the local spot market price and so it reflects the
local market conditions. It is affected by the following factors:
Local supply and demand.
Storage costs.
Profit margins.
!
!
!
Basis Market Condition
Spot Price <Futures Price
Spot Price >Futures Price
34
Negative
Positive
Contango
or Normal
Backwardation
or Abnormal
35
Chapter 4
Basis is usually a negative number because of carrying charges. In
normal market conditions, cash prices are lower than the nearby
futures prices. With the approach of delivery on the futures, carrying
charges diminish and the price difference between cash and futures
will decrease.
The basis can change in two directions, either increase or decrease.
An increasing basis means that the basis is becoming less negative or
more positive. This is called a strengthening or narrowing basis. A
decreasing basis means that the basis is becoming more negative or
less positive. This is called a weakening or widening basis.
Strengthening / Weakening of Basis
Strengthen
Basis becomesmore positive or
less negative
Weaken
Basis becomesmore negative or
less positive
10
5
0
-5
-10Cash price increasing fasterrelative to futures price
Cash price decreasing fasterrelative to futures price
Basis is a crucial factor on which hedging decisions are based. The
matrix of sale and purchase for producers and consumers on basis is
given below:
The long hedger or the consumer of the commodity prefers for the
basis to weaken. In this scenario, the cash price will be lower than
futures and hence the hedger's procurement price in the spot market
will be less than the futures market.
The short hedger or the producer of the commodity prefers for the
basis to strengthen. In this scenario the cash price will be higher
relative to the future and the hedger realizes a higher selling price in
the spot market than the futures market.
Hedging & Basis
Purchase as much as possible and storeor Hedge using futures
Long Hedge High Cash Price Low Cash Price
Short Hedge High Cash Price Low Cash Price
Strong Basis
Weak Basis
Strong Basis
Delay Cash PurchaseNo Hedging Required
1. Delay Cash Purchase
2. Hedge - Long Futures
Sell Product in Cash
2. Re-own by going long on futures
Weak Basis Store for selling later
1. Sell Produce
The Concept of Basis in Commodity Futures
36
Purchase immediaterequirements only
2. Hedge - Short Futures
1. Delay Cash Sales / Store Produce
HOW TO TRADE IN COMMODITY
FUTURES IN INDIA
CHAPTER 5
With the setting up of nation-wide multi commodity exchanges, a new
avenue has been thrown open for Indian investors. These exchanges
have electronic trading and settlement systems making it easy to
trade in commodity futures. Trading on these exchanges does not
require the investor to possess physical stocks. In fact less than 1% of
the total traded volume involves the transfer of physical commodities.
Trading in commodity futures comprises of three simple steps.
The broker you choose should be a member of the exchanges you
wish to trade in. Other than this, one should keep the following factors
in mind while choosing a broker:
Competitive edge provided by the broker.
Broker's knowledge of commodity markets.
Credibility of the broker.
Experience of the broker.
Net-worth of the broker.
Quality of broker's trading platforms.
!
!
!
!
!
!
39
Chapter 5
How to Trade in Commodity Futures
in India
How to Trade in Commodity Futures
in India
Step One: Choosing a Broker
How to Trade in Commodity Futures in India
The relationship between the broker and the client is long-term. Thus
there must be a strong rapport, and mutual trust between the client
and the broker. Further, the client must communicate clearly to the
broker his needs and objectives for trading in commodities, whether
they are for the purpose of hedging, investment, etc. Further, your
objectives for entering the market provide you with a valuable
parameter to judge whether a broker fits your needs.
To begin trading, the investor needs to deposit a margin with his
broker. Margin requirements are of two types, the initial margin and
the maintenance margin. These margin requirements vary across
commodities and exchanges but typically, the initial margin ranges
from 5-10% of the contract value.
The maintenance margin is usually lower than the initial margin. The
investor's position is marked to market daily and any profit or loss is
adjusted to his margin account. The investor has the option to
withdraw any extra funds from his margin account if his position
generates a gain. Also, if the account falls below the maintenance
margin, a margin call is generated from the broker and the investor
needs to replenish his account to the initial level.
Step Two : Depositing the Margin
40
41
Chapter 5
As commodity futures are not long-term investments, their
performance needs to be monitored. The investor should have
access to the prevailing prices on the exchanges as well as market
information that can help predict price movements. Brokers provide
research and analysis to their clients. Other information sources are
financial dailies, specialized magazines on commodities and the
internet. Further, an investor requires a trading plan. Such a trading
plan can be developed in consultation with the broker. In any case, the
investor has to remember to ride his profits and cut his losses by using
stop loss orders.
Step Three: Access to Information and a Trading Plan
DEMATERIALIZATION
CHAPTER 6
Some basics for giving and taking delivery of commodities in the
Indian commodity futures markets.
Dematerialization is the process of recording physical holdings
(warehouse receipts) in electronic form. It facilitates the easy transfer
of holdings through electronic mode. The investor opens an account
with a depository participant (DP) of NSDL, gets the goods to the
warehouse and makes a request for Demat credit. The warehouse
accepts goods for storage and delivery. The goods are assayed and
the information is given to the NSDL via the Registrar and Transfer
Agent (R&TA). The R&TA is the link between the warehouse and the
depository. NSDL, upon confirmation from the R&TA, credits the ICIN
(a unique number allotted by NSDL for identification purposes)
balance into the Demat account of the client.
45
Chapter 6
DematerializationDematerialization
Dematerialization
Dematerialization
46
Seller Clientof Member
Warehouse
R & T Agent Acceptsgoods
NSDL
Credits into the ICIN balance inDemat account ofClients with DP
Entities in Dematerialization
Process Flow in Dematerialization
WH
WH
WH
WH
Open demat a/cWith DPgets goods to the WH, fills in Demat Request form for demat credit
Empanelled Dps in which members / clients open demat account
Holds commodity balances in electronic form facilitates transactions in commodities
Link between the warehouse and the DepositoryStandardized Screens
Accepts goods forstorage / deliveryAssaying done and information given to NSDL via R&T
Source: NCDEX
NSDL DP CLIENT R&T AGENT
Submits commodities andDemat Request form
Assaying done, Deliverynorms checked
Sends data toNSDL via the R&T
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Chapter 6
Process Flow in Commodity Futures Trading
ExchangeTrading System
Clearing CorporationDaily Mark to Market
Broker’sClearing Bank A/c
Investor
Order Confirmation
VSATLink
DailyMargin
Order Confirmation
Gain / LossCredited / debited to
Investor A/c
Broker
Arbitrage - The simultaneous purchase and sale of similar
commodities in different markets to take advantage of a
price discrepancy.
Arbitration - The procedure of settling disputes between members,
or between members and customers.
Bar Chart - A chart that graphs the high, low, and settlement prices
for a specific trading session over a given period of time.
Basis - The difference between the current cash price and the
futures price of the same commodity. Unless otherwise
specified, the price of the nearby futures contract month
is generally used to calculate the basis.
Bear - Someone who thinks market prices will decline.
Bear Market - A period of declining market prices.
Bid - An expression indicating a desire to buy a commodity at
a given price; opposite of offer.
Clearing Corporation - An independent corporation that settles all
trades made at an exchange acting as a guarantor for
all trades cleared by it, reconciles all clearing member
firm accounts each day to ensure that all gains have
49
Glossary of TermsGlossary of Terms
Glossary of Terms
been credited and all losses have been collected, and
sets and adjusts clearing member firm margins for
changing market conditions.
Broker - A company or individual that executes futures and
options orders on behalf of financial and commercial
institutions and/or the general public.
Brokerage Fee - See Commission Fee.
Brokerage House - See Futures Commission Merchant.
Bull - Someone who thinks market prices will rise.
Bull Market - A period of rising market prices.
Carrying Charge - For physical commodities such as grains and
metals, the cost of storage space, insurance, and
finance charges incurred by holding a physical
commodity. Also referred to as cost of carry or carry.
Cash Commodity - An actual physical commodity someone is
buying or selling, e.g., soybeans, palm oil, gold, silver,
etc. Also referred to as actuals.
Cash Market - A place where people buy and sell the actual
commodities. Also called spot market.
Charting - The use of charts to analyze market behavior and
anticipate future price movements. Those who use
charting as a trading method plot such factors as high,
low, and settlement prices; average price movements;
volume; and open interest. Two basic price charts are
bar charts and point-and-figure charts.
Clearing Member - A member of an exchange clearing house.
by companies. Clearing members are responsible for
the financial commitments of customers that clear
through their firm.
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Chapter 7
Clearing House - An agency or separate corporation of a futures
exchange that is responsible for settling trading
accounts, clearing trades, collecting and maintaining
margin monies, regulating delivery, and reporting
trading data. Clearing houses act as third parties to all
futures and options contracts acting as a buyer to every
clearing member seller and a seller to every clearing
member buyer.
Closing Price - See Settlement Price.
Closing Range - A range of prices at which buy and sell transactions
took place during the market close.
Commission Fee - A fee charged by a broker for executing a
transaction. Also referred to as brokerage fee.
Commodity -An article of commerce or a product that can be used for
commerce. In a narrow sense, products traded on an
authorized commodity exchange. The types of
commodities include agricultural products, base
metals, bullion and energy products.
Convergence - A term referring to cash and futures prices tending to
come together (i.e., the basis approaches zero) as the
futures contract nears expiration.
Cost of Carry (or Carry) - See Carrying Charge.
Daily Trading Limit - The maximum price range set by the exchange
each day for a contract.
Deferred (Delivery) Month - The more distant month(s) in which
futures trading is taking place, as distinguished from the
nearby (delivery) month.
Day Traders - Speculators who take positions in futures and liquidate
them prior to the close of the same trading day.
Deliverable Grades - The standard grades of commodities or
instruments listed in the rules of the exchanges that
must be met when delivering cash commodities against
futures contracts. Grades are often accompanied by a
schedule of discounts and premiums allowable for
delivery of commodities of lesser or greater quality than
the standard called for by the exchange. Also referred
to as contract grades.
Delivery - The transfer of the cash commodity from the seller of a
futures contract to the buyer of a futures contract. Each
futures exchange has specific procedures for delivery
of a cash commodity. Some futures contracts, such as
stock index contracts, are cash settled.
Delivery Month - A specific month in which delivery may take place
under the terms of a futures contract. Also referred to as
contract month.
Equilibrium Price - The market price at which the quantity supplied
of a commodity equals the quantity demanded.
Expiration Date - Options on futures generally expire on a specific
date during the month preceding the futures contract
Full Carrying Charge Market - A futures market where the price
difference between delivery months reflects the total
costs of interest, insurance, and storage.
Fundamental Analysis - A method of anticipating future price
movement using supply and demand information.
Futures Contract - A legally binding agreement, made on the trading
floor of a futures exchange, to buy or sell a commodity
or financial instrument sometime in the future. Futures
contracts are standardized according to the quality,
Glossary of Terms
52
53
Chapter 7
quantity, and delivery time and location for each
commodity. The only variable is price, which is
discovered on an exchange-trading floor.
Futures Exchange - A central marketplace with established rules
and regulations where buyers and sellers meet to trade
futures and options on futures contracts.
Hedger - An individual or company owning or planning to own a
cash commodity such as gold, soybeans, silver, etc.
and concerned that the cost of the commodity may
change. While holding it a hedger achieves protection
against changing cash prices by purchasing (selling)
futures contracts of the same or similar commodity.
Hedging - The practice of offsetting the price risk inherent in any
cash market position by taking an equal but opposite
position in the futures market. Hedgers use the futures
markets to protect their businesses from adverse price
changes. See Selling (Short) Hedge and Purchasing
(Long) Hedge.
High -The highest price of the day for a particular futures
contract.
Initial Margin - The amount a futures market participant must deposit
into his margin account at the time he places an order to
buy (sell) a futures contract.
Inverted Market - A futures market in which the more distant the
contract month, the lower is the futures price.
Liquidate - Selling (or purchasing) futures contracts of the same
delivery month purchased (or sold) during an earlier
transaction or making (or taking) delivery of the cash
commodity represented by the futures contract. See
Offset.
Long - One who has bought futures contracts or owns a cash
commodity.
Long Hedge - Buying futures contracts to protect against a possible
price increase of cash commodities that will be
purchased in the future. At the time the cash
commodities are bought, selling an equal number and
type of futures contracts as those that were initially
purchased closes the open futures position.
Low - The lowest price of the day for a particular futures
contract.
Maintenance Margin - A set minimum margin (per outstanding
futures contract) that a customer must maintain in his
margin account.
Margin Call - A call from a clearing house to a clearing member, or
from a brokerage firm to a customer, to bring margin
deposits up to a required minimum level.
Market Order - An order to buy or sell a futures contract of a given
delivery month to be filled at the best possible price and
as soon as possible.
Marking-to-Market - To debit or credit on a daily basis a margin
account based on the close of that day's trading
session. In this way, buyers and sellers are protected
against the possibility of contract default.
Nearby (Delivery) Month - The futures contract month closest to
expiration. Also referred to as spot month.
Offer - An expression indicating one's desire to sell a
commodity at a given price; opposite of bid.
Offset - Taking a second futures position opposite to the initial or
opening position. See Liquidate.
Glossary of Terms
54
55
Open Interest - The total number of futures contracts of a given
commodity that have not yet been offset by an opposite
futures transaction nor fulfilled by delivery of the
commodity or option exercise. Each open transaction
has a buyer and a seller, but for calculation of open
interest, only one side of the contract is counted.
Position - A market commitment. A buyer of a futures contract is
said to have a long position and, conversely, a seller of
futures contracts is said to have a short position.
Price Discovery - The generation of information about ”future'' cash
market prices through the futures markets.
Price Limit - The maximum advance or decline from the previous
day's settlement price permitted for a contract in one
trading session by the rules of the exchange.
Settlement Close Out Price - The last price paid for a commodity on
any trading day. The exchange clearing house
determines a firm's net gains or losses, margin
requirements, and the next day's price limits, based on
each futures and options contract settlement price. If
there is a closing range of prices, the settlement close
out price is determined by averaging those prices.
Short - One who has sold futures contracts or plans to
purchase a cash commodity. Selling futures contracts
or initiating a cash forward contract sale without
offsetting a particular market position.
Short Hedge - Selling futures contracts to protect against possible
declining prices of commodities that will be sold in the
future. At the time the cash commodities are sold,
purchasing an equal number and type of futures
Chapter 7
contracts as those that were initially sold closes the
open futures position.
Speculator - A market participant who tries to profit from buying and
selling futures and options contracts by anticipating
future price movements. Speculators assume market
price risk and add liquidity and capital to the futures
markets.
Spot - Usually refers to a cash market price for a physical
commodity that is available for immediate delivery.
Spread - The price difference between two related markets or
commodities or between contracts of different
maturities of same commodity.
Volatility - A measure of the change in price over a given time
period. It is often expressed as a percentage and
computed as the annualized standard deviation of
percentage change in daily price.
Volume - The number of purchases or sales of a commodity
futures contract made during a specified period of time,
often the total transactions for one trading day.
Warehouse Receipt - Document guaranteeing the existence and
availability of a given quantity and quality of a
commodity in storage; commonly used as the
instrument of transfer of ownership in both cash and
futures transactions.
Glossary of Terms
56
