HOW COMMODITY MARKET WORKS

Commodity Market

Financial markets are those which operate to determine the price of the product that is being dealt with. There are basically three broad sets of prices in a country: interest rates, exchange rate and prices of commodities. While the first two are relatively narrow in scope in so far as that there are a fixed sets of such rates, the last consists of a large number of products, each with their own characteristics. Future interest rates can be distinguished as between rates that are fixed by central bank and rates fixed by the banks and other players in the market. On the other hand, exchange rates are between different currencies at both nominal and real rates, while commodities are distinctively different. Every commodity has its own price, and varies across market even at the point of first sale, i.e. the wholesale market. Commodity trading is similar in most countries. The most common form is futures contract. Some stock exchanges also offer Exchange Traded Funds (EFT,s) that mirror futures contracts of certain commodities. Then futures exchange specifies the details of a futures contract, for instance, 10 ton of rice of certain type and quality to be delivered by certain date and etc. One unique thing about trading futures is that it can be bought or shorted with money (called margin) of about 10% the contract value. So essentially, if you have bought certain number of contracts of a commodity, and if the price goes up by 2%, your investment goes up by 20%; but if the price goes down by 2%, your investment does down by 20% too. In the opposite case, if you have sold short certain number of contracts of a commodity (which you don't own), and if the price goes down by 2% your investment goes up by 20%; but if the price goes up by 2%, your investment goes down by 20% too. The margin is reevaluated and required everyday when one has an open position. If your account does not have enough money to cover the margin required, you will be called to deposit more money and if you don't add more money your position will be forcibly closed. The famous movie margin call is just about this. The majority futures traders close their positions before the delivery date of the contract. If you don't close your position the you will be required to deliver or receive the goods. To trade futures, you need to open a futures account (different from the stock account0 in a futures brokerage. ETF's are traded just like stocks and can be done from your stock account. There, you don't enjoy the low margin rate as with futures. One nice thing about commodities is that prices are linked (though not strongly) with physical goods and across exchanges in the globe. Cross trading mechanisms are put in place to ensure this. So even though you trade in India with rupees, someone trading in Chicago with dollars can affect your profit/loss.

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