World over, most commodities/goods are traded on the exchanges or commodity markets where buyers & manufacturers place their buy/sell bids on goods, and prices are decided based on the demand & supply metrics.
There is a continuous variation in demand and supply of the commodities which results in their prices to fluctuate. Commodity markets allow its participants to procure or sell goods at the right price, this is often done in the form of trading instruments like Spot, Forwards, Futures or Options contracts.
There are more than 100 commodities that are traded all over the world in different commodity exchanges. These tradable commodities or goods are categorized into four basic groups namely energy, metals, livestock, and agriculture.
These days, online trading on commodities has become very popular as electronic technologies have made trading more efficient than traditional trading methods and they enable the commodity traders to see real time data and make faster decisions by placing online buy/sell orders, this saves them of losses resulting from delays in getting market data, execution of orders and other hassles involved in traditional mediums like placing orders through phone.
With the online trading, now retail investors and speculators have also come to the scene which has allowed them to make money via arbitrage on prices, and producers to get better price discovery with an increased market demand & participation.
What is a Commodity?
Commodities are tangible goods that have economic value, they are often used as raw material or input to produce various goods and services like Wires from Copper, Flour & Cookies from Wheat; or sometimes they are used directly like Gold or Coffee beans.
These goods can be bought or sold for a value or even exchanged with other goods of similar value or type where the quality remains nearly similar. Commodities can be either extracted from natural resources via mining activity or grown through farming.
Commonly traded commodities include Gold, Silver, Crude Oil, Natural Gas, Coffee, Wheat, Soybeans, etc.
Commodity Market in South Africa
Commodity markets have enabled better buying/selling of commodities by having a central market infrastructure where market participants from different corners of a country or whole world can place bids to sell/buy goods and their orders are fulfilled instantly based on settlement method agreed by the parties. They provide price determination and price risk management facility to its participants.
Manufacturers like Farmers don’t have to worry where or to whom to sell their output, they can sell on spot price at the exchange or agree on a future price in form of a futures contract - which gives them the right to sell their output at an agreed price on the set expiry date in the contract.
In South Africa, Commodities are mainly traded on JSE or Johannesburg Stock Exchange’s Commodity Derivatives Market. There is also another option of trading commodity through CFD brokers which is suited for experienced speculative investors.
Common Types of Commodities traded in South Africa:
- A commodity trader or participant can trade in following types of commodities at JSE through online derivatives broker:
- Metals - Metals like Gold, Silver, Copper, Platinum are available at JSE.
- Agriculture – JSE offers Grain Futures & Options, Zambian Grain Contracts, Soy complex Futures and Options, Soft Red Wheat Futures and Options, Hard Red Winter Wheat, Corn Futures and Options, SAVI White Maize, Beef Carcass.
- Energy - JSE allows trading on Crude Oil Futures and Options, Diesel Hedge Futures and Options.
- Commodities on Global Market - Since 2010, JSE allows participants to trade in global commodity markets and the final settlement is done in Rand (ZAR).
Participants in Commodity Markets:
1) Businesses & Individuals using it for Risk Hedging - These participants mainly use the derivatives market for risk hedging against future price fluctuations. JSE allows buyers or manufacturers or producers or other participants like financial institutions/banks to manage their price risk of underlying commodities in the physical market, using future contracts or option contracts.
Example – A farmer producing grains or miller involved in grain processing, exporter dealing in grain exports, bank financing such businesses can use future contract to ensure that they get the same price in future date of delivery, irrespective of price changes in the physical market.
2) Speculators – Another major participant are speculators who want to benefit from directional move in the commodity market. Speculative traders can make a profit by buying commodities at lower prices and selling at higher.
E.g.: A farmer who want to diversify his/her position by buying F&O contracts of a crop that he/she is not growing. Retail or institutional investors who want to benefit from price movements in commodities.
What Affects Commodity Prices?
The commodities are either naturally occurring or grown through farming. However, there will always be variation in the supply and demand of the commodities due to natural and artificial causes, which is the major factor affecting commodity prices.
The prices of commodities can also variate due to numerous national and international issues, trends, and, activities. The government policies, currency fluctuations, inflation, technology, weather, trades, and various other factors play an important in guiding price movements of commodities.
Methods to Trade in Commodity Markets
There are 2 methods to trade commodities in South Africa:
1) JSE Derivatives Market - Participants can trade commodities on JSE derivatives market through JSE authorized derivatives member.
2) CFD Brokers – Besides trading commodities on JSE, speculative investors can also trade commodities via CFD brokers.
Retail or Speculative investors can trade CFDs via FSCA regulated brokers who are authorized to offer trading on derivatives instruments in South Africa.
But not all CFD brokers offer all the commodities that JSE offers. Some brokers like Hotforex SA, Avatrade offer CFDs on popular metals & some other global commodities.
It is important to note that CFDs are complex investment instruments, which have many associated risks & trading fees. Leveraged CFD trading can result in losses, so you must have adequate financial literacy before you choose this method. CFD trading doesn’t provide delivery of actual goods and it is purely for speculation.
Important Terminologies of Commodity Trading
Spot Trades are settled within 2 days of sale without any future settlement date. In this buyer gets delivery on the settlement, Spot trades are more exposed to demand and supply pressures than F&O.
Commodity Futures and Options
Commodities can be traded on the JSE derivatives market in South Africa through futures and options contracts.
A commodity futures contract is a forward agreement in which one party agrees to buy and the other party agrees to sell an underlying commodity at a predetermined future date and price. The date on which the contract expires and the agreed trade is settled is called the expiration date and the future price is called forward price.
The commodity option contract is a similar agreement but the only difference is that trader does not have obligation to exercise the contract and can choose whether to exercise the contract or not.
For example, suppose the current price for 1,000Kg of potato is R3700. The futures contract is agreed between a trader and exchange/broker in which the trader has the right and obligation to buy 1,000Kg of potato for R3800 after one month from today expecting upward price movement. After one month, if the price of 1000Kg potato jumps to R4000, the trader would make a profit of R200 (R4000-R3800) which will be paid by the broker without actually buying or selling the potatoes. This is called as cash settlement. If the price dropped to R3600, the trader will have to pay R200 (R3800-R3600) to settle the futures contract.
In the same example, if it was an option contract, the trader will have a right for not exercising the contract if a loss is faced. In this case, the trader will not buy 1000Kg of potatoes if the actual price is R3600 and the right to buy according to the contract is R3800. The trader will only lose the premium paid to buy the contract.
Clearing & Settlement
Clearing is a process of settlement of derivatives in the books of an exchange after the contract expires. Most metal, energy commodities are settled in cash in JSE while all agriculture commodities have physical settlement except for Cash Settled Corn. Roughly, 2% of grain contracts on JSE are physically settled. Physical settlements rely on warehouse receipts for delivery.
Contract for Difference (CFD)
CFD is an arrangement to speculate the price movement of the underlying asset without actually buying or selling it. The price difference between the opening and closing price of the asset is cash-settled.
This is a modern and advanced method to trade on multiple assets without lesser restrictions and complexity of the market. Brokers offer CFDs on commodities, indices, stocks, and various other instruments.
Spread & Fees
CFD Brokers charge a fee for entering into contract for derivatives & CFDs, this fee is called spread. There may be other fees like Contract price, rollover fees etc.
Margin and Leverage
Many CFD brokers offer leverage on commodity trading which allows traders to open a larger position with a small initial deposit. Leverage is the amount that is borrowed from the broker for trading purposes while margin is the amount that is initially paid by the trader to open position. Involving higher leverage can provide higher profits but can also lead to significant losses.
JSE also allows margin-based trading in derivatives exchange to enter into futures & options contract. You can check the margin calculator on JSE to see initial margin requirements. You need to be careful while using margin-based trading or before entering leveraged trade.
Commodity prices are affected by various market factors and there are various risks associated with trading instruments of Commodities. All participants including speculators & hedgers need to understand these market factors and risks before trading in the Commodities market.
It is advisable for all beginners to hire a licensed financial advisor to help you understand the risks & basics.