Crude Oil Trading

Crude oil is the fuel that drives global economy. One of the widest consumed commodity, crude oil trading is also among the most liquid in the world. Indian commodity exchanges too trade in crude oil. 

A Commodity Worth Noting

 In the commodity market, if there is one product that has shown dramatic changes in price, that product is crude oil. If you don’t believe it then the chart below will surely justify the first statement.

Crude Oil Trading

Source: Researchgate.net

With that graph, we can learn a few things about trading in crude oil futures

  • Crude oil is one of the most liquid commodities in the world
  • You can use both fundamental and technical analysis to understand crude oil futures trading
  • Understanding the fluctuations in demand and supply for crude oil is crucial for making the most profits.

Crude oil is a commodity worth noting as is evident from the factors mentioned below.

 It is Complex – If there were ever a commodity that has rampant upswings and downswings on the stock markets, it is crude oil. As an international commodity that is actively traded by several thousand traders across the world, it is quite complex. 

 Examine the Factors that Influence the Crude Oil Market

 The crude oil market is influenced by the following factors. 

  • The Organization of the Petroleum Exporting Countries (or OPEC) output and supply impact crude oil markets. 
  • Shifting scenarios in oil demand within emerging and developing countries play a hand in crude oil movements. 
  • American crude oil and product inventories impact this market.
  • The refinery utilization rate is relevant here as well.
  • Global geopolitics can influence the movement of crude oil prices.
  • The crude oil market is influenced by speculative buying and selling.
  • Weather conditions and natural disasters are relevant. 

Trading in crude oil futures on the MCX

Crude oil is traded in two contract types

  1. Crude oil (main)
    1. Price quote: per barrel
    2. Lot size: 100 barrels
    3. Expire: 19th or 20th of every month
  2. Crude oil (mini)
    1. Price quote: per barrel
    2. Lot size: 10 barrels
    3. Expiry: 19th or 20th every month

Crude oil mini is more widely traded among traders due to its low lot size and hence the margin required is also less.

 Wrapping Up

 In order to accrue consistent profits from trades conducted on crude oil as well as within the broader energy markets, you must possess exceptional skills. Should you seek to successfully trade crude oil futures along with its various derivatives, you must understand what governs the commodity’s movement, the nature of the crowd that dominates this market, the long-term price history and the physical variations that exist between varied grades.

 

Basics of Commodity Trading in India

Just like equities there is an active market for commodities and currencies. Globally, commodities and currencies are much bigger market than equities. 

Just like how shares are bought and sold in the stock market, commodities are bought and sold in the commodity market. A Commodity market is a market where various commodities and their derivatives products are transacted in. A commodity could be any raw material or primary agricultural product that is marketable, that is, it can be bought or sold. It could be wheat, gold, or crude oil, among many others.

Types of commodities traded in India

In general, there are broadly four categories in the commodities market:

  • Metals (gold, silver, platinum, copper, among others)
  • Energy (crude and heating oil, natural gas and gasoline)
  • Agricultural produces like corn, soybeans, wheat, rice, cocoa, coffee, cotton, etc)

The table below gives a list of all the commodities that are traded

Metal Aluminium, Copper, Lead, Nickel, Sponge Iron, Steel Long (Bhavnagar), Steel Long (Govindgarh), Steel Flat, Tin, Zinc
Bullion Gold, Gold HNI, Gold M, i-gold, Silver, Silver HNI, Silver M
Fiber Cotton L Staple, Cotton M Staple, Cotton S Staple, Cotton Yarn, Kapas
Energy Brent Crude Oil, Crude Oil, Furnace Oil, Natural Gas, M. E. Sour Crude Oil
Spices Cardamom, Jeera, Pepper, Red Chilli, Turmeric
Plantations Arecanut, Cashew Kernel, Coffee (Robusta), Rubber
Pulses Chana, Masur, Yellow Peas
Petrochemicals HDPE, Polypropylene(PP), PVC
Oil & Oil Seeds Castor Oil, Castor Seeds, Coconut Cake, Coconut Oil, Cotton Seed, Crude Palm Oil, Groundnut Oil, Kapasia Khalli, Mustard Oil, Mustard Seed (Jaipur), Mustard Seed (Sirsa), RBD Palmolein, Refined Soy Oil, Refined Sunflower Oil, Rice Bran DOC, Rice Bran Refined Oil, Sesame Seed, Soymeal, Soy Bean, Soy Seeds
Cereals Maize

Guargum, Guar Seed, Gurchaku, Mentha Oil, Potato (Agra), Potato (Tarkeshwar), Sugar M-30, Sugar S-30

India has had a long history of commodity trading with its own share of ups and downs, it has, however, grown exponentially, since the introduction of favourable laws.

The derivative market in commodity trading came into operations as a means to protect the buyers and producers from price fluctuations over time. For example, a farmer worried about the future price of his wheat in the market can use a commodity derivative to hedge and mitigate his risk. Similarly, airline companies worried about the price of fuel too can use Oil futures to mitigate this risk. These traders could opt for actual physical delivery of the commodities upon expiry.

Likewise, people who have no exposure in the underlying too could trade in the commodity market to make profits. This type of trader is called a speculator. They participate in order to profit from the volatile price movements. 

Commodities, like any other asset class, are traded in exchanges and regulated by SEBI. 

Commodity Exchanges in India

Just like how the stock market has the BSE and NSE, the commodity exchanges present in India are:

  • Multi Commodity Exchange – MCX
  • National Commodity and Derivatives Exchange – NCDEX
  • National Multi Commodity Exchange – NMCE
  • Indian Commodity Exchange – ICEX
  • Ace Derivatives Exchange – ACE
  • The Universal Commodity Exchange – UCX

The trading of commodities in the commodity market is regulated by SEBI and facilitated by MCX. The MCX provides a platform for trading in stocks. More than 100 commodities are traded in the Indian Commodity futures markets. Gold, Crude Oil, Copper, Nickel etc. are some of the popularly traded commodities. Of the above, the first three are the most popular exchanges with huge volumes of trade activity. 

There are also many new index funds and mutual funds like Gold Exchange Traded funds which can be invested in if one is willing to invest in the commodities market. 

How does the commodity market work?

This can be best explained with the help of an example. Let’s say you bought a silver futures contract on MCX at Rs. 60,000 for every 100gm. The margin of Silver is 3% on the MCX. So basically you will be paying Rs. 1,800 for the silver. Now let’s assume that on the following day, the cost of silver increases to Rs. 63,000 per 100gms. In this case, Rs. 3000 will be credited to your account. But if the price drops to Rs. 57,000 then Rs. 3000 will be debited accordingly.

Benefits of trading in Commodity Market

As with any market investment, the commodities market too has its own share of pros and cons. The pros are increased potential returns, diversification, and an effective hedge against inflation risk. But there also exist a number of disadvantages especially the huge volatility and speculative risk in this market. 

  • Diversification – the performance of the commodity market is inversely related to the performance of the stock market. This is because some outside factors like inflation which impacts the stock market may benefit the commodity market since the price of commodities go up when the inflation also goes up. Having investment in this will certainly help protect against risk from the stock market.
  • Real Returns – While some goods remain relatively stable, some commodities are extremely volatile. Agriculture commodities for instance will give a good return in case of bad monsoon, similarly at times of war crude oil and gold tends to outperform a other asset class. 
  • Margin Trading – When trading in futures, the margin paid in commodity futures is lesser than the margin paid in the stock market exchange. This helps traders benefit from bulk orders and earn larger profits.

Cons of trading in commodity market

  • High Risk – Due to its volatility, there is high risk involved in trading as well. If you have invested in a certain commodity and the demand for the commodity changes then that can affect the price and hurt your profits significantly.
  • High Leverage – With an average of 3-6 percent as margin, commodities is a highly leveraged market. A wild swing can blow up a traders account easily. 

Commodity Market vs Stock Market – The difference

Here is a quick reference table to chart out the difference between the stock market and the commodity market.

 

Particular Commodity Market Equity Trading
Nature of the product Products that are consumed in everyday life Stocks or equities that represent ownership
Ownership Normally ends with the buyer taking the physical product but can also be cash-settled Owning shares gives you ownership in a company
Duration Normally traded for very short durations Can be held for both short and long durations
Purpose To   speculate  against price fluctuations of the underlying assets To create long-term wealth and capital appreciation
Volatility Are extremely volatile Are less volatile compared to commodity trading
Margin Are traded on margins and high leverage Not necessarily traded on margins but has the option to do so
Trading Hours Trading on the MCX takes place between 9am to 11:55pm Trading takes place between 9:15am to 3:30pm

Commodity Trading charges

When you open a demat account in the stock market and conduct trades, there are certain charges involved in ensuring that the trade is conducted smoothly. In the same way in commodity trading, there are certain charges given by the DP. Commodities in the commodity are most widely traded in futures and options and hence the charges offered by TradeSmart is given below

 

TradeSmart Charges MCX Futures MCX Options
Brokerage Rs. 15/trade Rs. 15/trade
STT Rs. 1000/crore Rs. 5000/crore
Turnover Charges Rs. 390/crore Rs. 2000/crore of premium
GST 18% on (Brokerage + Transaction Charge) 18% on (Brokerage + Transaction Charge)
SEBI charges Rs 10/Crore (Sebi Fees for MCX Agri Commodities is Rs 1 for Rs 1 Crore turnover) Rs 10/Crore
Stamp charges State wise State wise

How to invest in commodities?

Commodity trading is not the only way to invest in commodities in India. There are other means by which you can get involved in the commodity market and those points are given below.

  • Physical commodity
  • Commodity ETF
  • Commodity Mutual funds
  • Commodity options
  • Commodity futures

Physical commodity – This refers to actually physically buying the commodity for yourself and keeping it and them selling it in the future. But the main issue here the storage and high logistic costs which will eat into the returns generated later on. Commodities like Gold are still traded this way even today.

Commodity ETF – Commodity Exchange Traded Funds are passively managed funds that invest in physical commodity and futures contracts and are traded on real-time basis. This helps investors in benefitting from the price changes and not worrying about the physical and liquidity issues of the commodity 

Commodity Mutual Funds – These are mutual funds which are invested in the mutual fund ETFs.They offer diversification since fund manager is investing their money in multiple commodities and at the same there is no risk of liquidity of the commodity.

Commodity Options – in the case of commodity options, the buyer has the right to buy but not obligated to execute the contract in the future. In the commodity market, the MCX offers commodity options in Gold, Silver, Crude Oil and Zinc and the NCDEX exchange offers options in soya bean, soya refined oil, guar seed, guar gum, chana etc.

Commodity futures – This is situation where the buyer and seller of the commodity get into a contract to trade the commodity at an agreed price on a pre-determined date in the future. Unlike options, both parties have to honour their contract. Commodity futures are available on petrol, gold, silver, natural gas, wheat etc/

In conclusion

Trading in commodities is a great way to tackle inflation and is a hedge on the stock market since it is inversely related to the stock market. Since it is a highly leveraged market, one should be cautious in trading in commodities. 

 

Futures Trading – Basics & Benefits

Futures contract is a derivative financial instrument within which an agreement is entered into between a buyer and a seller where the buyer agrees to purchase the underlying at a specified time in the future for a fixed price.

They are powerful derivative financial instruments made use of by hedgers and speculators alike depending on their individual financial interests.

To give clarity, let’s take an example. Suppose there are two traders, Aman and Nitin. Aman has a point of view that the value of a particular stock will rise from it’s present value in the future while Nitin believes that the value of that same stock will fall. So Aman and Nitin both get into a contract with Aman buying the shares of the stock from Nitin at the present price sometime in the future. If Aman’s prediction comes true where the value of the stock increases then he can buy the stock at a discounted price where is the price if the stock falls as predicted by Nitin, then Nitin can sell the stocks at a premium which is higher than the current price.

How does future trading work?

In futures trade, there is no actual exchange of assets that takes place like normal trading. They only take advantage of the price changes and buy and sell the contracts in short time and earn profits for themselves. Below is the process of how it works.

  • It is available in both the BSE and NSE
  • The trader can either place a buying order which means agreeing to buy it at a certain price or place a selling order which means selling it at a fixed price
  • In this case the buyer takes a bullish approach while the seller takes a bearish approach
  • Futures can only be bought in lots. Each lot size depends from company to company. Some may have a lot size of 250 shares or 500 shares or even 100 shares, it varies.
  • Each future contract expires on the last Thursday of every month by which all payments are settled and new contracts are created.
  • Once you buy a future contract, you can also end up selling it to others.
  • A futures contract position, either on the buy or sell side can be held by paying a small amount called the margin. Say, if a trader wants to buy one contract of Nifty consisting of 50 units of Nifty he has to pay a margin as specified by the exchange. If Nifty is trading at 17500 the cost of buying a lot of Nifty would have been Rs 875,000 (17500 X 50). But in futures market one can hold a contract of Nifty by paying as little as Rs 120,000. 

Benefits of Future contracts

Some of the main benefits of trading in a futures market are as follows:

  • Effective hedging mechanism

Futures are instruments that can be employed effectively to mitigate or hedge against systemic risks of movement in the underlying. One of the common ways in which a future is used as hedging tool is in the currency segment. Companies and even Governments use futures contracts to hedge against any potential currency fluctuations especially when they indulge in international trade. For example, Infosys expecting a dollar payment of 1 million dollars six months down the line for a software project could mitigate the risk of fluctuations in the USD INR market by entering into a currency futures trade. Airline companies wanting to hedge risk of rising fuel costs can enter into oil commodity futures to hedge and manage this risk. Likewise, even traders in the equity markets who hold positions in the Cash market often make use of the futures market to hedge the risk of volatile movements.  

  • The power of Leverage trading

Yet another important benefit of trading futures is the power of leverage it offers making it a more attractive investment than a cash market trade.

Let us demonstrate how with an example. 

Assume that you decide to buy Reliance shares today since you feel that the price will go up in the next few days and you can profit from this transaction. Your capital is Rs.1.5 lakh and timeframe is going to be the end of December because you want money for your new year celebrations. You have two options.

Option-1

Buy Reliance shares in the Spot market

Benefits of Trading in futures

Reliance currently happens to be trading at Rs. 2,411.25 (The value of the underlying is the value of the share in the spot market if you remember. The spot market is nothing but the cash market or the equity market)

So, with Rs. 1 lakh, I can buy 1,50,000/ 2411.25 which is about 62 shares. On December 31st, if the share price grows to Rs.2,500 as you had predicted, you would make a profit of Rs. (2,500- 2,411 = Rs.89) per share. In total, your profit will be Rs. 5,518 when calculated for 62 shares and the return on your investment about 3.65%. Now let us evaluate option-2.

Option-2: Buy Reliance Futures

The December expiry Reliance future is trading at Rs.2,425 per share (Last price in the above snap) and the lot size is 250 shares as we had discussed before. So, the contract value would be Rs.2,425 * 250 = Rs.6,06,250. But wait, this is outside my investment limit, right? 

Now this is where the derivatives market offers leverage facility. To trade in Reliance futures, you need not pay the entire amount. It is sufficient if you pay what is known as margin amount, which is usually a percentage of the contract fixed by the Exchange. For Reliance, the margin happens to be 22%. Thus, you need to may about 22% of Rs.6,06,250 which is about Rs.1,33,375, which happens too be within your investment limit. 

Now, upon expiry, your profit per share would be Rs. (2,500-2,425= Rs.75 per share). When multiplied for 250 shares, your profit is Rs. 18,750 and your return on investment, about 12%. Impressive right! To be able to make about Rs. 13,000 more with the same capital does amount to something significant. 

In conclusion

In general, the futures market is a highly liquid market that offers a great mechanism to hedge risks and also the power of leverage trading to maximise your gains. It is a bet on the direction of the movement of the stock and buyer profits with a rise in price while a seller profits from a drop in the price.

 

 

What is F&O Ban?

What is it?

If you’re someone who wants to enter into future and option trade then you should know that at certain times the stock exchange imposes a ban on certain stocks. When the ban takes place, traders cannot enter into new contracts with those particular stocks, however, if you already have before the ban, then you can reduce your position by squaring off positions. This is done to prevent excessive speculation and to keep this under control, the stock exchange imposes a ban when the aggregate open interest of the stock crosses 95% of the MWPL.

The stocks traded in the futures and options space have a limit set by the exchange known as the Market Wide Position Limit (MWPL).  If the open interest of any of the stocks crosses 95% of the MWPL, then, all the F&O contracts of that stock could be put under a period of ban. 

Now, to understand this further, let us understand what we mean by Open Interest and Market Wide Position Limit. 

Open Interest

Open interest refers to the total quantum of outstanding derivative contracts, such as options or futures that are not yet been settled. We know that every contract has two parties, a buyer and a seller. 

Open interest equals the total number of bought or sold contracts, not the total of both added together. So, what do we mean by this? Let us take an example to understand our position.

On Monday, Vijay decides to buy ten contracts of Reliance Futures. He goes to the exchange and sees that he has a potential buyer in Meera. The Open Interest as on Monday is 10 contracts outstanding.

Now, on Tuesday, say Meera wants to get rid of 5 of her contracts and she finds Ahmed, a willing counterparty to execute her transaction. Since Meera has an outstanding sell position, she would give a counter buy while Ahmed would be entering into a buy position. This transaction doesn’t create any new contract. It just transfers five of Meera’s contracts to Ahmed. Hence, the Open Interest remains at 10 contracts. 

On Wednesday, Arjun wants to buy 5 more contracts as he is bullish on Reliance Shares. He finds Jordan, a new person as the willing counterparty. Now since this transaction creates five new contracts, the Open interest increases to 15. 

On Thursday, Meera decides to close out her position and finds that Arjun is a willing counterparty for 2 of her contracts. For the remaining three, she finds Natalie, a willing counterparty. Here, Arjun and Meera close off two of their contracts each bringing down the Open interest by two. The trade with Natalie is a mere exchange of parties and hence does nothing to the Open Interest. Hence the current Open Interest is 15-2= 13 contracts. 

A summary of this looks as below:

Party Buy Sell Total
Arjun 10
Meera 10
Day 1- Open Interest 10
Meera 5
Ahmed 5
Day 2- Open Interest 10
Arjun 15
Meera 5
Ahmed 5
Jordan 5
Day 3- Open Interest 15
Arjun 13
Meera
Ahmed 5
Jordan 5
Natalie 3
Day 4- Open Interest 13

 With this, we have understood fairly what Open Interest stands for. Now, let us try to wrap our head around Market wide Position Limit. 

Market Wide Position Limit (MWPL)

The Market Wide Position Limit is calculated by the Exchange for all stocks trading in the F&O segment. 

At the end of every day, the Exchange evaluates the aggregate open interest across all exchanges in the futures and options on individual shares, comparing it with the market wide position limit for that share and tests whether the aggregate open interest for any scrip exceeds 95% of the market wide position limit set for that particular share. If the answer is affirmative, no fresh positions are allowed for any of the futures and options contracts in that stock. You will only be allowed to square off the existing positions during this period.

Normal trading is allowed to be resumed only after the aggregate open interest across Exchanges comes down to 80% or below of the market wide position limit.

For example, say the MWPL of Reliance is 1,00,000 contracts and the current Open Interest reaches 96,000 contracts which is over 95% of the MWPL, then, normal trading will be suspended in Reliance F&O segment until the Open Interest falls down to 80,000 or below contracts which is 80% of 1,00,000. 

If a trader violates the F&O ban by increasing or creating a new position in the stock, then that trader will be penalised by paying 1% of the value of the increased position. This is subject to a minimum limit of Rs. 5,000 and a maximum limit of Rs. 1L. To ensure that traders do not end up trading or are unaware of the ban, TradeSmart sets up an alert on those particular stocks that are current on the F&O ban list.

The final word

It is the job of the exchanges to keep a check on the speculation and activities around this from getting out of control since it can affect the stability of the market.

NSE publishes the MWPL of every scrip trading on the F&O segment in its website which can be accessed below. 

https://www1.nseindia.com/products/content/derivatives/equities/position_limits.htm

If you follow the news, you would see many stocks being placed under the ban on different days. This is a measure undertaken by the exchange to prevent excessive speculation and volatility on a share. 

 

What Are Futures?

A future is an important derivative trading financial instrument. Before we dive deep into the subject it is essential for us to know what a derivative trading instrument is. 

What is a derivative?

A derivative, as the name suggests, is a product whose value is derived from one or more underlying variables. The underlying variables can be either stock, foreign currency or even interest rates like LIBOR, OIS etc.

For example, the below is a snip of futures of Tata Motors shares, with different expiry dates. Let’s understand about expiry dates later, for now, our focus remains on understanding what I mean by a derivative. 

What are futures

Source: NSE India

Notice that the last column has details about the underlying value? 

For a Tata Motors future, the underlying is obviously going to be a Tata Motors share. So, going by this logic, the share price of Tata Motors for today must be Rs.496, isn’t it?

Well, here you go!

What are futures

Source: NSE India

If we revisit our understanding of what is a derivative, which is a product whose value is derived from one or more underlying variables, we see that it seems to make more sense. 

There are several types of derivative instruments in the market namely Forwards, Options, Futures, Swaps, Swaptions, Collars etc. Our present discussion is going to be limited to understanding what we mean by futures. 

Understanding forward contracts.

A futures contract is a standardised form of what we call a forward contract. So, to understand a future better, let us first take a simple example to understand a forward contract. Now imagine a wheat farmer in Punjab. Let’s say that his harvest cycle is 6 months which means that if he sows in March, he can reap the wheat in September. In March, when the wheat costs Rs. 400 per kilo, he decides to begin his cropping mentally calculating his profits from this harvest. In September, once he has harvested his grains, he sets forth towards the mandi, mentally fantasising the good profits he is about to reap at Rs.400 a kilo. At the mandi though, owing to markets conditions, the price of wheat has fallen to Rs.350 a kilo, leading to a significant fall in the forecasted profits of the farmer. 

In order to avoid this risk of fall in prices at a future date, what can the farmer possibly do while standing in March? If he has a mechanism to agree at a locked selling price of Rs.400/ kg with a promise of delivery at a later date, he would be able to lock his profits and hence mitigate his risk. Now, this is what we call a forward contract

A forward contract is an agreement between two parties, where one party agrees to by an underlying instrument, be it stock, currency, index or a commodity at an agreed price on a future date from another party. 

Transitioning from forwards to futures

Now, imagine about one lakh farmers wanting to do the same thing. All of them gather at a market, desperately seeking out potential buyers to agree upon prices for a future harvest. Apart from causing chaos, it could also have other repercussions like say, the risk of default on the part of the farmer or the buyer. To avoid all this, there enters a crucial player, the one called an Exchange. The exchange acts as an intermediary between the buyer and the seller to facilitate the trades, streamline quantities and delivery dates and so on. This standardisation of a forward trade through the system of exchange leads to the creation of a powerful derivative instrument called Futures. Also, another benefit of having an exchange as a middle man is that the burden of finding a counterparty is shifted onto them. 

As with forward contracts, the agreement is completed on a future date, either by actual delivery of goods or by cash settlement of the difference between the current market price on the future date and the agreed price. In general, the futures market is used as an effective hedge tool to lock your price, however, in practice, there are several people who speculate through futures market as well. 

Some of the common features of a futures trade that are worth understanding are as follows:

  • The price of a future is correlated to the underlying. 
  • Futures contract sizes are standardised.
  • Futures contracts are regulated by Exchanges. 
  • Futures contracts are time-bound. 
  • Futures trades are mostly cash-settled

How is profit or loss made on futures trade?

Now assume that you are buying one lot of Reliance futures December expiry at the current price of 2,425. 

What are futures

Let us assume that you are holding the contract until the expiry date i.e. 30th December. The value of your contract as on today will be Lot size multiplied by price today which is 250 * 2425 = Rs.6,06,250. 

As on the expiry date, three possible scenarios enfold. 

  1. The price moves to Rs.2,500

In this case, you are making a profit because your selling price which is Rs.2500 is more than your agreed price which is Rs.2,425. Thus, you are making a profit of Rs.75 per share. Your total profit which is 250 shares * Rs.75 per share = Rs.18,750 will be credited to your account. 

  1. The price moves to Rs.2,400 

You make a loss here. Your loss of Rs. 25 per share multiplied by 250 shares which equals Rs.6,250 will be debited from your account. 

  1. The price remains at 2,425

In this case, your agreed price and the actual price is the same. You neither make a profit, nor a loss. 

Note that you could either opt for a buy or a sell future. What this means is that you could either have an agreed price of Rs.2,425 per share at which you will buy the share on expiry or agreed selling price of Rs.2,425 upon expiry. Depending upon your assessment of how the market is going to unfold, you could choose your position. 

A person who anticipates the market to fall would make a profit by selling futures now while a person who believes that the market would rise would make a profit by buying futures now. 

Margins and Futures Profits or Loss

We saw above, theoretically, how one could profit from a futures trade. But in the practical world, with huge volume of players involved, how does the futures market operate? When the exchange acts as a regulator for huge volumes and several counterparties, what are the potential risks it faces?

What if all sellers chose not to honour the contract for a particular expiry? Since the NSE is the regulator, it has to compensate the buyers. But doing so would result in a huge loss for the NSE. Hence, to protect the financial risk of the contract and to prevent unnecessary speculation, the NSE often fixes a margin to be paid for each share or index to be traded in the futures segment. The calculation of margin is based on complicated algorithms, inherent volatility, value at risk and several other company-specific and market-specific factors. It is not a constant number and is subject to change. SEBI comes up with margin requirement modifications. 

The initial margin percentage is a combination of what we call SPAN margin and exposure margin. The SPAN is a tool used to calculate the SPAN margin and it uses a portfolio-based approach. Exposure margin is usually charged in addition to the SPAN margin as an added security. The SPAN margin is usually needed to be maintained at all times failing which a penalty is charged while the exposure margin generally adjusts for any mark to market losses.

What is MTM?

MTM or Mark to Market is the mechanism by which profit in futures contracts are calculated. 

Typically, in futures market, the profit or loss is calculated on a daily basis and reflected in your margin account. 

Assume that you buy Reliance futures today at Rs.2,425 per share for a 250 lot size. Tomorrow, if the price rises to Rs. 2,450, a profit of Rs.25 per share or a total profit of Rs. 6,250 will be credited to your margin. 

On the next day, if the futures price falls to Rs.2,400, the loss of Rs. (2,450-2,400) = Rs.50 per share or Rs. (12,500) is debited from your margin account. 

Combining margin requirements and MTM

The below table shows you a snapshot of how your margin account appears like. 

What are futures

As you can see, the cash balance is nothing but your initial margin plus or minus your mark to market profit or loss. As long as your balance exceeds the SPAN margin, it is fine. On 16th, when your cash balance falls below your SPAN margin, your broker will do what is known as a Margin Call asking you to pump money into your margin account. 

Futures Pricing

The next exciting thing to understand is the mechanism of futures pricing. Although much of technical trading doesn’t really require an understanding of this, advanced strategies might require one to understand this mechanism. 

In the above example for Reliance Industries, we noticed that the current market price was Rs.2,411.25 whereas the futures price today was Rs. 2,425. This difference between the spot and the futures price is known as spread.

Futures Price = Spot Price * (1 + Risk free rate of interest * Days to expiry/365) – Dividends if any

Please note that the actual market future price may not equal the theoretical price calculated above due to demand-supply differences, any news, brokerage and other charges etc.

But in general, the actual futures price is very close to the theoretical futures price calculated.

If the future price is higher than the spot, then the future is said to be trading at a premium or what is called Contango. Our Reliance example reflects this.

However, it is also possible for a future to be trading at below the spot price due to a negative outlook for the stock. Then the future is said to be trading at a discount or backwardation. 

Upon expiry, the spot price and the futures price Converge since Reliance share and futures price on 31st December must essentially be the same.

What are futures

Open Interest

Another important measure, that is used frequently in derivatives trading is what is known as the open interest. In simple terms, Open Interest refers to the number of outstanding contracts open in the market for a particular expiry. 

For instance, see the below snap shot.

What are futures

In the above, we see Open Interest as 3,65,16,500. We also see a change in Open interest which is nothing but new contracts added or deleted to the particular scrip. 

Conclusion

In summary, the future is an important derivative instrument used by hedgers and speculators for their respective requirements in the market. 

  • Its price is correlated to the underlying base
  • It is cash-settled and traded in lots
  • It gives you the benefit of leveraged trading
  • It is regulated by Exchanges

What Are Options? Types of Options

An option is a financial derivative instrument that derives its value from the underlying instrument. The underlying could be a stock, a commodity, an index or an interest rate.  

One of the specialities of the option as a derivative instrument is that it gives the buyer an extra privilege of having the right to exercise his option if the conditions turn in his favour. 

An Option contract that give the holder the right to buy is called a Call Option and an Option contract giving the right to sell is called a Put Option. 

Example of Option Trading

Now that we have understood what an option is with an example, let us try to extend the same understanding to the financial markets and see if our understanding holds good.

What are Options

The above is a snapshot of Tata Consultancy services Call Option quote from the NSE India website. What does it indicate?

It indicates that this contract gives you the right to buy a TCS share on 27th January, 2022 expiry date at Rs.3920 per share which is the strike or the agreed price. The value of the underlying is currently Rs.3885.35 and the premium or upfront payment to enjoy this right to buy is Rs.91.25 today. Also, if you notice above, there is a field called market lot which says 150. Typically, futures and options are traded in lot size. In this case, you can buy in lots where one lot would give you the right to buy 150 shares of TCS. Thus to buy one lot, your investment would be Rs.91.25 multiplied by 150 shares which is Rs.13,687.5.

Now, as a trader, say you are bullish on TCS stock with the results and feel that a good move is on the cards and decide to enter this trade. Let us see what could be the possible scenarios that could unfold. 

Scenario 1: The share price moves up to Rs. 4100 on expiry

In this case, you would feel elated. You have the right to buy this share at Rs.3920. Assume that you exercise this right and buy this at Rs.3920 and sell it immediately at Rs.4100. Your profit from the trade would be Rs.180 per share! But then, to have this right to buy at Rs.3920, you have paid Rs.91.25 which is also a cost you bear. So, the next profit from the trade you make will be Rs.180-Rs.91.25 = Rs.88.75 per share! For one lot you purchased, your profit would be Rs.88.75 X 150 which is Rs.13,312.25! This act of buying at the agreed price is called exercising the contract.

Scenario 2: The share price falls to Rs.3800 on expiry

In this case, you would be feeling sad since you’ve a right to buy at Rs.3920, but the price falls to Rs.3800. So, if you buy and sell at these respective levels you will be left with a loss of Rs.120 per share. 

But wait, an option contract gives you a right to buy, not an obligation. As the name suggests, it is an option. So, in this case, since the share movement is not in your favour, you will not exercise or in other words, lapse your right. 

You will still be losing the premium of Rs.91.25 per share that you paid or in other words, your investment in premium for 150 shares of Rs. 13,687.5, but then, this is better than a potential loss of Rs.120 per share, isn’t it?

Scenario 3: The share price touches Rs.3920 and holds

At this level, you are indifferent. You could buy and sell at Rs.3920, but then, you aren’t making any gains from this. So, typically, you would let the right to lapse. Still, you would be losing the premium of Rs.91.25, that is, your investment of Rs.13,687.5

In any sort of worst case, your maximum loss will be limited to the premium you paid. On the flip side, if the share turns in your favour, your gains could be unlimited. Also, another added advantage is that the Options segment lets you use the power of leverage. To buy 150 actual shares of TCS at Rs.3920 would cost your Rs.5,88,000! But now, at a minimal investment of Rs.13,687.5, you could enjoy the profitable movement in the price of this stock. 

Now, you might wonder, why would someone be interested to transact with you as a Call writer with the risk of unlimited loss, gains limited to the premium amount and an obligation to sell when you exercise your right to buy?

Well, a simple answer to that is seen from the above scenarios. If you look closely, in two out of three instances, your contract lapses. In other words, the Writer has a 2/3rd chance of pocketing the premium which makes the risk of unlimited loss attractive to them. 

Types of Options

Call Options and Put Options

Now that we have understood how options contracts work, let us understand the two types of options, a call option and a put option. 

The ‘Call Option’ gives the holder of the option the right to buy the underlying at the strike price on or before the expiration date in return for a premium paid upfront to the seller. The value of a call option increases when the price of the underlying increases.

The Put Option gives the holder the right to sell the underlying at the strike price anytime on or before the expiration date in return for a premium paid upfront. The value of a Put option increases when the price of the underlying decreases. 

Intrinsic value vs time value of options

Based on the price of the underlying and the strike price, the intrinsic value of an option can be classified as either In the Money, At the Money or Out of Money.  This classification helps the trader to choose their strike price wisely. 

In simple terms, the intrinsic value of an option refers to the money the trader could make from the underlying if given a chance to exercise the right on that day. 

For example, in the above chart, the TCS Share price of the underlying was Rs. 3883.35. The Strike price was Rs.3920. Thus, if the trader were to exercise the right on that day, they would be buying at the Strike price of Rs. 3920 and selling at Rs.3883.25 resulting in a loss of Rs.36.65 per share. 

Thus, the intrinsic value of this TCS Call option is Rs. (36.65) per share which is calculated as the Spot Price of the underlying minus the Strike price. 

The same logic can be applied to a put option to and the method of calculations would be Strike Price minus the Spot price since the put gives us a right to sell. 

Broadly, the intrinsic value of an option is classified into three.

  • In the money
  • At the money
  • Out of money

To make our understanding easier, let us understand this with the help of a call option. The logic can then easily be extended to put options. 

An in the money call option is an option whose spot price exceeds its strike price or an option with a positive intrinsic value. Assume that the shares of TCS are trading at Rs.9,000 today. When you go to the market, you find call options for January expiry with strikes ranging from Rs.8,000 to Rs.10,000. 

An option with a strike price of Rs.8,500 would be an in the money call option because if you choose to buy this, your intrinsic value today would be Spot price minus the Strike price would result in Rs.500, a positive intrinsic value. So, if this option is exercised today, you would be gaining Rs.500 per share.

On the flip side, a call option with strike price of Rs.9,500 would be classified as an out of money options because the spot price happens to be below the strike price. In this case, since the conditions don’t favour you, you would let the option lapse, leaving you with a zero intrinsic value.

An at the money option is an option whose spot price is the same or approximately the same as the strike price. In our case, an option with a Rs.9,000 strike price would be an at the money option. Again, here too, you typically let the option lapse and have a zero intrinsic value. 

The intrinsic value of an options contract can never be negative. It can be either zero or a positive number

Call option Intrinsic value = Spot Price – Strike Price

Once you understand this, the same logic can be extrapolated to put options as well.

Put option Intrinsic value = Strike Price – Spot price 

Option Pricing

The pricing of an option premium is typically controlled by two factors. One is the intrinsic value that we understood above and the other is called as time value. 

Time Value basically puts a premium on the period remaining to exercise an options contract. This means if the time left between the current date and the expiration date of a contract is longer than that of another, the first contract has higher value.

This is because of the simple logic that contracts with longer expiration periods give the holder greater flexibility on when to exercise their option. This longer time window lowers the risk for the contract holder and prevents them from landing in a bad scenario. 

What are Options

In the above chart from NSE India for TCS call option for a strike of Rs.3,920, you can see that the last traded option premium for January expiry is about Rs.92.45 while the same for February expiry is Rs.143.45, that is, the longer expiry has higher premium due to the advantage that time value bestows upon it. 

Initially, the time value of the contract is high. If the option remains in-the-money, the option price for the same would also be high. If the option goes out-of-money or stays at-the-money this affects its intrinsic value, which becomes zero. In such a case, only the time value of the contract is considered and the option price goes down.

As the expiration date of the contract approaches, the time value of the contract falls, negatively affecting the option price.

The popular valuation model to value an option is known as the Black Scholes model, named after the people who devised the model. 

Profit and loss on options trade.

Calculation of profit or loss on options varies based on two scenarios. 

  1. Options squared off before expiry
  2. Options held to expiry

Squared before expiry

Since there are no margin requirements, this calculation is fairly simple. 

The profit on a call option squared off before expiry is:

P&L = [Difference between buying and selling price of premium] * Lot size * Number of lots

If you buy a TCS Call options with January expiry on 5th January for a lot size of 150 shares at Rs.80 and sell it on January 15th at Rs. 95, then the profit on your trade is (95-80) *150*1= Rs.2,250.

In practice, there could be brokerage and other charges deducted from your profits. 

For an option seller too, the same holds good. However, since in the case of an option seller, his risk of loss is unlimited, he is required to maintain a margin with the exchange. Let us try to understand what this margin actually is. The seller, unlike the buyer has the risk of unlimited loss. Similar to futures traders, to protect the counterparty from any risk of default, the exchange levies a margin upon the option seller. In simple terms, this is nothing but a minimum amount of money based on calculations made by the exchange that needs to be maintained by the seller in his margin account all the time, like say, a savings bank with a minimum balance. If the balance in the margin account falls below this level, your broker directs you to deposit the requisite amount in your account.

The margin percentage is a combination of what we call SPAN margin and exposure margin. The SPAN is a tool used to calculate the SPAN margin and it uses a portfolio-based approach. Exposure margin is usually charged in addition to the SPAN margin as an added security. Any failure to meet the margin requirements could lead to a levy of penalty

The profit on their transaction is:

[Difference between the buy price and sell price of premium] * lot size * number of lots

Once the position is squared off, the margin of the seller is released after adjusting for profit or loss. 

Held to Expiry

In the money (ITM), options which have been held to expiry get physically settled. If the option is Out of money (OTM), then as we know, since the contract is lapsed, the buyer loses the premium paid, and the seller gets to retain the entire premium received at the time of writing the option.

In our case, if you buy a TCS Call options with January expiry on 5th January for a lot size of 150 shares at Rs.80 and a strike price of Rs.9000 and the actual price of the underlying share is Rs.9500 on expiry leaving your option in the money, then you would be delivered 150 shares of TCS shares at Rs.9000 per share on a T+2 settlement basis. Your cost price overall here will be Rs.9000 + Rs.80 premium totalling to Rs.9,080. You can either sell it in the market at Rs.9,500 levels at which it is currently trading and make a profit of Rs. (9500-9080) = Rs.420 per share or hold on to the share if you deem it fit. 

How does the same look like from the position of an option writer?

The seller, being obliged to sell has to physically deliver the TCS shares to you at Rs.9000 per share. But since he has received a premium of Rs.80 per share, his effective price is Rs. 9,080 and his loss will be Rs.9,500- Rs.9,080 which is Rs.420 per share.

Conclusion

Options are complex and powerful financial derivative instruments used by speculators and traders alike. Options in the currency markets help companies hedge their open exposures in any foreign currency transactions. These are widely traded instruments in the share markets making them one of the most important derivative financial instruments. 

Futures vs Options – What is the Difference?

One thing that is guaranteed in the stock market is uncertainty. Prices can go up or they go down or even not move at all depending on the market conditions like economic factors, elections, weather, agricultural produce and output. Since there are so many fluctuations that can take place, traders look to protect themselves from such fluctuations and resort to an instrument called derivatives. A derivative is a contract that derives its value from the underlying asset which could be anything like a stock, commodity or currency or so on. And the two most common derivatives are Futures and Options.

Futures and Options are probably the most widely traded derivative instruments across the world. But then, despite having their own inherent advantages, they differ in a few ways. But before we get into the differences between them, it’s important to know what each of them means.

Futures – What are they?

A futures contract is an agreement between two parties, where one party agrees to by an underlying instrument, be it stock, currency, index or a commodity at an agreed price on a future date from another party. The agreement is completed on a future date, either by actual delivery of goods or by cash settlement of the difference between the current market price on the future date and the agreed price. In general, the futures market is used as an effective hedge tool to lock your price, however, in practice, there are several people who speculate through futures market as well. 

Let’s explain this with an example. Let’s say you bought a futures contract of 1000 shares of Nestle at Rs. 100 each at a specific date. On the expiry of the contract, you will get those shares at the agreed price irrespective of the current market price. If the market price is Rs. 110 then you will still get it at Rs. 100 and in the process make a profit of Rs. 10,000. But if the market price of the share is Rs. 90 then you will still get it at Rs. 100 but make a loss of Rs. 10,000.

The whole idea of futures is to help in evading the price fluctuations of the market and is an effective tool used by traders to protect their portfolios.

What are options?

Options are a type of derivative contract wherein the buyer or seller has the right, but not the obligation to buy or sell a particular asset at a specified price and date.

For example, suppose Rahul bought a ticket to a screening of Dilwale Dulhania Le Jaayenge that is due to happen on a future date. Having bought the ticket, he has officially got the right to view and attend the concert but are under no obligation to do so. In fact, he can either attend the movie, sell the ticket for a higher price or do neither and let it go waste. But the seller who sold the ticket has the obligation to play the movie irrespective of whether Rahul exercises it or not. This is how options work in the stock market. 

Options are of two types

  • Call Option – A call option is a contract that gives the buyer the right but not the obligation to buy a particular asset at a specified price and date. 
  • Put Option – A put option is a contract that gives the buyer the right but not the obligation to sell a particular asset at a specified price and date. 

How do Futures and Options differ from each other?


While both instruments are similar in hedging the portfolio from market volatility and price fluctuations, they are different on several factors. They are

  • Nature of the contract

A futures contract is a derivative instrument within which an agreement is entered into between a buyer and a seller where the buyer agrees to purchase the underlying at a specified time in the future for a fixed price. Thus, on the agreed expiry date, both parties are expected to fulfil their obligations and honour the contract. The buyer is expected to buy at the agreed price and the seller, to sell.

An options contract, on the other hand, gives the buyer the right to buy the asset at a fixed price. However, there is no obligation on the part of the buyer to buy- they have a right to exercise their option only if the conditions turn favourable. Nevertheless, should the buyer choose to buy the asset, the seller is obliged to sell it. 

Thus, the first point of difference is that an options contract gives a right to the holder while there is no such privilege in a futures contract. 

  • The risk involved

As we saw earlier, both parties of the futures contract are expected to honour the contract even if the market moves against them. 

On the flip side, the buyer in an options contract has a privilege here. If the underlying moves in a direction unfavourable to them, the buyer can opt-out of buying it. This limits the loss incurred by the buyer.

In simple terms, a futures contract could bring unlimited profit or loss. Meanwhile, buying an options contract can bring unlimited profit, but it reduces the potential loss.

  • Concept of Premium

The holder in an options contract has to pay an upfront payment of what is known as a premium. The payment of this premium grants the options buyer the privilege to lapse or exercise his right depending upon the movement of the underlying either unfavourably or favourably. Should the options contract holder choose not to buy the asset, the premium paid is the amount he stands to lose. This right to exercise or lapse ensures that the maximum loss that the holder can suffer is restricted to the premium paid. The writer though has unlimited loss potential. 

On the contrary, since the futures market grants no such special rights, there is no requirement for any premium payments in the futures segment. A futures trader has on the other hand put up a margin for initiating a position. 

  • The Concept of Margin and Profit and Loss

Considering the risk of potentially unlimited loss, the Exchange warrants both the buyer and a seller in a futures market to deposit what is known as a margin. The margin requirement varies based on the scrip traded in and acts as a safeguard for the exchange to mitigate any counterparty risk of default. 

The profits or losses on a futures trade are calculated and marked to market on a live market and adjusted in their margin account. Any fall in the margin levels due to losses might lead to the issue of a margin call. A margin call is when the broker asks the trader to either add more margin in his account or square off the position. Any gains on the trade are credited to the margin account. 

Typically, in the Options market too, the profit or loss is calculated on a real-time basis and reflected in your position. Unlike a futures contract, an option buyer doesn’t have any margin that he needs to maintain if he is a buyer. This is because margin money is a typical requirement by the exchange to protect against the risk of default. 

If I want to buy a TCS option for Rs.9,000 strike at Rs.100 premium for a lot size of 150 shares, I can buy it if I have Rs.15,000 in my account. Now, as a call option holder, we know that the maximum loss I can suffer is Rs.15,000 which happens to be my premium. Therefore, there is no risk of default or loss since I am paying the premium upfront. Thus, an option holder needs to hold no margin. However, in the case of an option seller, the risk of loss is unlimited and hence they are required to maintain a margin with the exchange. This margin too changes based on the scrips, strike prices, expiry and so on. 

The profit on a call option is calculated as follows. 

P&L = [Difference between buying and selling price of premium] * Lot size * Number of lots

If you buy a TCS Call options with January expiry on 5th January for a lot size of 150 shares at Rs.80 and sell it on January 15th at Rs. 95, then the profit on your trade is (95-80) *150*1= Rs.2,250.

In practice, there could be brokerage and other charges deducted from your profits.

For a seller too, the profits are similar:

The profit on their transaction is:

[Difference between the buy price and sell price of premium] * lot size * number of lots

In case the options are held to expiry, as per SEBI guidelines, physical delivery of the share could be warranted. 

Conclusion

Futures and Options are a way for traders to protect themself from the constant price fluctuations in the market. Often this kind of trading is seen in the commodity market as well where people trade in futures and options for commodities like crude oil, gold, wheat, maize etc. while trading in this segment gives quick profits over a short period of time, it is imperative that those who trade in such segments are experienced with knowledge of the market as profits are there but the losses are unlimited.

Futures and Options (F&O) Stocks List

Derivatives, in simple terms, means the financial instruments which derive their value from the underlying. The underlying could be a share, an index, an interest rate or a currency. In India, in the share exchange segment, we have two markets in operation. One is the cash market and the other, is the F&O market. 

The cash market is easy to understand as it indicates the buying/selling of shares at the current market price. 

When you visit the NSE India website, you see more than 1300 companies’ shares have been listed and are being traded, but then, in the F&O space, you see only about two hundred securities. This raises the important question- What qualifies security to be added to the F&O segment?

How are stocks added to the F&O Segment?

Securities and Exchange Board of India (SEBI), the primary body to regulate capital markets in India, has laid down the criteria for the introduction of stocks in the derivatives segment. They are as follows –

  • The stock shall be chosen from amidst the top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basis.
  • The stock’s median quarter sigma order size (MQSO) over the last six months, on a rolling basis, shall not be less than Rs 25 lakh. Median quarter sigma order size in essence means the order size (in value terms) that is needed to cause a change in the stock price equal to one-quarter of its standard deviation. In simple terms, it is the order size needed to impact the share price. The NSE website has a detailed note on how this calculation is made. 

https://www1.nseindia.com/products/content/derivatives/equities/selection_criteria.htm#:~:text=A%20stock%20which%20is%20excluded,re%2Dintroduced%20for%20derivatives%20trading

  • The market-wide position limit in the stock shall not be less than Rs 500 crore on a rolling basis. This, in essence, refers to the liquidity of the security in terms of market-wide position limit, a means to evaluate if a stock is a widely traded or a closely held stock.
  • Average daily delivery value in the cash market shall not be less than Rs 10 crore in the previous six months on a rolling basis.

The important point is that the above criteria need to be met for a continuous period of 6 months. 

The NSE keeps monitoring and adding new scrips to the F&O space from time to time. If you follow the news, you could see many such inclusions being made from time to time. The list of stocks trading in this segment can be accessed from the NSE website.

Now that we have understood how security gets added to the F&O space, let us also know when security is removed. 

Why do stocks get excluded from F&O space?

If a stock is not in conformity with any of the above-mentioned criteria, the exchange removes it from the segment. What this essentially means is that this stock has lost its liquidity in the eyes of the Exchange and is not fit for the derivatives segment.

Please note that removal from the F&O segment is not the same as an F&O ban. An F&O ban is temporary, a span of a few days, but a stock excluded from the F&O space needs to meet the above criteria for a period of six months to have a chance of re-entry.

It is mainly in the interests of investors and to maintain the transparency that the Exchange removes stocks that don’t meet the criteria from the F&O space.

Latest F&O stock list with lot size

https://www.nseindia.com/content/fo/fo_underlyinglist.htm

What is the Commodity Market?

A Commodity market is a market where various commodities and their derivatives products are transacted in. A commodity could be any raw material or primary agricultural product that is marketable, that is, it can be bought or sold. It could be wheat, gold, or crude oil, among many others. 

A brief history

The Amsterdam Stock Exchange, often considered as the first stock exchange, originated also as a market for the exchange of commodities. Early commodity trades in this market ensued in an open hall and included advanced systems such as contracts, short sales, forward contracts and even options.

At about 1864, in the United States, commodities such as wheat, corn, cattle, and pigs were extensively traded using standard instruments on the Chicago Board of Trade (CBOT), which is the world’s oldest futures and options exchange. Other food-related commodities were added to the Commodity Exchange Act and traded through CBOT in the 1930s and 1940s, the list growing to include rice, mill feeds, butter, eggs, Irish potatoes and soybeans.

Commodity Exchanges in India

Some prominent commodities exchanges have merged or gone out of business in recent years. The majority of exchanges carry a few different commodities, although some specialize in a particular group. For instance, in the United States, there is the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX), the Intercontinental Exchange (ICE) etc.. In Europe, there is the London Metal Exchange (LME) which deals only in metals. 

In India, the most famous exchange to trade in commodities is the Multi Commodity Exchange or MCX followed by National Commodity and Derivatives Exchange or NCDEX. However, there are other exchanges too that facilitate commodity trade. Other exchanges include the Indian Commodity Exchange (ICEX), National Multi Commodity Exchange in India (NMCE).

Common types of commodities traded

 Some of the common types of commodities traded are as follows:

  1. Agricultural (e.g. soya, jeera, rice, rubber)
  2. Metals (e.g. industrial metals like aluminium, copper, brass and precious metals like gold)
  3. Energy (e.g. natural gas, crude oil, coal)

Typically, commodities trades happen as futures contracts which can either be cash-settled or undertaken as physical delivery. 

Who trades in the commodity market?

Speculators, arbitrageurs and traders are found in the commodity market. Typically, a trade in the commodity market is entered into by a hedger who is seeking to mitigate the risk of price fluctuations. For example, business houses dealing in steel trade could make use of the commodity futures market to hedge their risk. 

How to trade in commodity markets?

To invest in a commodities market, you first need to open a trading account with a broker of your choice who is registered with the commodities market. TradeSmart is one such broker that can help you out in this regard. Note that you only need a trading account and not a demat account because in the commodity market you are dealing with actual physical goods which cannot be converted into electronic form. Once you’ve opened a trading account, you can trade in the commodities market in two ways, through a futures contract or options contract.

This is called a derivative contract. They derive the value from the underlying asset which is the actual commodity. When you enter into a contract you enter into an agreement to purchase or sell the underlying asset at a pre-determined price at a future date.

Let’s understand that with an example. Suppose you purchase a futures contract of 20 gms of Gold for Rs. 70,000. This means that now you’ve agreed to buy the 20gms of gold at a future date. During this period, you have the option to hold on to the contract or sell it to others depending on the price fluctuations. If you hold onto the contract till the expiry then the seller would be obligated to physically deliver the specified quantity to you.

 

Types of traders in the commodity market

There are three main types of participants in the market

  • Speculators – They are the ones who constantly examine the price changes in the market and play a role in forecasting the future price of the commodity. For example, if a speculator thinks that the price of gold is going to rise then they will purchase a commodity future contract. If gold prices do move higher, then the trader will benefit when he sells it. If the price goes down, the trader will end up in a loss if he decides to sell. Normally, exiting from a bad position early is better than hoping to wait for the price to recover. 

In case of a short position, if a trader expects prices to fall he will sell a futures contract and will benefit if the price does go down. Once the price falls, speculators buy the contract again for a lower price than what they sold it for. 

  • Hedgers – Those who manufacture the goods usually follow this type of trade. They hedge their risk by trading in the commodity futures market. Meaning they don’t want to face the loss of selling the product for a lower price in case the price of the commodity falls in the future. 
  • Arbitrageurs – These are traders who take advantage of price differences between two different exchanges. Suppose if gold prices are moving higher in India but is flat in the American market, the trader would buy in the US and sell in India. He will off course take a position in the currency market to take care of the currency risk. 

Benefits of commodity trading

Diversified portfolio – Commodity returns aren’t related much to other assets in the stock market. Thus, being an individual asset class, commodities can be considered to diversify your investment portfolio. 

Inflation safeguard – Commodities are considered a good hedge against inflation as typically, their prices tend to rise during periods of high inflation and enable maintain purchasing power parity.

Hedging –  Stakeholders in a commodity have an avenue to hedge their position in the commodity market. A farmer would like to lock his price whenever the price rises, knowing fully well that during harvest season price normally falls on account of increased supply. Similarly, a baker would like to lock his price during harvest season when prices are low. The farmer would sell futures roughly while a baker would buy a futures contract to hedge their position. 

Disadvantages of Commodity trading

As with any product, commodity trading has a flip side too. 

  • Commodities trading can be very volatile and lead to quick losses in a short span of time.
  • Since it is concentrated in a few industries, it may not provide a strong diversification advantage.

Some things to keep in mind

  • Just like stocks, there are many factors involved in the price changes in the commodity market. Hence it is important that you do proper research before investing in the commodities market.
  • While there is higher leverage in commodity trading, there are equally high risks in the market as well.
  • If you are new to commodity, it is advised to take the help of those who are experienced and can guide you to do better trading and help you keep a tab on the market.

In conclusion

Trading in the commodity market is a great way to tackle inflation as the cost of commodities when inflation rises. However, they are equally prone to high risk as well. Despite all this, the commodity markets have grown over 120 times since the launch of electronic trading in 2003 and provide excellent opportunities to create wealth in your portfolio.

What is Demat Account?

Ever since the initial public offers (IPOs) started raining and the stock markets began the journey of their biggest rally, DEMAT Accounts have been the stock of the town. In the fiscal year ended March 31, 2018, Indian investors opened a record number of Demat accounts, largely due to the global pandemic and the disruptions caused by the business disruptions. The numbers talk for themselves, don’t they? It is not late if you are new to investing.

In this blog, we will enlighten you with all the details regarding DEMAT Account so when you go out to the next social meetup and this topic comes up, it should feel like a familiar subject.

DEMAT Account – What does it mean?

First things first. The term DEMAT is a shorter version of dematerialized shares. After dematerialization, the shares were converted into an electronic form from the physical form, and the Demat account became the safe house for such electronic shares.

A Demat Account is similar to a bank account that enables investors to hold their shares and other securities in electronic format. It eliminates the need for maintaining paper documents for these types of investments.

 

 

What is Dematerialization?

Converting physical securities to electronic form is known as dematerialization. This process helps minimize the cost and complexity of doing business. Earlier, the shares of the companies were held in physical form such as pieces of paper. A company used to issue a share certificate in the name of the shareholder mentioning the number of shares held by them.

Many issues such as physical damage, loss, theft, forgery, etc. used to take place and it was a tedious process to transfer those physical shares. Dematerialization is nothing but the conversion of those physical shares into electronic form. Today, we do not have physical shares in the market. As per the SEBI Guidelines, all the physical shares have been mandatorily converted into dematerialized form.

Dematerialized shares allow easy transfer and all the problems related to theft, forgery, etc, have been taken care of with this change.

Depositories and Depository Participants

A depository is an organization that stores financial assets electronically which aids traders in buying, selling or holding these assets. In India, we deal with two depositories that are maintaining all demat accounts in the country. These are

  • National Securities Depository Limited (NSDL)
  • Central Depository Securities Limited (CDSL)

But you cannot deal with the depositories directly and are required to go through a depository participant like TradeSmart. They act as an intermediary between you and the depository.

How does Demat account work?

While buying and selling of stocks happens through a trading account, the demat account is used to hold the shares bought through the trading account. That’s why it’s important to link your demat account with your trading account though today, both the trading and demat account are opened together. The following points tell us how the demat account works.

  • After placing a buy order on your trading platform, a buy request is forwarded by your depository participant to the stock broker.
  • The stock exchange then matches your buy request with a similar sell request and then sends an order to the clearing house.
  • Once found, the clearing house then debits the specific number of shares from the seller’s account and credits it to your account at the close of the share market.

Types of DEMAT Account

There are three kinds of DEMAT Account available in India. Let us discuss them below.

  • A Regular Account

You can open a regular Demat account with any of the participating banks or financial institutions in India. This type of account does not provide any additional facilities, say, international transfer of funds for instance.

  • Repatriable Account

If a non-resident Indian carries out some business activity in India, then they have to open a special non-resident rupee account (SNNR). It is a current account. An investor who has an SNNR Account can open a repatriable Demat account that allows them to transfer funds internationally.

  • Non-repatriable Account

Like SNNR Account is a current account, a non-resident Indian can open a non-resident ordinary account (NRO) which is a savings or fixed deposit account. Investors with NRO accounts can open non-repatriable Demat accounts. This account does not facilitate the international transfer of funds.

Components of DEMAT Account

A DEMAT account has the following main components.

  • Depository

Depositories are the parties that hold the shares in the dematerialized form electronically. In India, there are two depositories – National Securities Depository Ltd. (NSDL) and Central Depository Service (India) Ltd. (CDSL).

  • Depository Participants

Depository Participants, commonly known as DPs, are the agents of depository that facilitate buying and selling of shares electronically by providing a trading platform to their clients.

  • Investor

The individuals like you and me who hold the DEMAT Account and invest in shares and other investments assets.

  • Client DP ID

This is a 16-digit exclusive identity number assigned to each investor (client of the depository participant). With the help of this unique identification number, it becomes easier and safer to transfer the shares from one account to another.

Features of DEMAT Account

Features of a DEMAT Account vary from broker to broker. Some brokers also offer various plans with different features to their clients. TradeSmart offers some of the best and most competitive features in the industry. Some of them are included below.

  • A trading terminal or platform that is easy to understand for beginners
  • Market depth with bid and offer prices and the total number of buying and selling orders
  • Customizable watch-list with multiple rows
  • A full-features technical chart with multiple indicators
  • A mobile application to support quick actions on the go
  • Basic fundamental analysis of the companies 
  • Portfolio analysis with details such as overall position, day’s position, percentage change, the total return on investment, etc.
  • Secure, biometric login process
  • Cover, bracket and after market orders feature on the app.

Benefits of DEMAT Account

Following are some of the benefits of the DEMAT Account.

  • With DEMAT, traders can make transactions without having to enter their details in a paper trail. It’s also convenient and time-saving.
  • No risk of theft or forgery since these securities are stored electronically.
  • You can now manage all of your debt and equity instruments in one platform. It includes an automated credit facility that can be used for various purposes, such as bonuses, splits, and mergers.
  • Electronic alerts are sent to every stakeholder of the transaction, allowing them to easily and quickly contact the company, investor, or any other stakeholder in case of any discrepancy.
  • The account holder can transfer their entire or a portion of their portfolio to another person. All that is required is filling a Delivery Instruction Slip.
  • The securities in a Demat account are linked to the company. In this case, if there is a split in the company’s equity or bonus is declared, the investor is notified and the transaction is automatically given effect immediately.

Demat account charges

While opening a demat account is not very hard and takes hardly any time, there are certain charges levied by the DP to maintain the demat account and ensure that smooth transactions take place whenever you trade. There are various charges like account opening fees, annual maintenance charges (AMC), custodian fees that a trader needs to incur. The details and definitions of each are given here. The charges TradeSmart provides can be summarised in the table below.

S.No Particulars Charges
1 Account Opening Charges FREE*
2 Dematerialisation charges Rs 500 per certificate
3 Demat transaction charges Rs 15 + Service tax
4 Off Market transfer (DP) Rs 25 + Service tax
5 Inter DP transfer Rs 25 + Service tax
6 Trade on phone Rs 20 + per executed order plus service tax
7 Physical contract note / other statements etc Rs 20 per contract note + courier charges
8 Demat AMC Rs 300 + Service tax
9 Cheque dishonour charges Rs 200 per instance
10 NEST Instant fund transfer charge Rs 8 + service tax
11 Third party fund transfer charges Rs.400 (For refund in 2 working days)
12 For refund in 2 working days Rs 400
13 For refund in 15 working days Rs 200

So as you can see, the charges levied for the demat account by TradeSmart are extremely competitive in the market and the advantage is that it is free for the first year and nominal charges are billed from the second year onwards. So you can open a demat account for free and begin your trading journey.

Demat account and Trading account – Are they the same?

It is important to know that when you open a new demat account, it may seem like you’re opening only one account, but in reality there are two accounts that are interlinked , that is, the trading account and demat account. In today’s time, when you open an account with any of the depository participants like TradeSmart, you open both a demat account and trading account at the same time. They are opened together because in order to conduct smooth and hassle free trading, both are dependent on each other. A demat account is used to store your securities that you purchase and a trading account is used for buying and selling of these securities. When someone speaks of or uses the word demat account in a statement, it is understood that it means both trading and demat account. Although it is possible to open both accounts separately, doing so only makes your job tedious and unnecessarily time consuming.

Conclusion

While the above information contains a lot of benefits for having a demat account, there are even more that can be discovered only when you open one. In fact, one more feature is that you can temporarily freeze your demat account as well. The benefit is that whatever shares are stored in that cannot be touched by the broker or cannot be sold in cases where there is fraudulent activity going around. This gives an extra layer of protection for your securities and can only be reactivated by the account holder after submitting his details. So the possibilities are endless, all you have to do is open one and see for yourself.

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