Saturday, June 26, 2021 / 04:00PM / Saurav Sharma /Image Header Credit: Trading Tuitions
Commodity
trading is an act of buying and selling the basic goods or raw materials used
in commerce. Commodities are generally traded through derivatives like
forwards, futures, and options but can also be traded in the spot market
physically. Commodity trading is widely used for hedging, speculation, and
diversification in the portfolio. It also provides financial support to
small-scale commodity producers.
Commodity
trading in Nigeria began in 1947 and first commodity exchange (NCX) was established
in 2001. Historically, world’s oldest commodity markets are believed to have originated
between 4500-4000 BC in
Sumer. While Amsterdam Stock Exchange started in 1530 is the oldest commodity
exchange in the world.
The
commodity prices depend mainly on demand and supply but are difficult to
predict. This guide covers all the details and information regarding
commodities and its trading.
Commodities
are interchangeable raw materials or resource of nearly same quality in their
primary form. These are generally used as raw materials to produce various
goods in our daily life or are consumed directly. Breads made from wheat, parts
of cars made from metals, electricity made from coal, etc. In these examples,
wheat, metal, and coal are the commodities respectively that are used in their
basic form. Commodities like gold, silver, cashews, etc are used directly in
their natural form.
All
commodities have economic value and are tangible. It can be grown through
farming or extracted naturally through mining.
Based on their naturally occurring form, they can be grouped into 3
major categories.
- Agriculture: These are the
commodities that are grown through farming. Wheat, rice, corn, soybeans, maize,
groundnut, etc are examples of Agricultural commodities.
- Metal: These are
naturally occurring commodities that are extracted from ores in the earth’s
crust. These commodities are reliable as their production is not affected by
weather or natural phenomenon. Gold, silver, palladium, zinc, and aluminium are
examples of metal commodities.
- Energy: These are the
commodities that are used to produce energy around the world. Crude oil,
natural gas, coal, etc are examples of energy commodities. Technological advancements
and economic development have historically played a major role in the price
movement of these commodities.
Commodities
exchange or commodities market is a market where different types of commodities
are traded. There are nearly major 50 commodity exchanges in the world where
more than 100 types of commodities are traded. Future contracts are the most
preferred method to trade commodities.
The
history of the commodity market dates back to 4000 BC in Sumer civilization.
Evidence from nearly 6000 years ago has resembled future contracts for
livestock. The classical civilizations used gold and silver as money due to
their beauty, scarcity, and ability to be easily melted and reshaped.
Amsterdam
Stock Exchange started in 1540 is believed to be world’s first commodity
exchange which had contracts like short sales, forwards & options. The
currently used commodity exchange trading mechanism was developed in 1864 by
the Chicago Board of Trade (CBOT) in the United States. Wheat, corn, cattle,
and pig were the first commodities in CBOT to be traded through futures and
options. Later on, several more commodities were added. In 1940, the first
commodity price index was created in the US which included 22 basic
commodities. In 1970s, most commodities were introduced to cash settlements
instead of physical delivery.
The
exponential growth of the commodity markets began in 1980s, 1990s when major
commodity exchanges all around the world became electronic. Major commodity
exchanges include Chicago and New York Mercantile Exchange (CME Group) in the
USA, Singapore Commodity Exchange, Tokyo Commodity Exchange in Asia, Deutsche Börse/Eurex,
Euronext in Europe, Safex (under JSE) in South Africa, NCX, LCFE, and AFEX in
Nigeria.
South
Africa’s SAFEX is the most successful commodity exchange in Africa. Ethiopian Commodities Exchange (ECX)
established in 2008 is often seen as a success model by other countries.
Commodity Markets in Nigeria
Nigeria’s
commodity markets go back to 1947 when three produce marketing boards were
setup in colonial era as a price stability mechanism and to act as source of
funds for economic development and R&D in the region. These boards mainly
dealt in cocoa, cotton, groundnuts,
palm products and rubber. These boards were renamed as Commodity Boards in
1967.
Modern commodity
exchange in Nigeria was conceptualized in 1989 by Inter-Ministerial Technical
Committee setup on the advice of CBN which noticed the vacuum created by
scrapping of Commodity boards under Structural Adjustment Programme (SAP) in
1986. But no exchange was setup till 2001, when federal government ordered
conversion of Abuja Stock Exchange to make first commodity exchange (NCX) and it
began trading in
2006 with an aim to enhance commodity financing, standardize output, set uniform
pricing & standards and improve quality of exports.
Second
exchange AFEX obtained license from SEC in 2014 and became first private sector
commodity exchange in Nigeria. Third exchange Lagos Commodities and Futures Exchange (LCFE) got
licensed in 2019.
The
commodity market mainly aims to connect the producers and consumers in a
centralized liquid marketplace. These exchanges are vital for the economic
growth of the nation. Countries with older and better commodity exchange have
historically gained an economical advantage over others. Following are the
major roles of the commodity market:
Connecting Buyers and Suppliers
Connecting
the commercials with the large and small-scale producers in a transparent and
regulated marketplace is advantageous for both parties. The commodity exchange
ensures fair pricing for all types of producers that may not be able to find
buyers. For the corporates and industries, it reduces the effort to search for
producers of the required commodity. The market also ensures that the quality
of the commodities exchanged is according to the required guidelines.
Promote Investment in Commodity Ecosystem
The
involvement of retail traders or speculators increases the liquidity in the
market which facilitates smooth flow of funds. Participation of speculators in
commodity exchanges also creates volatility in the market but the increased
liquidity supports fair pricing and availability of trades.
Price Discovery/Setting
With
a centralized marketplace for the exchange of commodities on a large scale, it
is convenient to measure and monitor the supply and demand of raw materials. If
the production of crude oil increases, its price will decrease and when the
crude oil supplies decrease, price needs to be increased to balance the demand.
It won’t be possible to adjust the prices and balance the economy without a
centralized commodity exchange.
Hedging and Risk Distribution
Commodity
exchanges reduce the risk for producers as well as consumers. Suppose a farmer
producing wheat is expecting his crops to be ready for harvesting in 3 months.
To mitigate the risk of volatility, he will enter into a future contract with
the buyer with an expiry of 3 months. This will fix the price at which he will
sell after harvesting even if the price of wheat decreases after 3 months. This
contract will also give a right to the buyer to receive the stated quantity and
quality of wheat at the predefined price. Entering a future contract through a
regulated commodity exchange will also mitigate the third-party risk and assure
the farmer to get predefined prices for his produce.
Producers
and consumers are the major participants of the commodity market. The primary
objective of the commodity exchange is to offer fair pricing to the producers
and deliver genuine commodities to the consumers.
Speculators
These
are the participants of the commodity market who seek to book profits through
futures and options contracts. The pros and cons of speculators are often
debated as they create volatility in prices. Although, the liquidity created
due to increased participation is an important factor due to which the modern commodity
markets have been functioning efficiently for over 150 years. Speculators form
the largest proportion of participants in every commodity market all over the
world.
Hedgers
These
are the participants of the commodity market who seek to mitigate the risk factor
by hedging. Hedgers can either be producers, consumers, or speculators. Trading
in commodities for speculators creates diversification on the conventional
capital markets like stocks and bonds. Gold is the most traded commodity and
its prices generally increase during the bearish stock market trend. Producers
and consumers of commodities also hedge against devaluation and overvaluation
of commodities through futures and options contracts.
How can you Trade Commodities in Nigeria?
As
a speculator and hedger, there are various methods to participate in commodity
market in Nigeria.
Trading Futures via Commodity Exchanges
In
Nigeria, 3 commodity exchanges are regulated by the Securities and Exchange
Commission of Nigeria.
1. Nigeria Commodity Exchange (NCX)
2. Lagos
Commodities and Futures Exchange (LCFE)
These
commodities exchanges allow retail traders and investors to trade through spot
or futures on a variety of commodities via their registered trading members.
The NCX allows trading on 5, LCFE on 45, and AFEX on 6 commodities. These
include Agricultural products, Minerals, Oil & Gas, and livestock.
Most
exchanges in Nigeria offer spot contracts while futures contracts are also
available in exchanges like LCFE. Future contracts are generally cash-settled
by the retail traders, but can also be physically settled for select commodities.
The
specification and details of each available commodity and registered brokers
are described on the official websites of these exchanges.
Investing via Stocks of Companies Selling
Commodities
The
stocks of companies dealing with the commodities are more likely to follow the
price movement of commodities rather than stock market trends. Agriculture,
Natural Resources, Oil & Gas are the sectors of the stocks that have their
business in commodities.
The
shares of listed commodity stocks can be traded
through any of the stockbrokers regulated by the Nigerian Stock Exchange (NGX).
Investing via ETFs, Mutual Funds, and Indices
The
price movement of commodities can also be speculated through Exchange Traded
Funds, Mutual Funds, and Indices.
Mutual
funds and ETFs are the pooled investment funds in which the portfolio contains
stocks from commodity selling companies. Mutual funds are actively managed by a
fund manager. This means the fund manager can add or remove stocks as per
his/her skills. Mutual funds have slightly higher fees than ETFs as ETFs are
passively managed. In commodity-based ETFs, the stocks of the agriculture,
natural resources, oil & gas sectors are grouped in the portfolio. Pooled
investments are ideal for beginners and investors who cannot actively
participate in the capital markets.
Commodity
indices are the stock index of the commodity-based sectors. These indices move
according to the price movements of all the stocks of the particular sector.
It
is important to note that investors must only invest in ETFs & Mutual Funds
through SEC & NGX regulated fund managers.
Commodity Trading via CFDs
Experienced
Speculators can trade on global commodities via advanced strategy/instrument
called CFD. CFD is the most
popular commodity trading method among online retail traders. It is a
derivative contract on commodities in which only the price movement of
commodities is speculated. There is no actual buying, selling, or any physical settlement
of commodities via CFDs and traders don’t own an asset.
CFD
trading does not involve any commodity exchange or clearinghouse and contracts
are totally over the counter between broker & traders and are cash settled.
CFD
trading services are offered by various foreign regulated CFD & forex brokers in Nigeria. Commodity CFD
trading brokers generally offer attractive leverages which makes it feasible to
trade high volumes with a smaller investment. Traders can go long as well as
short on commodities via CFD.
But
it is important to note that CFD trading is not yet regulated in Nigeria. It is a short-term trading strategy and
involves very high risk.
How is Price Decided in Commodities? What factors affects its pricing and How Does it chanSpot prices of commodities in the market are decided by major commodity exchanges based on various factors.
- The spot prices of commodities can differ on each exchange as each exchange has different demand and supply and also differ geographically.
- Among the several factors affecting commodity prices, the demand and supply to and from the exchange is a major contributor. Speculators also play a vital role in the fluctuation of commodity prices on the exchange.
- The government policies, currency fluctuations, population growth, inflation, trades, and other geopolitical factors can largely affect the prices of commodities in each country.
- The overall economic trends, national and international capital market trends can also motivate or demotivate the sentiments of commodity traders. Resulting in price movement.
- The prices of each commodity can move differently depending on different factors. Natural phenomena like floods, drought, thunderstorms, tides, etc are more likely to affect agricultural commodities. Technological advancement can affect the energy sector.
Commodity
Trading is Risky
Commodity
trading can be risky for investors/speculators as prices are constantly affected
by volatility in the markets depending on various factors. The risk can be
magnified by instruments like CFDs or derivative contracts involving high
leverage. Investors must apply caution while investing in commodity markets.
About
the author
Saurav
Sharma is a finance writer experienced in stocks & forex. His research
& publications mainly cover the analysis, news related to financial markets
in emerging countries.
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