Can You Become a Better Trader by Understanding Commodities?

β€œIf you are an equities trader or a derivatives trader, you should understand that there is something beyond analyzing a company’s financials. That something can be found in the commodities market.”

Mr. Jay Prakash Gupta

Mr. Jay Prakash Gupta recently appeared on the Upsurge trading podcast to have a conversation about commodities. Mr. Gupta has been active in the commodity market for 18 years. His wealth of experience can give you a glimpse into the nuances of trading, not just commodities but equities as well.

What’s the Market Like in 2022?

Pratik: I’ve been watching the markets for the last 10 years or so, and it’s quite comical. What’s happening in the markets right now? Where while the volatility is quite there but we do not know the direction. It fluctuates a lot. And at this point in time at this juncture, what kind of markets are you looking at? 

Jay: Well Pratik, the market, it’s a phenomenon, right? You need directionals. What we had seen in the last couple of years, during covid times was an aberration. The market has always been historically volatile. At this point in time, if you talk about the equities market, as you rightly say, it’s directionless.

Because what’s coming in the future? Nobody knows. There are so many headwinds right from starting from the US, China Taiwan issues, then Russia. Apart from that, you know, there is always a fear of inflation. There’s a fear of global recession. 

So, equities markets are likely to be uncertain for the next eight months or one year. But what is happening?

The Dark Horse of the Securities Market

Jay: Interestingly, as far as the Indian market is concerned, there has been huge traction happening on the commodities side. Yet, the commodities market was always underpenetrated – the market lacked depth. 

The market didn’t have many instruments to trade in. It was only futures, which were allowed for trading. But in the last three years, there have been so many new things, which have come up. They are doing very well on the options side. Now, mutual funds are allowed to participate. 

Very soon, you will have FPIs also participating. You know, the whole ecosystem is changing and that’s clearly reflected in the kind of volumes you are seeing on the exchanges, just to give you data on the last year. Of commodity options, was around 900 crores in a single side, on a daily basis. 

Currently it’s around Rs. 33,000 crores. It’s almost a 40x jump. Even globally if you see, the commodities market is almost thrice of the equities market. So in India, I believe that this is a market to watch out for. 

The Connection Between Commodities & Equities

Jay: For traders, somebody who is new to the market, commodities give you a better perspective because it is directly linked to demand and supply, right? There is always a third element on the equity side, you know, which is management.

You don’t know the quality of the management and how the company is functioning, but you have a very direct correlation with demand and supply, in terms of commodities in the commodity market. 

So, I think for a beginner, this is a market you should look at and the kind of instruments available. The options have very high liquidity. Futures are also doing well. The volumes are increasing. And you have some serious participants who are coming into the market like mutual funds. 

They are serious guys. If FPIs are allowed, I think it can be a game changer. This is very interesting. 

Pratik: Jay, especially given the 40x jump that you talked about, for someone who is looking into the equity market, how can they jump on to the commodities market? And is there a linkage between the two? 

Jay: Well I will answer the second one first. There’s obviously a linkage, okay, if we talk only about the index composition, if you see direct metals and energy have almost 20% of share in the Nifty index. And the kind of movements we have seen in metals in the last couple of years, as well as an energy crude oil and natural gas, it has just been, you know, from zero, almost a negative pricing in crude oil to 120 dollars, that’s been phenomenal. You always can correlate what’s happening in the commodities market. But usually what happens is, you know, equities market, or economy always has a lag effect or of what’s happening in commodities market, right? 

If you understand commodities, if you are able to study the demand cycle of commodities, it can also help you with equities.

So if you take an example. When crude was at $120, so there are a lot of sectors including your paint industry, you know, your and there, there are a host of industries rare. So those industries’ raw material prices will have gone up.

Their margins are likely to shrink. If you bold position in those stocks, you can better know or exit or try to hedge those positions. The same thing works for metals as well, right? Copper prices made a lifetime has aluminum prices went up.

If you see the raw material prices going up, you always will have an impact on your margins, right? And if there are large companies who have backward integrations, who have a huge surplus of finished goods. They had a windfall. 

Understanding commodities and how the cycle is going to behave may help you in designing your portfolio in a better way for the equities market.

Pratik: That’s quite interesting. Especially even crude has a direct impact on inflation. So, especially countries like countries, like ours, wherein all the transportation causes deeply linked with crude. And if, if transportation goes up FMCG goods prices goes man, everything else goes for a toss, basically. So I completely second you on the thought, that if we understand the commodities, it is probably a leading indicator of what’s going to happen in the economy going forward. So kudos to your bit, your two cents on that. So for someone who is just stepping into this commodities market, what will be your piece of advice? What? What can possibly go wrong for the trader and what he should be very careful about like what I need to watch out for these parameters before even getting into the commodities side of the trading? 

The Importance of Risk Profile & Starting Small

Jay: For any beginner, it’s always better to start small – whether you want to start in equities, derivatives, or in commodities.

The first thing, you need to look at is understanding your risk-return profile. You need to understand your risk appetite. 

One thing which works as an advantage, as well as a disadvantage in commodities, is that the margin requirement is very very low compared to what equity is just to give an example. If you are trading in nifty, right in, futures the margin requirement varies from 12 to 15 percent correct.

The maximum margin in commodities is 5%. So your leverage is quite high. So second, you need to identify commodities that you understand, which, you can correlate with your daily lives.

So the very basic commodity, which everybody in India understands is good gold, right? Because every household knows right. What’s the gold price and what kind of like when it goes up comes down? 

So to track say gold, for example, what you need to always watch out for there are few very, you know, basic indicators. Like when the economy is not doing well, when there is a war-like scenario where there is a recession, you know, you always find people want to say favor, and the gold prices go up. 

Gold During Recession

Now if our economy goes into a recession or the equity market goes into a recession, people find peace in gold. And when markets are volatile you always need to have more allocation towards you know other asset classes and gold is a preferred one and absolutely works.

Gold is something that you understand and there are data available, and the third thing is that you can’t operate or break prices because it’s a huge market, right? And India is one of the leading players.

So there are certain data points, which come say every first Friday of the month you get data from the US, which speaks about unemployment. Okay so if you track that, if see the US is a leading market, right? Everyone else follows. 

So if there is the unemployment rate that is going up in the US, the US economy may not do well and that will have a positive linkage on your commodity price, correct? So you can create a position in gold in that case. Okay, so if you don’t want to get into, say a large contract, you can start with options first. 

Smaller positions. Just to take you to another example, say crude oil, prices are very volatile. Now, it is, and, you know, the factors which affect crude oil prices, if you hear anything, which is happening in the Middle East, right, there is some kind of war likes scenario in Israel in Iran or Saudi Arabia, crude prices shot up.

If there is fallen inventory, which comes on every Wednesday at 8pm Indian time, you get crude oil inventory data. It shows whether there is a pile-up of inventory or the inventory is falling. So when the inventory is down or it’s negative, it shows that there is less crude available in the market in the market, right? 

You can watch the entire discussion on this trading podcast:

Disclaimer: This blog is not to be construed as investment advice. Trading and investing in the securities market carries risk. Please do your own due diligence or consult a trained financial professional before investing.