What is a commodity?

What is a commodity?

Commodity includes all kinds of goods. FCRA defines “goods” as “every kind of moveable property other than actionable claims, money and securities”.

Futures trading are organized in such goods or commodities as are permitted by the central government. The national commodity exchanges have been recognized by the central government for organizing trading in all permissible commodities which include precious (gold & silver) and non-ferrous metals; cereals and pulses; oil seeds, raw jute and jute goods; sugar; potatoes and onions; coffee and tea; rubber and spices, etc.

Commodity Futures Trading

The commodity futures trading, consists of a futures contract, which is a legally binding agreement providing for the delivery of the underlying asset or financial entities at specific date in the future.

Like all future contracts, commodity futures are agreements to buy or sell something at a later date and at a price that has been fixed earlier by the buyer and seller.

So, for example, a cotton farmer may agree to sell his output to a textiles company many months before the crop is ready for actual harvesting.

This allows him to lock into a fixed price and protect his earnings from a steep drop in cotton prices in the future. The textiles company, on the other hand, has protected itself against a possible sharp rise in cotton prices.

The complicating factor is quality. Commodity futures contracts have to specify the quality of goods being traded. The commodity exchanges guarantee that the buyers and sellers will stick to the terms of the agreement.

When one buys or sells a futures contract, he is actually entering into a contractual obligation which can be met in one of 2 ways.

First, is by making or taking delivery of the commodity. This is the exception, not the rule however, as less than 2% of all the futures contracts are met by actual delivery. The other way to meet one’s obligation, the method which everyone most likely will use, is by “offset”.

Very simply, offset is making the opposite or offsetting sale or purchase of the same number of contracts sold, sometimes prior to the expiration of the date of the contract. This can be easily done because futures contracts are standardized.

Investor’s choice

The futures market in commodities offers both cash and delivery- based settlement. Investors can choose between the two. If the buyer chooses to take delivery of the commodity, a transferable receipt from the warehouse where goods are stored is issued in favour of the buyer. On producing this receipt, the buyer can claim the commodity from the warehouse.

All open contracts not intended for delivery are cash settled. While speculators and arbitrageurs generally prefer cash settlement, commodity stockist and wholesalers go for delivery. The options to square of the deal or to take delivery can be changed before the last date of contract expiry. In the case of delivery- based trades, the margin rises to 20-25% of the contract value and the seller is required to pay sales tax on the transaction.