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.
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 BÃ¶rse/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.
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.
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.
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.
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.
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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