Tips for commodity traders to avoid facing default or paying penalty

Picking the right broker can help resolve all the doubts for a first-time commodity trader.

Dec 23, 2013, 08.35 AM IST

Tips for commodity traders to avoid facing default or paying penalty

Naveen Mathur

With an organised electronic exchange platform in the Indian commodity market, one can trade with ease, but it helps to be aware of its functionality, both for the investor and trader. Besides knowing how to choose the right broker, minimum investment required, applicable charges and taxes to be paid, one should also know if the contract is available for delivery or is settled in cash and, most importantly, about the risk management procedure.

Picking the right broker can help resolve all the doubts for a first-time commodity trader. One can shortlist the brokers with a nationwide presence and conduct a comparative analysis based on the following factors:

1. Brand strength.

2. Number of years for which the company has been in the commodities business.

3. Market share of the broker in this business; a higher share shows strength in the industry.

4. Broker’s network in terms of the branches and franchises.

5. Availability of important services, such as research and online/offline trading facility.

6. Brokerage charges; the lower the better.

7. Media presence in print and television.

8. Employee strength.

9. Net worth strength in terms of infrastructure.

10. Business focus (if it is in the financial services space then it shows a focused approach).

11. Track record since inception.

12. Presence of the branch in your locality.

Though the list seems long, it is the most important step for a beginner as it simplifies the trading on a day-to-day basis.

Once you have finalised the broker, decide the minimum investment with which you want to start commodity futures trading. In case of futures, an investor has to pay a margin ranging from 5-10 per cent, depending on the commodity. So, if you want to trade in a gold contract of 1 kg, which is worth around Rs 30 lakh of contract value, then the minimum investment required will be around 5 per cent, or Rs 1.5 lakh. Trading in commodity futures offers the advantage of leveraging and a trader has to pay only the margin amount.

Now, depending on the risk appetite of the trader, he can decide the percentage of allocation to commodities. Used in combination with traditional assets, such as stocks, fixed deposits bonds and physical commodities like gold and silver, commodities can help reduce the overall portfolio risk for the long term, besides increasing the upside potential.

Before starting trading, one must identify the applicable charges as well. From brokerage, stamp duty and exchange transaction charges, to commodities transaction tax, service tax on brokerage and exchange transactions, a trader must comply with these in order to conduct smooth trading.

One of the most important aspects of trading in commodity futures is to understand the delivery procedure. In the case of most agricultural commodities, the contracts are delivery-based, and in the nonagri commodities, delivery is only available in gold and silver contracts, with base metals (except for steel) and energy contracts settled in cash. If the above factors are studied carefully, one can create a simple formula for trading and reap the benefits of avoiding defaults.

Finally, it’s important to understand the role of risk management since it ensures that day-to-day margins are collected and any shortage of margin is met.

Traders must realise that in case of shortage or failure of payment of margins, positions are liquidated. In case of a default by the trader with respect to delivery, he is liable to pay a penalty of 3-5 per cent of the contract value. Hence, it is critical to observe caution while trading in commodities. Trading in any financial instrument involves procedures and guidelines, which can help the investor make long-term gains.