Description
A commodity broker is a firm or individual who executes orders to buy or sell commodity contracts on behalf of clients and charges them a commission. A firm or individual who trades for his own account is called a trader. Commodity contracts include futures, options, and similar financial derivatives.
TRADING ON COMMODITY FUTURES
CONTENT
Page No 1, EXECUTIVE SYNOPSIS................................................................................. 4 2, INTRODUCTION TO THE PROJECT .4
3, SCOPE OF THE PROJECT............................................................................ 4 3.1 Objectives of the project.......................................................................... 4 3.2 Methodology.............................................................................................. 3.3 limitations of the study.............................................................................. 4, PROFILE OF PRABODH GROUP ................................................................ 4 5 5
4.1 Joining Hands For Mutual Growth......................................................... 6 4.2 Investment consultancy............................................................................. 6 4.3 Management consultancy ........................................................................ 6 4.4 Engineer house........................................................................................... 7 4.5 Image house................................................................................................ 7 4.6 Real estate................................................................................................... 7 4.7 Members of PRABODH Group................................................................ 8 5, INTRODUCTION ABOUT COMMODITIES AND THEIR ROLES.......... 8 5.1 What is a commodity? .............................................................................. 8 5.2 Commodity market in India..................................................................... 9 5.3 Different commodity exchange markets in the world 10 5.4 Structure of the commodity market in India .. 11 5.6 Participants in Commodities Market . 12 6, INTRODUCTION TO DERIVATIVES............................................................ 12 6.1 Derivatives definition: ............................................................................. 12 6.2 Products of Derivatives market: ............................................................. 12 6.3 Participants in Derivatives market. ....................................................... 13 6.4 Functions of derivatives: ......................................................................... 13 6.5 Derivatives markets: ............................................................................... 13 6.6 Differences between Spot transaction and forward/futures transaction................................................................... 14 7, INSTRUMENTS AVAILABLE FOR TRADING............................................ 14 7.1 Forward contract .................................................................................. 14 7.1.1: Advantages of forward markets............................................. 15 7.1.2: Limitations of forward markets............................................. 15 7.2: Futures: ................................................................................................ 15 7.2.1 Distinction between futures and forwards contracts.. ... 15 7.2.2 Futures terminology................................................................ 16 7.3 Introduction to options ........................................................................ 19 7.3.1 Option terminology................................................................ 19 7.4: Basic payoffs ....................................................................................... 20 7.4.1: Payoff for futures .................................................................. 20 7.4.2: Payoff for options.................................................................. 21
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Trading on commodity futures
8, COMMODITY FUTURES............................................................................... 23 8.1 Difference between commodity futures and financial futures ............................................................................. 8.2 Evolution of the commodity futures trading in India and present status....................................................... ................................. 8.3 The Indian scenario................................................................................. 8.4 Different commodity exchanges in India............................................... 8.5 Advantages when Investing in commodity futures 8.6. Role of commodity futures and prospect............................................. 29 8.7 Using of commodity futures: .................................................................. 8.7.1 Hedging....................................................... ........................... 8.7.2 Speculation. ............................................................................ 8.7.3 Arbitrage: ............................................................................... 8.8 Commodities in which futures trading is being conducted in Indian market: ....................................................... ................................. 9, TRADING OF SOME MAJOR COMMODITIES........................................ 37 9.1 Gold: ....................................................... ................................................ 37 9.2 Silver: ....................................................... ................................................ 39 9.3 Cotton: ...................................................................................................... 40 10, TRADING IN COMMODITY FUTURES...................................................... 42 10.1 Entities in the trading system................................................................ 42 10.1.1 Trading cum Clearing members........................................... 42 10.1.2 Professional clearing members............................................ 42 10.2 Methods of trading: .............................................................................. 42 10.2.1 Open outcry........................................................................... 42 10.2.2 Electronic trading................................................................. 43 10.3 Format for tickers: ................................................................................ 43 10.4 Contract specifications: ........................................................................ 43 10.5 Example of futures contract specifications for Rubber on NCDEX. 44 10.6 Types of orders in futures trading........................................................ 47 10.6.1 Time conditions order........................................................... 47 10.6.2 Price conditions orders.......................................................... 47 10.6.3 Limit order: ........................................................................... 47 10.6.4 Stop Loss order: .................................................................... 48 10.6.5 Spread Order: ....................................................................... 48 10.7 Margin requirements. ........................................................................... 48 10.7.1 Ordinary (Initial) Margin: ....................................................48 10.7.2 Special Margin: .................................................................... 49 10.7.3 Delivery Period Margin: ...................................................... 49 2 30 30 32 32 33 23 24 26 27 28
Trading on commodity futures
10.8 Price in futures: How to interpret ....................................................... 49 10.9. Matching Rules..................................................................................... 50 11, CLEARING AND SETTLEMENT IN FUTURES CONTRACT 11.1Types of settlement in futures contracts: ............................................ 11.1.1 Daily settlement: mark to the market................................... 11.1.2 Final settlement: .................................................................. 11.2 Settlement methods: ............................................................................. 11.2.1 Physical delivery settlement.................................................. 11.2.2 Closing out by offsetting position....................................... 11.2.3 Cash settlement: ................................................................... 50 51 51 52 53 53 53 53
12, REGULATOY ISSUES FOR COMMODITY FUTURES TRADING 54 12.1 Government Policies on futures trading.............................................. 54 12.2 The forward contracts regulation Act. ................................................ 54 12.3 Forward market commission................................................................. 55 12.4 Regulation for Brokers in commodity futures trading 55 12.5Payment of sale tax/VAT in futures trading......................................... 57 12.5.1 Responsibility of seller member: .......................................... 57 12.5.2 Responsibility of buying members......................................... 57 13, FINDINGS......................................................................................................... 58 14, RECOMMEDATIONS..................................................................................... 59 15, RESEARCH QUESTIONNAIRE FOR COMMODITY FUTURES 16, BIBLIOGRAPHY.............................................................................................. 62 16.1 Reference Books: ................................................................................ 62 16.2 Company Literature........................................................................... 62 16.3 List of Websites................................................................................... 62 60
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Trading on commodity futures
1, EXECUTIVE SYNOPSIS The summer project that I did with PRABODH Group was a learning based project with some analysis to be done on it. I was given a chance to learn about commodity exchange market in India, how products are traded online and many things helpful and new to me. The key learning of the project is: Functions of commodities Benefits of commodity futures Prospect of commodity futures trading Innovation in commodity trading (derivatives, futures, options) Commodity markets in India Structure of commodity markets in India Clearing and settlement of commodity futures Regulations on commodity futures trading Sale tax in commodity futures trading Trading commodities through PRABODH Group The learning made me realize that the gamut of commodities market is vast. It would be impossible for me to cover all the aspects in just two months. My attempt was to do a lot of readings to understand the mechanism of commodity trading in India especially futures trading. 2, INTRODUCTION TO THE PROJECT Title of the project: Trading on commodity futures Name of the organization: PRABODH Group, Pune Name of department: Commodity department Name of Project guide: Prof. R. Balachandran 3, SCOPE OF THE PROJECT 3.1 Objectives of the project Prime objective of the project is to understand and analyze the commodity trading system in India and also at Prabodh Group. This project has been undertaken to give an outlook on the potential growth of online (E-broking) Commodities trade in India. This project studies the current prospects of online commodities trading of Prabodh Group and critical issues faced by the company and also the functionality of the commodities market. Thus looking from both perspectives will help to get the clear picture of current scenario of commodity market, which will enable me to arrive at conclusion for the future potential growth. The secondary purpose of the project is to find out the expectation of clients of Prabodh Group in terms of trading on commodities futures. Thus providing better solution to the client s requirements. With the changing times it is important for an institution to withstand the competition by offering customer innovative and improved products, upgrading system. 3. 2 Methodology i, Research Design:
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Trading on commodity futures
Research design is the basic framework, which provides guidelines of research process once the problem of opportunity is identified. This study helps in collection and analysis of the data. ii, data collection In any report data is very important since it provides the information needed for analysis and interpretation. For this report two kinds of data are being used. They are: + Primary data + Secondary data Primary data: Primary data were collected from the most prominent category of participants related to commodity market. The list includes NCDEX, MCX, brokers, investor, customers etc. Personal interview and telephonic interview were also taken. To maintain the consistency they were asked similar set of questions and responses have been collected. Secondary data: Company profile, existing files, records and others (like company brochures etc) served as secondary data to the reports. Circulars, Articles and newspapers provided needed information. Also Books on commodity markets (NCDEX, MCX guide books) and websites are important sources. 3.3 Limitations of the study - Touching the real customer is the ultimate aim. Since the actual commodity traders in PRABODH GROUP are very few, I am unable to find the appropriate numbers of traders and failed to derive any logical conclusions from their response. This is also because the volume traded is very miniscule and the market is still in the infancy stage that it will take some time for the market to grow as in case of the Equity market. - The time factor was a major limitation. As time elapsed I realized that the future decisions aren t taken in isolation. There are numerous factors affecting the decision making which are dynamic in nature. It cannot be summarized in such a short span of time. 4, PROFILE OF PRABODH GROUP Prabodh Group was founded in 1988. Prabodh is a group of entrepreneurs who conduct a cluster of professional activities, the surplus generated from which is dedicated to the work of Jnana Prabodhini, an educational trust in Pune. Prabodh Group stands for a movement in the business field, which creates wealth but uses it predominantly for social purpose. Prabodh, the very name indicates its origin from the educational heritage of this innovative institution- Jnana Prabodhini, which means Awakening through Knowledge. The alma mater cherishes a life- long relationship with its students and puts forth a dream of solving problems of our country through man - making education. Financial autonomy is preserved by its alumni by offering Guru Dakshina - a devotional sum in gratitude, regularly. Prabodh Group was founded in 1988 with this very objective. There is a ceiling on the individual income, while the surplus goes back to the society.
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Trading on commodity futures
Having accomplished excellence in education, the Prabodh members acquired long professional experience in various fields. The multi dimensional activities as elaborated further, depict this versatility of the Prabodh Group. It, therefore, transcends the conventional concepts of modern business. Prabodh is a highly professional body in Print Expression, Manufacture, Investment and Consultation. Not only an efficient service is provided, but a hope for the future is incarnated in the endeavour. PRABODH Group includes Prabodh Sankul Pvt. Ltd. Prabodh Udyog Prabodh Vinimay Prabodh Sampada Prabodh Samwardhan Prabodh Nirman Pvt. Ltd. Prabodh Artha Sanchay Pvt. Ltd. Prabodh Artha Wardhini Ltd. Business of PRABODH Group 4.1 Joining Hands For Mutual Growth To achieve this, PRABODH Group commits in many things from compiling information, exploring together new business ideas and working in cohesive clusters. Autonomous in spirit and work culture, complementary in abilities and resources, this ' dream internet ' can lead to a bigger size comprising of suitable entities. Businesses of PRABODH Group related to any frontier field of science and technology, including Information Technology, Biotechnology, Multi - Media and others. 4.2 Investment consultancy - SHARE BROKERS Members of Pune Stock Exchange Members of National Stock Exchange Services of Bombay Stock Exchange. - FUND MANAGERS Mutual Fund of more than 400 Individual Investors. Present amount deployed is above Rs. 8 to 10 crores Corporate Funds of even larger size being handled through PRABODH GROUP . Inter - Corporate Deposits Bill Discounting facilities Funds Deployed in Share Market for Attractive Returns Funds fully secured against shares. - INVESTMENT SERVICES Portfolio Advice New Issue services Secondary Market Operations. 4.3 Managemetnt consultancy Project Management Project Formulation
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Trading on commodity futures
Appraisal for Bank Finance Social Organisation Services in Foreign Funded Projects. Training In HRD Training Courses for Industries in Communication , Motivation and Leadership Counseling to budding Entrepreneurs. Farmers' Organisations Field assignment of Water Users' Associations Awareness Building in Common Natural Resources 4.4 Engineer house - DESIGN & PROTOTYPES Special Purpose Machines Assembly Automation Mechanisation of Processes Computer controlled Stage Lighting Systems for studios Reciprocators for Painting Agitators Reliability Testing Equipment Components / Assemblies Centrifuges up to 5,000 G & Fuze Spinners upto 50,000 RPM. - MANUFACTURE & MARKETING Microprocessor based Controllers for Automation Industrial Washing Machines Glove Boxes Vice Lift Capacitor Foil Winding Machines. 4.5 Image house - IMAGE PROJECTION Marketing Literature Exhibition Displays Calendars, Diaries House Journals, Periodicals Packaging Materials Books and Publications. - CONFIDENCE BUILDING Annual Reports Industrial Manuals Pre- printed Continuous Stationery Stickers and Labels. 4.6 Real estate Agency Service Industrial Plots around Pune. Farm House Development. Land Developers & Managers Long Term Caretakers Horticulture Managers.
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Trading on commodity futures
Rural life Consultancy Dairy and allied Products Food Processing Projects. 4.7 Members of PRABODH Group - Mr .Mohan Chimanlal Gujarathi M.Com., M. B.A. Investment Consultancy, Portfolio Management Share Broker Financial Management - Mr.Anil Risbud B.E.(Mech.), MMS. MIE Chartered Engineering Management of Engineering Units Design of Special Purpose Machines, SAP, Computer Management Consultant - Prafulla Kulkarni B.Com. ,Grad. C.W.A. Multicolor Printing Finance Management System - N. N. Kanade D.I.T. , D.B.M. Offset Colour Printing Marketing of various Products - V. Y. Kulkarni B.E (Mech.) Precision Engineering Product Development - V. S. Gole B.E. (Mech.) Design & Devalopment of Special Purpose Machines - Ram Dimble M. A Real Estate Transactions Rural Development Projects - Subhash Deshpande M.A. , M.B.A. Human Resource Development Entrepreneurship Development
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Trading on commodity futures
5.INTRODUCTION ABOUT COMMODITIES AND THEIR ROLES 5.1 What is a commodity? Commodities are an integral part of our life - We can not live without the food we eat: Wheat and Rice - Cotton is the king of yarn - Gold and Silver are eternally attractive to mankind All the above are commodities. 5.2 Commodity market in India
Commodity market
Precious Metal
Other metals
Gold Silver
Aluminum, Zinc, Brass, etc
Agriculture
Energy
Cotton, Soya bean, Rapeseed.
Gas and Petroleum
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Trading on commodity futures
5.3 Different commodity exchange markets in the world
Country United States America
Exchange of Chicago Board of Trade (CBOT) Chicago Mercantile Exchange New York Cotton Exchange New York Board of Trade The London International Financial Futures Options Exchange The London Metal Exchange The Winnipeg Commodity Exchange Brazilian Futures Exchange Commodities Sydney Futures Exchange Ltd.
United Kingdom
Canada Brazil Australia
People s Republic of Beijing Commodity Exchange Shanghai China Metal Exchange Hong Kong Japan Malaysia New Zealand Singapore France Italy Netherlands Russia Hong Kong Futures Exchange Tokyo International Financial Futures Exchange Kuala Lumpur commodity Exchange New Zealand Futures and Options Exchange Ltd Singapore commodity Exchange Ltd Le Nouveau Marche MATIF Italian Derivatives Market Amsterdam Exchanges option Traders The Russian Exchange Petersburg Futures Exchange The Spanish Options Exchange Citrus Fruit and Commodity Futures Market of Valencia
Spain
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Trading on commodity futures
5.4 Structure of the commodity market in India
Ministry of Consumer Affairs, Food and Public Distribution
Forward Market commission
Online Exchanges
Open outcry Exchanges
NCDEX
NMCE
MCX
NBOT
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Trading on commodity futures
5.6 Participants in Commodities Market: Hedgers, speculators, investors and arbitragers Producers Farmers Consumers, refiners, food processing companies, jewelers, textile mills, exporters and importers Institutional proprietary traders ( currently disallowed)
6. INTRODUCTION TO DERIVATIVES 6.1 Derivatives definition: Derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other assets. 6.2 Products of Derivatives market: Derivative contracts are of different types. The most common ones are forwards, futures, options, warrant and swaps. Forwards: A forward contract is an agreement between two entitles to buy or sell the underlying assets at a future date, at today s pre-agreed price Futures: A futures contract is an agreement between two parties to buy or sell the underlying assets at a future date, at today s future price. Futures contracts differ from forward contracts in the sense that they are standardized and exchange traded. Options: There are two types of options Calls and Put. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying assets, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-date options are called warrants and are generally traded Over- the- counter Baskets: Basket options on portfolios of underlying assets. The underlying asset is usually a weighted average of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. 6. 3 Participants in Derivatives market. Participants who trade in the derivatives market can be classified under the following three broad categories: Hedgers, speculators and arbitragers. - Hedgers: Ones who offset the price risk inherent in any cash market position by taking the opposite position in the futures market. Hedgers use the market to protect their businesses from adverse price changes.
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Trading on commodity futures
- Speculator: One who tries to profit from buying and selling future contracts by anticipating future price movements. - Arbitragers: Ones simultaneously purchase and sale of similar commodities in different exchanges or in different contracts of the same commodity in one exchange to take advantage of a price discrepancy. 6.4 Functions of derivatives: The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. the derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. derivatives, due to their inherent nature, are linked to the underlying cash market. With the introduction of derivatives, the underlying market witness higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Speculative traders shift to amore controlled environment of the derivatives market. In the absence of an organized derivatives markets, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunity, the benefit of which are immense. Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity. 6.5 Derivatives markets: Derivatives can broadly be classified as commodity derivative market and financial derivatives markets. As the name suggest, commodity derivatives market trade contracts for which the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybean, cotton, etc or precious metals. Financial derivatives markets trade contracts that have a financial asset or variable as the underlying.
Derivatives markets
Financial market 13
Commodities market
Trading on commodity futures
6.6 Differences between Spot transaction and forward/futures transaction
Transactions
Spot transactions
Future transactions
Using the example of a forward contract, let us try to understand the difference between a spot and derivatives contract. Every transaction has three components: trading, clearing and settlements In spot transaction, the trading, clearing and settlement is the actual process of exchanging money and goods and at the spot. Consider this example. On 1st January 2004 B wants to buy some gold. The gold quotes at Rs 6,000 per 10 grams. B pay Rs12,000 and get the gold, this is spot transaction. In forward/future contracts trading happens today, but the clearing and settlement happenstat the end of the specified period. Now suppose B does not want to buy gold on the 1 January 2004, but wants to buy it a month later. The gold quotes Rs 6,015 per 10 gram. They agree upon the forward price for 20 gram of gold that B wants to buy and B leaves. One month later B pays Rs 12,030 and collects his gold. This is a forward contract. 7, INSTRUMENT AVAILABLE FOR TRADING 7.1 Forward contract A forward contract is a contract between two people who agree to buy/sell a specified quantity of a financial instrument/commodity at a certain price at a certain date in future. For example, Mr X and Mr Y. Mr X is a wholesale sugar dealer and Mr Y is the prospective buyer. Mr Y agrees to buy 30 kg of sugar at Rs 15 per kg after three months. The price is arrived at on the basis of prevailing market conditions and future perceptions about the price of sugar. If after three months, the market price of sugar is Rs 20 per kg, then Mr Y is a gainer. and if the price of sugar is Rs 10 per kg, then Mr X is a gainer. The salient features of forward contract are: - They are bilateral contracts and hence exposed to counter party risk - Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. - The contract price is generally not available in public domain. - On the expiration date, the contract has to be settled by delivery of the asset. - If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.
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Trading on commodity futures
7.1.1: Advantages of forward markets Use for hedging Use for speculation 7.1.2: Limitations of forward markets Lack of centralization of trading. - Illiquidity - Counterparty risk 7.2: Futures: Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contracts. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, and a standardized time of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. Standardized items in a futures contract are - Quantity of the underlying - Quality of the underlying - The date and the month of delivery - The units of price quotation and minimum price change - Location of settlement - Unlike Equity futures, the commodity future contract expires on the 20th day of the delivery month. 7.2.1 Distinction between futures and forwards contracts Forward contracts are often confused with futures contracts. However there are some differences between forward contracts and future contracts. Future contracts are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. A futures contract is an agreement between two parties to buy or sell a specified quantity and quality of asset at a certain time in future at a certain price agreed at the time of entering into the contract on the futures exchange. Forward contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. Forward contract is not traded on an exchange. Trading place: Futures contract is entered on the centralized trading platform of the exchange. Forward contract is OTC in nature. Size of the contract: Futures contract is standardized in terms of quantity as specified by the exchange. Size of the forward contract is customized as per the terms of agreement between buyer and seller. Transparency in contract price: Contract price of futures contract is transparent as it is available on the centralized trading screen of the exchange. Contract price of forward contract is not transparent, as it is not publicly disclosed.
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Trading on commodity futures
Valuation of open position and margin requirement: In case of futures contract valuation of open position is calculated as per official closing price on daily basis and Mark to Market margin requirement exist. In case of forward contract valuation of open position is not calculated on daily basis and thereis no provision of Mark to Market margin requirement. Liquidity: Futures contract is more liquid as it is traded on the exchange. Forward contract is less liquid due to customized nature and mutual trade. Counter party risk: In futures contract Clearing House becomes counter party to each transaction, which is called Novation, so counter party risk is nil. In forward contract counter party risk is high due to decentralized nature of the transaction. Regulations: A government regulatory authority and the exchange regulate futures contract. Forward contract is not regulated by any authority or exchange Settlement: Futures contract is generally cash settled but option of physical settlement is available. Forward contract is generally settled by physical delivery Delivery: Delivery tendered in case of futures contract should be of standard quantity and standard quality as per contract specification at designated delivery centers of the exchange. Delivery in case of forward contract is carried out at delivery center specified in customized bilateral agreement. Futures Trade on an organized exchange Standardized contract terms More liquid Requires margin payments Follows daily settlement Forward OTC (over the counter) in nature Customized contract terms Less liquid No margin payment Settlement happens at end of period
7.2.2 Futures terminology Arbitrage: The simultaneous purchase and sale of similar commodities in different markets to take advantage of a perceived price discrepancy. Basis: The difference between the current cash price and the futures price of the same commodity for a given contract month. Bear Market: A period of declining market prices. Bull Market: A period of rising market prices. Broker: A company or individual that executes futures and options orders on behalf of financial and commercial institutions and/or the general public. Cash (Spot) Market: A place where people buy and sell the actual (cash) commodities, i.e., grain elevator, livestock market, etc.
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Trading on commodity futures
Commission (Brokerage) Fee: A fee charged by a broker for executing a transaction. Convergence: A term referring to cash and futures prices tending to come together as the futures contract nears expiration. Cross-hedging: Hedging a commodity using a different but related futures contract when there is no futures contract for the cash commodity being hedged and the cash and futures markets follow similar price trends. For example, hedging cull cows on the live cattle futures market. Daily Trading Limit: The maximum price change set by the exchange each day for a contract. Day Traders: Speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day. Delivery: The transfer of the cash commodity from the seller of a futures contract to the buyer of a futures contract. Forward (Cash) Contract: A cash contract in which a seller agrees to deliver a specific cash commodity to a buyer at a specific time in the future. Fundamental Analysis: A method of anticipating future price movement using supply and demand information. Futures Contract: A legally binding agreement, made on the trading floor of a futures exchange, to buy or sell a commodity or financial instrument sometime in the future. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. The only variable is price, which is determined on an exchange trading floor. Hedger: An individual or company owning or planning to own a cash commodity - corn, soybeans, wheat, U.S. Treasury bonds, notes, bills, etc. - and concerned that the costs of the commodity may change before they intend to either buy or sell it in the cash market. A hedger achieves protection against changing cash prices by purchasing (selling) futures contracts of the same or similar commodity and later offsetting that position by selling (purchasing) futures contracts of the same quantity and type as the initial transaction and at the same time as the cash transaction occurs. Hedging: The practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Hedgers use the futures markets to protect their business from adverse price changes. Initial Margin: The amount a futures market participant must deposit into his/her margin account at the time he/she places an order to buy or sell a futures contract. Intrinsic Value: The difference between the strike price and the underlying futures price for an option that is in-the-money. Liquidate: Selling (or purchasing) futures contracts of the same delivery month purchased (or sold) during an earlier transaction or making (or taking) delivery of the cash commodity represented by the futures contract.
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Trading on commodity futures
Long: One who has bought futures contracts or plans to own a cash commodity. Maintenance Margin: A set minimum margin (per outstanding futures contract) that a customer must maintain in his margin account. Nearby (Delivery) Month: The futures contract month closest to expiration. Also referred to as spot month. Open Interest: The total number of futures or options contracts of a given commodity that have not yet been offset by an opposite futures or option transaction nor fulfilled by delivery of the commodity or option exercise. Each option transaction has a buyer and a seller, but for calculation of open interest only one side of the contract is counted. Purchasing Hedge (long hedge): Buying futures contracts to protect against a possible price increase of cash commodities that will be purchased in the future. At the time the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those that were initially purchased. Selling Hedge (short hedge): Selling futures contracts to protect against possible declining prices of commodities that will be sold in the future. At the time the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those that were initially sold. Short Position: One who has sold futures contracts or plans to sell a cash commodity. Selling futures contracts or initiating a cash forward contract sale without offsetting a particular market position. Speculator: A market participant who tries to profit from buying and selling futures and option contracts by anticipating future price movements. Speculators assume market price risk and add liquidity and capital to the futures markets. They do not hold equal and opposite cash market risks. Spread: The price difference between two related markets or commodities. For example, the April-August live cattle spread. Strike Price: The price at which the futures contract underlying a call or put option can be purchased (call) or sold (put). Also called exercise price. Technical Analysis: Anticipating future price movements using historical prices, trading volume, open interest, and other trading data to study price patterns. Time Value: The amount of money option buyers are willing to pay for an option in the anticipation that, over time, a change in the underlying futures price willcause the option to increase in value. In general, an option premium is the sum of time value and intrinsic value. Any amount by which an option premium exceeds the option's intrinsic value can be considered time value. Underlying Futures Contract: The specific futures contract that can be bought or sold by exercising an option. Volatility: A measurement of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.
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Trading on commodity futures
Volume: The number of purchases or sales of a commodity futures contract made during a specified period of time, often the total transactions for one trading day. 7.3 Introduction to options - As the word suggests option is a contract that gives you an option, but not the obligation to buy or sell something. Unlike futures, there is an option writer who initiates the contract. An option writer is treated as the seller of the contract. The purchase of options requires an up-front payment. - Commodity options are totally prohibited in Indian market. 7.3.1 Option terminology Underlying - The specific security / asset on which an options contract is based Call Option: A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at a specified price on or before a specified time. The seller (one who is short call ) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Example: An investor buys 100 European call options on Infosys at the strike price of Rs3500 when the current price of the stock is Rs3400 at a premium of Rs100. If the stock price, on the day of expiry is more than Rs3600 (Strike Price + cost incurred in form of premium paid), lets us say Rs3800, the buyer of the call option will decide to exercise his option to buy the 100 Infosys shares. If the buyer sells the shares in the market immediately, he will earn Rs200 per share as profit (or Rs20,000 in the whole of transaction). The seller of the call will have the obligation to deliver the stock. In another scenario, if at the time of expiry stock price falls below Rs3500 say suppose it touches Rs3000, the buyer of the call option will choose to not to exercise his option. In this case the investor loses the premium paid which shall be the profit earned by the seller of the call option. Put Option: A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at a specified price on or before a specified time. The seller (one who is short Put) however, has the obligation to buy the underlying asset if the buyer of the put option decides to exercise his option to sell. Example: An investor buys 100 European put options on Reliance at the strike price of Rs300 when the current price of the stock is Rs280 at a premium of Rs15. If the stock price, on the day of expiry is less than Rs300 (Strike Price + cost incurred in form of premium paid), say Rs270, the buyer of the Put option will decide to exercise his option to sell the 100 Reliance shares. He will buy 100 shares of Reliance from the market @ Rs270 / share and sell the same at Rs300 / share, he will earn Rs15 per share (taking premium paid into consideration), as profit or Rs1,500 in the whole of transaction. The seller of the Put will have the obligation to buy the stock. In another
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Trading on commodity futures
scenario, if at the time of expiry stock price rises above Rs300 (strike price), say suppose it touches Rs320, the buyer of the Put option will choose to not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid which shall be the profit earned by the seller of the Put option. Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment. Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or sell. Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless. Exercise Date - is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option) Open Interest - The total number of options contracts outstanding in the market at any given point of time. Option Holder - is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer. Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited. Option Class - All listed options of a particular type (i.e., call or put) on a particular underlying instrument. 7.4: Basic payoffs A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on X-axis ant the profits/loss on the Y-axis. 7.4.1: Payoff for futures Pay off for buyer of futures: Long futures The payoff for a person who buys a future contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
20
Trading on commodity futures
Profit +500
5500
6000
6500
Gold
-500
Loss
The Figure shows the profits/losses for a long futures position. The investor bought gold when gold futures were trading at Rs. 6000 per 10 gm. If the price of the underlying gold goes up, the gold futures price too would go up and his future position starts making profits. If the price of gold falls, the futures price falls too and his futures position starts showing losses. Payoff for a seller of futures: Short position. The payoff for a person who sells a future contract is similar to the payoff for a person who sells an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Profit
+ 500
6000 0
6500
7000
-500 Loss
21
Trading on commodity futures
The figure shows the profits and losses for a short futures position. The investor sold cotton futures at Rs. 6500 per quintal. If the price of the underlying cotton goes down, the futures prices also fall, and the short position starts making profits. If the price of the underlying cotton rises, the futures too rise, and the short position starts showing losses. 7.4.2: Payoff for options Pay of for buyer of call option: Long call Call option give the buyer the right to buy the underlying asset at the strike price specification in the option. The figure shows the profits/loss for the buyer of a three month call option on gold at a strike of Rs 7,000 per 10 gram, bought at premium of Rs 500.
profit 7000 gold 500
Loss Payoff for writer of call options: short call The figure shows the profits/loss for the seller of a three month call option on gold at a strike of Rs 7,000 per 10 gram, sold at premium of Rs 500 profit
500 7000 Gold
loss
Payoff for buyer of put options: Long put The figure shows the profit/loss for the buyer of a three month put option on gold at a strike of Rs 7,000 per 10 gram, bought at premium of Rs 500.
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Trading on commodity futures
Profit
7000 0 500 Gold
Loss
Payoff for a seller (writer) of put option: short put Profit 500 0 7000 Gold
loss
23
Trading on commodity futures
8, COMMODITY FUTURES 8.1 Difference between commodity futures and financial futures - The basic concept of a futures contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features which are very peculiar to commodity futures market. In the case of financial futures, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity market creates the need for warehousing. - Similarly, the concept of varying quality of asset does not really exist as far as financial underlying are concerned. However in the case of commodity, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. 8.2 Evolution of the commodity futures trading in India and present status Organized futures market evolved in India by the setting up of "Bombay Cotton Trade Association Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futures trading in oilseeds was organized in India for the first time with the setting up of Gujarati Vyapari Mandali in 1900, which carried on futures trading in groundnut , castor seed and cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds were functioning in Gujarat and Punjab. Futures trading in Raw Jute and Jute Goods began in Calcutta with the establishment of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd.,was set up in 1927 for organizing futures trading in Raw Jute. These two associations amalgamated in 1945 to form the present East India Jute & Hessian Ltd., to conduct organized trading in both Raw Jute and Jute goods. In case of wheat, futures markets were in existence at several centres at Punjab and U.P. The most notable amongst them was the Chamber of Commerce at Hapur, which was established in 1913. Other markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad and Barielly in U.P. Futures market in Bullion began at Mumbai in 1920 and later similar markets came up at Rajkot , Jaipur , Jamnagar , Kanpur, Delhi and Calcutta. In due course several other exchanges were also created in the country to trade in such diverse commodities as pepper, turmeric, potato, sugar and gur(jaggory). After independence, the Constitution of India brought the subject of "Stock Exchanges and futures markets" in the Union list. As a result, the responsibility for 24
Trading on commodity futures
regulation of commodity futures markets devolved on Govt. of India. A Bill on forward contracts was referred to an expert committee headed by Prof. A.D.Shroff and Select Committees of two successive Parliaments and finally in December 1952 Forward Contracts (Regulation) Act, 1952, was enacted. The Act provided for 3-tier regulatory system; (a) An association recognized by the Government of India on the recommendation of Forward Markets Commission, (b) The Forward Markets Commission (it was set up in September 1953) and (c) The Central Government. Forward Contracts (Regulation) Rules were notified by the Central Government in July,1954 The Act divides the commodities into 3 categories with reference to extent of regulation, viz: (a) The commodities in which futures trading can be organized under the auspices of recognized association. (b) The Commodities in which futures trading is prohibited. (c) Those commodities which have neither been regulated for being traded under the recognized association nor prohibited are referred as Free Commodities and the association organized in such free commodities is required to obtain the Certificate of Registration from the Forward Markets Commission. In the seventies, most of the registered associations became inactive, as futures as well as forward trading in the commodities for which they were registered came to be either suspended or prohibited altogether. The Khusro Committee (June 1980) had recommended reintroduction of futures trading in most of the major commodities , including cotton, kapas, raw jute and jute goods and suggested that steps may be taken for introducing futures trading in commodities, like potatoes, onions, etc. at appropriate time. The government, accordingly initiated futures trading in Potato during the latter half of 1980 in quite a few markets in Punjab and Uttar Pradesh. After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry liberalization in both the domestic and external sectors, the Govt. of India appointed in June 1993 one more committee on Forward Markets under Chairmanship of Prof. K.N. Kabra. The Committee submitted its report in September 1994. The majority report of the Committee recommended that futures trading be introduced in 1) Basmati Rice 2) Cotton and Kapas 3) Raw Jute and Jute Goods 4) Groundnut , rapeseed/mustard seed , cottonseed , sesame seed , sunflower seed , safflower seed , copra and soybean , and oils and oilcakes of all of them. 5) Rice bran oil 6) Castor oil and its oilcake
25
Trading on commodity futures
7) Linseed 8) Silver and 9) Onions. The committee also recommended that some of the existing commodity exchanges particularly the ones in pepper and castor seed , may be upgraded to the level of international futures markets. The liberalised policy being followed by the Government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management. The National Agriculture Policy announced in July 2000 and the announcements of Hon'ble Finance Minister in the Budget Speech for 2002-2003 were indicative of the Governments resolve to put in place a mechanism of futures trade/market. As a follow up the Government issued notifications on 1.4.2003 permitting futures trading in the commodities, with the issue of these notifications futures trading is not prohibited in any commodity. Options trading in commodity is, however presently prohibited. 8.3 The Indian scenario Commodity derivatives have had a long and a chequered presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over the years, there have been various bans, suspensions and regulatory dogmas on various contracts. There are 25 commodity derivative exchanges in India as of now and derivative contracts on nearly 100 commodities are available for trade. The overall turnover is expected to touch Rs 5 lakh crore (Rs 5 trillion) by the end of 2004-2005. National Commodity and Derivatives Exchange (NCDEX) is the largest commodity derivatives exchange with a turnover of around Rs 3,000 crore (Rs 30 billion) every fortnight. It is only in the last decade that commodity derivatives exchanges have been actively encouraged. But, the markets have suffered from poor liquidity and have not grown to any significant level, till recently. However, in the year 2003, four national commodity exchanges became operational; National Multi-Commodity Exchange of India (NMCE), National Board of Trade (NBOT), National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX). The onset of these exchanges and the introduction of futures contracts on new commodities by the Forwards Market Commission have triggered significant levels of trade. Now the commodities futures trading in India is all set to match the volumes on the capital markets.
26
Trading on commodity futures
8.4 Different commodity exchanges in India NO NAME AND ADDRESS
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.
National Commodity & Derivatives Exchange Ltd. Website: ncdex.com National Multi Commodity Exchange of India Limited. Website: nmcex.com Multi Commodity Exchange of India Ltd. Website: mceindia.com The Meerut Agro Commodities Exchange Co. Ltd., Meerut The Spices and Oilseeds Exchange Ltd. Ahmedabad Commodity Exchange Ltd. Vijay Beopar Chamber Ltd.,Muzaffarnagar India Pepper & Spice Trade Association.Kochi Rajdhani Oils and Oilseeds Exchange Ltd. Delhi National Board of Trade. Indore. The Chamber Of Commerce,Hapur The East India Cotton Association Mumbai. The Central India Commercial Exchange Ltd, Gwaliar. The East India Jute & Hessian Exchange Ltd. First Commodity Exchange of India Ltd, Kochi Bikaner Commodity Exchange Ltd., Bikaner. Esugarindia Limited. The Bombay Commodity Exchange Ltd.Mumbai Surendranagar Cotton oil & Oilseeds Association Ltd, The Rajkot Seeds oil & Bullion Merchants` Association Ltd Bhatinda Om & Oil Exchange Ltd., Batinda. Haryana Commodities Ltd., Hissar The Bullion Association Limited e-Commodities Ltd
27
Trading on commodity futures
8.5 Advantages when Investing in commodity futures - Commodity futures, which were traditionally developed for risk management purposes, are now growing in popularity as an investment tool. Most of the trading in the commodity futures market is being done by people who have no need for the commodity itself. They just speculate on the direction of the price of these commodities, hoping to make money if the price moves in their favour. The commodity futures market is a direct way to invest in commodities rather than investing in the companies that trade in those commodities. For example, an investor can invest directly in a steel futures rather than investing in the shares of Tata Steel. It is easier to forecast the price of commodities based on their demand and supply forecasts as compared to forecasting the price of the shares of a company - which depend on many other factors than just the demand - and supply of the products they manufacture and sell or trade in. - Also, futures are much cheaper to trade in as only a small sum of money is required to buy a futures contract. Let us assume that an investor buys a tonne of soybean for Rs 8,700 in anticipation that the prices will rise to Rs 9,000 by June 30, 2005. He will be able to make a profit of Rs 300 on his investment, which is 3.4%. Compare this to the scenario if the investor had decided to buy soybean futures instead. Before we look into how investment in a futures contract works, we must familiarize ourselves with the buyer and the seller of a futures contract. A buyer of a derivative contract is a person who pays an initial margin to buy the right to buy or sell a commodity at a certain price and a certain date in the future. On the other hand, the seller accepts the margin and agrees to fulfill the agreed terms of the contract by buying or selling the commodity at the agreed price on the maturity date of the contract. Now let us say the investor buys soybean futures contract to buy one tonne of soybean for Rs 8,700 (exercise price) on June 30, 2005. The contract is available by paying an initial margin of 10%, i.e. Rs 870. Note that the investor needs to invest only Rs 870 here. On June 30, 2005, the price of soybean in the market is, say, Rs 9,000 (known as Spot Price - Spot Price is the current market price of the commodity at any point in time). The investor can take the delivery of one tonne of soybean at Rs 8,700 and immediately sell it in the market for Rs 9,000, making a profit of Rs 300. So the return on the investment of Rs 870 is 34.5%. On the contrary, if the price of soybean drops to Rs 8,400 the investor will end up making a loss of 34.5%. If the investor wants, instead of taking the delivery of the commodity upon maturity of the contract, an option to settle the contract in cash also exists. Cash settlement comprises exchange of the difference in the spot price of the commodity and the exercise price as per the futures contract.
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Trading on commodity futures
At present, the option of cash settlement lies only with the seller of the contract. If the seller decides to make or take delivery upon maturity, the buyer of the contract has to fulfil his obligation by either taking or making delivery of the commodity, depending on the specifications of the contract. In the above example, if the seller decides to go for cash settlement, the contract can be settled by the seller paying Rs 300 to the buyer, which is the difference in the spot price of the commodity and the exercise price. Once again, the return on the investment of Rs 870 is 34.5%. The above example shows that with very little investment, the commodity futures market offers scope to make big bucks. However, trading in derivatives is highly risky because just as there are high returns to be earned if prices move in favour of the investors, an unfavourable move results in huge losses. - The most critical function in a commodity futures exchange is the settlement and clearing of trades. Commodity futures can involve the exchange of funds and goods. The exchanges have a separate body to handle all the settlements, known as the clearing house. For example, the seller of a futures contract to buy soybean might choose to take delivery of soyabean rather than closing his position before maturity. The function of the clearing house or clearing organisation, in such a case, is to take care of possible problems of default by the other party involved by standardising and simplifying transaction processing between participants and the organisation. In spite of the surge in the turnover of the commodity exchanges in recent years, a lot of work in terms of policy liberalisation, setting up the right legal system, creating the necessary infrastructure, large-scale training programs still need to be done in order to catch up with the developed commodity derivative markets. 8.6. Role of commodity futures and prospect: Futures contracts perform two important functions: price discovery price risk management with reference to the given commodity. It is useful to producer because he can get an idea of the price likely to prevail at a future point of time and therefore can decide between various competing commodities, the best that suits him. It enables the consumer get an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. The futures trading is very useful to the exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and thereby secure export contract in a competitive market. Having entered into an export contract, it enables him to hedge his risk by operating in futures market. Other benefits of futures trading are: (i) Price stabilization-in times of violent price fluctuations - this mechanism dampens the peaks and lifts up the valleys i.e. price variation is reduced. 29
Trading on commodity futures
(ii) Leads to integrated price structure throughout the country. (iii) Facilitates lengthy and complex, production and manufacturing activities. (iv) Helps balance in supply and demand position throughout the year. (v) Encourages competition and acts as a price barometer to farmers and other trade functionaries. Futures trading is also capable of being misused by unscrupulous speculators. In order to safeguard against uncontrolled speculation certain regulatory measures are introduced from time to time. They are: a. Limit on open position of an individual operator to prevent over trading; b. Limit on price fluctuation (daily/weekly) to prevent abrupt upswing or downswing in prices; c. Special margin deposits to be collected on outstanding purchases or sales to curb excessive speculative activity through financial restraints; d. Minimum/maximum prices to be prescribed to prevent future prices from falling below the levels that are un remunerative and from rising above the levels not warranted by genuine supply and demand factors. During shortages, extreme steps like skipping trading in certain deliveries of the contract, closing the markets for a specified period and even closing out the contract to overcome emergency situations are taken Prospect: With the gradual withdrawal of the government from various sectors in the post-liberalization era, the need has been felt that various operators in the commodities market be provided with a mechanism to hedge and transfer their risks. India's obligation under WTO to open agriculture sector to world trade would require futures trade in a wide variety of primary commodities and their products to enable diverse market functionaries to cope with the price volatility prevailing in the world markets. 8.7 Using of commodity futures: Unlike Equity markets, commodity markets also give opportunity for all three kinds of participants: - Hedging - Speculation - Arbitrage 8.7.1 Hedging Illustration Hedging is a futures transaction that acts as a substitute for a later cash transaction. It is roughly equal and opposite to the position the hedger has in the cash market Let us take the example of Company A, which produces sugar and Company B, a consumer of sugar. Company A plans to sell 50,000 quintals of sugar in December 2005. It expects futures prices to be lower and feels that Rs 1,850 per quintal will be a good price to get in December. This will cover the cost of production and give a reasonable margin. The Strategy
30
Trading on commodity futures
So, Company A decides to lock in 50,000 quintals at a price of Rs 1,850 on the futures market for December contract. Scenario I The predictions of Company A has come true. Spot prices for December 1 st is Rs.1840 per quintal. Spot Futures Locked in at Rs 1,850 for 50,000 qtls. Price Rs 1,840 Current price @ Rs 1,840 Sells all of 50,000 qtlsSquares off 50,000 qtls @ Rs 1,840 Sales in the spot @ Rs 1,840 Gain of Rs 10 per quintal from spot Result Loss of Rs 10 againstagainst the budget. Bought @ Rs 1,840 budget and sold @ Rs 1,850 for 50,000 quintals Net No profit or No loss on the budgeted price of Rs 1,850 Scenario II The predictions of Company A has gone wrong. Spot prices for December 1 st is Rs 1,870 per quintal. Spot Futures Rs 1,870 Locked in at Rs 1,850 for 50,000 qtls. Sells all of 50,000 qtls inSquares off 50,000 qtls @ Rs 1,870 the spot @ Rs 1,870 Make Rs 20 profit asBought @ Rs 1,870 and sold @ Rs 1,850. Loss against the budget of Rs 20
Price Sales Result
Net result is that Company A has got an average price of Rs 1,850. Example on hedging with Futures by a sugar consumer The strategy The Company B buys 50,000 quintals of sugar for December Contract at Rs 1,850 since it expects the prices to go up in future. Scenario I The predictions of Company B has come true. Spot prices for December 1 st is Rs 1,870 per quintal. Purchase Buys all of 50,000 qtls inSquares off 50,000 qtls @ Rs 1,870 the spot @ Rs 1,870 Result Loss of Rs 20 as againstGain of Rs 20. Bought @ Rs 1,850 and sold @ the budget Rs 1,870.
31
Trading on commodity futures
Scenario II The predictions of Company B has gone wrong. Spot prices for December 1 st is Rs 1,830 per quintal. Spot Futures Price Rs 1,830 Locked in at Rs 1,850 for 50,000 qtls. Purchase Buys all of 50,000 qtls inSquares off 50,000 qtls @ Rs 1,830 the spot @ Rs 1,830 Result Gain of Rs 20 againstLoss of Rs 20. Bought @ Rs 1,850 and sold @ budget Rs 1,830 Net result is that Company B has got an average price of Rs 1,850. The Budgeted price of Rs 1,850 per quintal for 50,000 quintals is assured irrespective of the price fluctuation both in case of producer and consumer. What makes hedge work? Spot and Futures price for the same commodity tend to go up and down together. Losses in one side are cancelled out by gains on the other. 8.7.2 Speculation. Strategy for speculation: When futures price is overpriced: Buy spot sell at futures market When futures is underpriced: Buy futures sell at spot 8.7.3 Arbitrage: Investors can earn profit by simultaneously buying and selling at two markets without any risk.
32
Trading on commodity futures
8.8 Commodities in which futures trading is being conducted in Indian market: A, Fibres and Manufacturers 1. 2. 3. Kapas Hessian Indian Cotton A. S06 L S Cotton Ahmedabad B. CottonKadi C. J34 M S Cotton Bhatinda D. CottonAbohar Sttaple Fibre Yarn Sacking A. Jute (B twill-665 Gms) Kollata Gram A. Gram(Chana) - New Delhi cottonbales cottonseeds Long Staple Cotton Medium Stapple Cotton A. new Medium Stapple Cotton Silk A. Mulberry Raw Silk Bangalore B. Mulberry Green Cocoons Ramnagar Mulberry Raw Silk Mulberry Green Cocoons Coffee-Arabica Cotton Long Kadi Cotton Med Abohar Cotton Short Staple Sugar (S-30) Muatardseed Oilcake
4. 5. 6. 7. 8. 9. 10. 11.
12. 13. 14. 15. 16. 17. 18. 19.
B, Spices 1. Pepper Domestic-MG1 2. Turmeric A. Turmeric Nizamabad 3. Pepper Domestic-500g/l 4. Black Pepper Int'l-MLS ASTA 5. Black Pepper Int'l-VB ASTA 6. Black pepper Int'l FAQ 7. Pepper A. Pepper Dommestic-MG1. B. Black Pepper Int'l VB ASTA C. Black Pepper Int'l-MLS ASTA D. Black Pepper Int'l FAQ. E. Pepper Dommestic-500g/L
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Trading on commodity futures
F. Pepper Kochi 8. Cardamom 9. Pepper 550 G/L 10. Red Chilly A. Chilli (Paala) Guntur 11. Jeera 12. Rubber RSS4 13. Jeera Unjha C, Edible Oilseeds and Oil 1. RBD Pamolein A. RBD P'Olein Kakinada 2. Groundnut Oil 3. Sunflower Oil 4. Rapeseed/Mustardseed A. Rapeseed 42 B. Rape/Mustard seed Jaipur 5. Rapeseed/Mustardseed Oil 6. Rapeseed/Mustardseed oil-Cake 7. Soy bean A. Soy bean Indore 8. Soy Meal A. Soy Meal Indore B. Yellow Soybean Meal (Export) 9. Soy Oil A. Ref Soya oil Indore 10. Copra 11. CottonSeed A. Cottonbales 12. Safflower 13. Groundnut 14. Castor oil-Int'l 15. Coconut oil 16. Copra cake 17. Groundnut oilCack 18. Cottonseed oil 19. Sesamum (Til or Jiljili) A. Whitish Sesame Seed Rajkot 20. Sesamum oil 21. Sesamum OilCake 22. Safflower OilCake 23. Rice Bran 24. Rice Bran Oil 25. Rice Bran OilCake 26. Safflower Oil 27. Sanflower OilCake 28. Sunflower Seed 29. Crude Palm Oil
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Trading on commodity futures
30. Cottonseed Oilcake A. Cotton Seed Oilcake Akola 31. Vanaspati 32. Soybean Oilcake 33. Linseed 34. Linseed Oil 35. Linseed Oilcake 36. Coconut Oilcake 37. Mustard Seed 38. Mustard Seed Jaipur 39. Sesame Seed ( Natural 99.1) 40. Castorseed- Disa D, Metals 1. Aluminium Ingots 2. Nickel 3. Copper A. Copper Cathode 4. Zinc 5. Lead 6. Tin 7. Gold A. Gold-M B. Pure Gold Mumbai C. Kilo Gold D. Gold HNI E. SONA995MUM F. Pure Gold - Mumbai - 1 Kg 8. Silver A. Silver-M B. Pure Silver - New Delhi - 30 Kg (Mega) C. Pure Silver - New Delhi D. Silver HNI E. CHANDIDEL 9. Steel A. Steel Long B. Steel Flat C. Mild Steel Ingots Ghaziabad 10. Steel Long Bhavnagar 11. Steel Long Govindgarh E, Pulses 1. Masoor 2. Urad A. Urad Mumbai 3. Tur / Arhar A. Lemon Tur Mumbai B. Maharashtra Lal Tur Akola
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Trading on commodity futures
4. 5. Moong Yellow Peas A. Yellow Peas Chana
Mumbai 6.
F, Energy Products 1. Crude Oil 2. Brent Crude Oil G, Others 1. Gur A. Gur-chaku Muzaffarnagar 2. Coffee-Plantation A 3. Potato 4. Sugar A. Sugar M Grade Muzaffarnagar B. Sugar S Grade Vashi C. Sugar S Grade D. Sugar Grade M E. Sugar Grade S 5. Coffee-Robusta Cherry AB 6. Raw Coffee Arabica Parchment 7. Raw Coffee Robusta Cherry 8. Castorseed A. Castorseed-5 B. Castorseed Disa 9. Castor-oil 10. Coffee A. Coffee-Plantation A. B. Coffee-Robusta Cherry AB. C. Raw Coffee Robusta Cherry D. Raw Coffee Arabica Parchment E. Arabica Coffee Hassan F. Robusta Coffee Kushalnagar G. Arabica Coffee - Hassan (New) H. Robusta Coffee - Kushalnagar (New) 11. Guarseed A. Guarseed Jodhpur B. Guarseed BND 12. CastorOil Cake 13. Rubber 14. Rice A. Basmati Rice B. Grade A Parboiled Rice Delhi C. Common Parboiled Rice Delhi D. Grade A Raw Rice Delhi E. Common Raw Rice Delhi 15. Wheat
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Trading on commodity futures
A . Wheat - New Delhi SMQ B. Wheat Delhi (New) Raw Jute GuarGum A. GuarGum Jodhpur Guarseed Bandhani Maize A. Yellow Red Maize Nizamabad Guar Gum Bandhani CASHEW KERNEL W320 A. Cashew W 320 Kollam Sugar S Sugar M Sarbati Rice Coffee-Arabica Plantation A Cashews W-320-Kollam Mentha Oil Sugar (S30)
16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28.
9, TRADING OF SOME MAJOR COMMODITIES IN INDIA 9.1 Gold: Gold is primarily a monetary asset and partly a commodity. More than two thirds of gold's total accumulated holdings relate to 'value for investment' with central bank reserves, private players and high-carat jewelry. Less than one third of gold's total accumulated holdings is as a 'commodity' for jewelry in Western markets and usage in industry. Gold market is highly liquid and gold held by central banks, other major institutions and retail jewelry keep coming back to the market. Due to large stocks of Gold as against its demand, it is argued that the core driver of the real price of gold is stock equilibrium rather than flow equilibrium. Economic forces that determine the price of gold are different from, and in many cases opposed to the forces that influence most financial assets. South Africa is the world's largest gold producer with 394 tons in 2001, followed by US and Australia. India is the world's largest gold consumer with an annual demand of 800 tons. - Gold functions as a monetary instruments, as a financial asset and as a raw material used in jewelry & decorative Items. - Gold is used as a hedge against inflation and as a reliable store of value during times of political, social or economic distress. As an investment, gold can provide individual and institutional investors alike with a portfolio safety net against sharp downward spikes in complementary asset such as stock and bond
37
Trading on commodity futures
Basic structure of the gold market World Gold Markets London as the great clearing house New York as the home of futures trading Zurich as a physical turntable Istanbul, Dubai, Singapore and Hong Kong as doorways to important consuming regions Tokyo where TOCOM sets the mood of Japan Indian Gold Market Gold is valued in India as a savings and investment vehicle and is the second preferred investment after bank deposits. India is the world's largest consumer of gold in jewellery as investment. In July 1997 the RBI authorized the commercial banks to import gold for sale or loan to jewelers and exporters. At present, 13 banks are active in the import of gold.
Mining Coms
Central Banks
Investors
Bullion Banks
Fabricator
Jewelers
Central bank lends gold to bullion banks at an interest rate known to them, Bullion Banks in turn sell the gold to fabricators, jewelers etc, and use the proceeds for investment. Bullion banks are international banks with specified skill in bullion trading. Bullion Banks go long in the forward market & the counter-party is a gold mining company, investor or speculator.
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Trading on commodity futures
9.2 Silver: Silver's unique properties make it's a very useful 'Industrial Commodity', despite it being classed as a precious metal. Demand for silver is built on three main pillars; industrial uses, photography and jewelry & silverware accounting for 342, 205 and 259 million ounces respectively in 2005. Just over half of mined silver comes from Mexico, Peru and United States, respectively, the first, second and fourth largest producing countries. The third largest is Australia. Primary mines produce about 27 percent of world silver, while around 73 percent comes as a by-product of gold, copper, lead, and zinc mining. The price of silver is not only a function of its primary output but more a function of the price of other metals also, as world mine production is more a function of the prices of other metals. The tie between silver and economic activity is strong, given that around twothirds of total silver fabrication is in the industrial and photographic sectors Often a faster growth in demand against supply leads to drop in stocks with Government and investors Economically viable primary silver mine is a function of the world silver price level. World Silver Supply from Above-ground Stocks Million Ounces Implied Net Disinvestment Producer Hedging Net Government Sales Sub-total Bullion Scrap Total Indian Scenario 2004 -9.5 18.9 87.2 96.6 182.7 279.3 2005 20.9 -24.8 71.3 67.4 184,9 252.3
Silver imports into India for domestic consumption in 2004 was 3,400 tons down 25 % from record 4,540 tons in 2003. Open General License (OGL) imports are the only significant source of supply to the Indian market. Non-duty paid silver for the export sector rose sharply in 2004, up by close to 200% year-on-year to 150 tons. Around 50% of India's silver requirements last year were met through imports of Chinese silver and other important sources of supply being UK, CIS, Australia and Dubai. Indian industrial demand in 2004 is estimated at 1375 tons down by 13 % from 1,579 tons in 2003. In spite of this fall, India is still one of the largest users of silver in the world, ranking alongside those Industrial giants, Japan and the United States.
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Trading on commodity futures
By contrast with United States and Japan, Indian industrial offtake for fabrication in hardcore industrial applications like electronics and brazing alloys accounts for only 15 % and the rest being for foils for use in the decorative covering of food, plating of jewelry and silverware and jari.
In India silver price volatility is also an important determinant of silver demand as it is for gold. India Industrial Fabrication , 2004 Percentage Pharmacy & Chemicals Foil Plating Solders & Brazing Electrical Photography Jari World Markets London Bullion Market is the global hub of OTC (Over-The-Counter) trading in silver. Comex futures in New York is where most fund activity is focused Frequency Distribution of Silver London Fixing Volatility from 1995 till date
22.4 9.0 13.7 5.4 13.5 0.85 17.1
Percentage Change Daily Number of times Percentage times Weekly Number of times Percentage times
> 7% 7 0.3 9 21
5-7% 10 0.5 15 3.4
3 - 5% 85 3.9 50 11.4
<3% 2086 95.3 363 83.1
9.3 Cotton Cotton is among the most important non-food crops, which occupies a significant position both- from agricultural and manufacturing sectors' points of view. It is the major source of one of the basic human need- 'clothing' apart from other fibre sources viz. jute, silk and synthetic. Hence, it is one among the most cultivated and most traded commodities of the World. USA, China, Sudan, Egypt, Australia and India are the major producers of cotton. The table below provides a snip shot of global supplydemand scenario of cotton.
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Trading on commodity futures
(in million tons) 2000-01 Production Imports Consumption Exports Ending Stocks 19.18 5.77 19.89 5.75 9.22 2001-02 21.17 6.29 20.24 6.30 10.16 2002-03 19.43 6.64 20.78 6.58 8.90
While US, China, Sudan, Turkey, Egypt and Australia are the major players in the international export trade, the player on the import scene are EU, US, Brazil, India and the Middle-East. US is a major exporter of raw cotton, and at the same time, one of the largest importers of ready-made garments. The Indian scene. Cotton accounts for more than 75% of India's annual fibre consumption in the spinning mills and more than 58% of its annual fibre consumption in the textile sector. Textile industry in India (major share of which is constituted by cotton ) currently adds about 14% to the industrial production and 4% to the gross domestic product (GDP). It provides employment to about 35 million persons. Together with allied agriculture sector, it provides employment to over 90 million people. The contribution of this industry to the gross export earnings of the country is over 30% while it adds only 7-8% to the gross import bill of the country. At the average price of Rs 45/kg of over 170 lakh bales (average annual consumption, 1 bale = 170 kg) raw cotton traded in the country, the market size of raw cotton in India is over Rs 130 million. India's cotton supply and demand trend (in lakh bales of 170 kg)
Particulars Opening Stock Production Imports Total Supply
98-99 23.50 0.50
99-00 39.20 0.30
00-01 30.40 4.00
01-02 30.00 7.90
02-03 36.50 22.00
03-04 40.50 22.13
04-05 29.00 22.00
170.20 177.90 158.00 165.00 156.00 140.00 158.00
194.20 217.40 192.40 202.90 214.50 202.63 209.00
Domestic Consumption 154.30 170.20 158.90 165.30 173.40 173.03 173.00 Exports Total Demand Carryover stock 8.00 16.80 3.50 1.10 1.50 0.60 1.00
162.30 187.00 162.40 166.40 174.00 173.63 174.00 31.90 30.40 30.00 36.50 40.50 29.00 35.00
Maharashtra, Gujarat, Andhra Pradesh, Haryana, Punjab, Rajasthan and Karnataka, are among the major producing States of the country. Bengal Deshi, V-
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Trading on commodity futures
797, Jayadhar, J-34/ bikaneri NarmaSg, Y-1, NHH-44, LRA-5166, H-4/MECH-1, S6/4, MCU-5, DCH-32, 26 mm cotton are among the various varieties of cotton cultivated across the country. 'Short', 'Medium' and 'Elongated Long' Staple Length cotton are major grades, which is based on the staple length of the fibre. Among several other reasons, it is 'the lack of availability of desired quality cotton' that has made many Indian buyers (particularly the export oriented units) to opt for purchases of foreign cotton despite enough domestic supplies. Most importing mills in India are ready to pay 5-10% premium for foreign cotton due to its higher quality (less trash, uniform lots, higher ginning out turn) and better credit terms (3-6 months vs. 1530 days for local). Mills using ELS have been pleased with US Pima and its fibre characteristics. US has emerged as an important supplier in the last two seasons. Apart from US, India is also importing from Egypt, West Africa, the CIS countries and Australia on account of lower freight and shorter delivery periods offered to Indian buyers. Indian cotton farmers were producing enough to meet the domestic demand till 1998-99. Failure of monsoon in the main producing regions of Gujarat and Maharashtra during the two consecutive years of 1999 and 2000 pulled down the country's output during the corresponding years. Imports rose by an astounding 278.48% during 1999-00 (over the previous year). Similar quantum of imports continued into the subsequent years, turning the status of India from 'exporter' to 'importer' in the international cotton trade scene. Trading centres of Mumbai, Saurashtra region of Gujarat and Rajasthan serve as reference markets for prices of cotton traded across the country. Currently, raw cotton prices in upcountry markets across the country is ruling in the range of Rs 41-89/kg for various varieties/grades. Cotton prices in India are influenced by various demand-supply factors operating with the country, and the international raw cotton prices and demand for finished ready-made garments. 10,TRADING IN COMMODITIES FUTURES 10.1 Entities in the trading system 10.1.1 Trading cum Clearing members TCMs can trade and clear either on their own account or on behalf of their clients including participants. Each TCM has an unique ID and can has more than one user 10.1.2 Professional clearing members PCMs are members of NSCCL. The PCM membership entitles the members to clear trades executed though Trading cum Clearing Members both for themselves and/or on behalf of their clients. 10.2 Methods of trading: 10.2.1 Open outcry Open outcry trading is a face- to-face and highly activated form of trading used on the floors of the exchanges. In open outcry system the futures contracts are traded in pits. Normally one type of contract is traded in each pit.
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Trading on commodity futures
10.2.2 Electronic trading Electronic trading: Electronic trading systems have become increasingly popular in the past decade. The driving factor for the rise in the popularity of these systems is their potential to improve efficiency and lower the cost of transactions. In addition, electronic trading systems make exchanges available to remote investors in real time, which is an important benefit in the present situation of increased trading from remote locations. Components of the system: - Computer terminals, where customer orders are keyed in and confirmations are received - A host compute that processes trade. - A network that links the terminals to the host computer. 10.3 Format for tickers: XXXYYYZZZ XXX: Three letters for the commodity YYY: three letters for the grade ZZZ: Three letters for the location E.g: SYOREFIND: SYO:Soy oil REF: Refined IND: indore Instrument Type is to denote whether the ticker is a future contract or a spot price being disseminate or an options contract. E.g: COMDTY- Used for commodity spot price dissemination FUTCOM- Used for future on commodity OPTCOM- Used for options on futures on commodity.
Contract expiry for futures contract will be written as 20mmmYYYY mmm - denotes the month, e.g. DEC, JAN etc. YYYY denotes the year e.g. 2005, 2006 etc For spot price, no expiry will be displayed or required 10.4 Contract specifications: Contract specifications for commodity futures are vital and it is necessary for making a market efficient. The standard contracts traded on exchanges have number of criteria like type of contract, name of commodity, ticker symbol, trading system, unit of trading, delivery unit, quotation/base value, tick size, quality specification, quantity variation, delivery center, additional delivery centers, hours of trading, due date/ expiry date, delivery specification, closing of contracts, price limit, position limit, quality allowance, etc Commodity exchanges need to have standardized contracts which in turn help in trading in physical market also. It will improve market liquidity and transparency in the price formation.
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Trading on commodity futures
When the delivery of the commodity takes place, there must be a proper procedure / system in place. The exchange fixes reputed assessor to assess the quality of the product tendered for delivery. It is difficult for traders and processors to inspect each of lot of goods delivered. They always accept the certificate issued by the warehouse keeper, which will correspond to the physical product. The products delivered will command a premium or discount. Accordingly, the delivery prices will also be altered. The exchange fixes the range of delivery locations. It is normally at the seller s option for agri products. The exchange must strike a balance between making the delivery practices practical and reducing the scope for price manipulation. If there are many delivery locations, the market manipulation will not be possible. The buyer may incur transport cost if it is not in the convenient location. The exchange neutralizes the impact of it by adding or subtracting the cost of transport depending on the place of delivery. To avoid taking delivery, some of the users close their positions in the futures market, if it is advantage for them or close the contract and take fresh position for the next month. Timing of the contract is important. Experience has shown that the best time to launch a contract is that when the prices are volatile. There should not be any frequent changes in the contract specifications as it will affect the market. When the contract is launched, it should be as close as to reality. All the parameters and procedures must be tested before launching it. The exchange prepares the contract, test it and get it approved by the Forward Markets Commission (FMC) before launching it. 10.5 Example of futures contract specifications for Rubber on NCDEX Rubber Futures Contract Specifications. Type of contract Futures Contract Specifications Name of commodity Ticker symbol Trading system Rubber RBRRS4KTM NCDEX Trading System As per directions of the Forward Markets Commission from time to time, currently (with effect from April 25, 2005) Mondays through Fridays : Hours of Trading 10:00 AM to 05:00 PM Saturdays : 10.00 AM to 2.00 PM The Exchange may vary the above timing with due notice.
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Trading on commodity futures
RSS 4 (Ribbed Smoked Sheet 4 ) ex designated warehouse Kottayam exclusive of all taxes 1000 Kgs. (=1 MT) 1000 Kgs. (=1 MT) Rs per Quintal Re 1 Limit 10%. Quality Specifications as provided under Part II Section 1 of the "Green Book" as detailed below: Nothing but coagulated rubber sheets, properly dried and smoked can be used in making these grades: block, cuttings or other scrap or frothy sheets, weak, heated or burnt sheets, air dried or smooth sheets not permissible Slight resinous matter (rust) and slight amounts of dry mould on wrappers, bale surfaces and interior sheets, found at the time of delivery will not be objected to. Should "rust" or "dry mould" in an appreciable extent appear on more than 20% of the bales sampled, it shall constitute gr ound s for rejection. Medium sized bark particles, bubbles, translucent stains, slightly sticky and slightly over-smoked rubber are permissible to the extent as shown in the sample. Oxidized spots or streaks, weak, heated, under-cured, over-smoked (in excess of the degree shown in the sample) and burnt sheets are not permissible. The rubber must be dry, firm and free of blemishes, blisters, sand, dirty packing and all other foreign matter other than those specified above as permissible. Quantity variation No. of active contracts Delivery center Opening of contracts +/- 2% Maximum 12 monthly or minimum 2 monthly contracts running concurrently. Kottayam and Kochi Trading in any contract month will open on the 21st day of the month.If the opening day happens to be a non-trading day, contracts would open on the next
Basis Unit of trading Delivery Unit Quotation/Base Value Tick size Price Band
Quality specification
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Trading on commodity futures
trading day. Due date 20th day of the delivery months. If 20th happens to be holiday then the previous trading day. a. For all contracts with expiry dates till December 2005 Upon expiry of the contracts, if any seller with open position desires to give delivery at a particular delivery center, then the corresponding buyer with open position as matched by the process put in place by the Exchange shall be bound to settle by taking physical delivery b. For all contracts with expiry dates from January 2006 onwards Upon expiry of the contracts, any seller with open position shall give delivery of the commodity .In case of a failure to give delivery, it would be treated as default as per the Bye laws and Regulations of the Exchange from time to time. The corresponding buyer with open position as matched by the process put in place by the Exchange shall be bound to settle by taking physical delivery Member-wise: Max (Rs. 20 crore, 15% of open interest) Client-wise: Max (Rs. 10 crore, 10% of open interest) None
Delivery specification
Position limits
Premium / Discount
Normally range of futures contracts will be in place. In the case of NCDEX, all contracts expire on the 20th of expiry month. The new contracts will be introduced on the trading day following the expiry of the near month contract. The following figure shows the contract cycle over the time.
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Trading on commodity futures
10.6 Types of orders in futures trading With electronic trading, a lot of flexibility is available to investors in executing various types of orders. They must familiarize themselves with the various types. The orders can be categorized into time conditions, price conditions and other conditions. 10.6.1 Time conditions order Day order: The order is valid for the day on which it is entered. If the order is not executed during the trading session, the system itself will cancel the order at the end of the day. Fresh order has to be entered for the next day. Good till cancelled: It remains in the system till the order is cancelled by the user. The maximum number of days the order will remain in the system will be notified by the Exchange. Good till date: The order will remain in the system up to the date the user has specified, if it is not executed. Immediate or cancel: An immediate or cancel order allows the user to buy or sell a contract as soon as it is entered into the system. If it is not matched or partial match has been done, any balance portion of the contract will be automatically cancelled. All or none order: It is a limit order in which the order will be executed in its fully entirety or not executed. Fill or kill order: Like the previous one, it is a limit order. It should be executed immediately and if the order is not executed, it gets cancelled. 10.6.2 Price conditions orders 10.6.3 Limit order: This is an order to buy or sell the futures contract of a commodity at a specified price. 10.6.4 Stop Loss order: Stop Loss order is a facility given to the traders/clients to use it to limit their amount of loss, if the futures contracts move against their position. It is an order to buy or sell when the market price reaches the specified level. When the price reaches the point, the order gets triggered and it becomes a market order. For example, a trader has purchased gold futures at Rs.7,000/-. He is uncertain about the market movement. He plans to limit his loss, if the prices go down. He will place a stop order if the price falls less than Rs.6900/-. When the market goes down, the stop order gets executed at this price Other conditions
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Trading on commodity futures
Market Price: Market orders are those for which no price is specified at the time of entering the order. Market on open: This kind of orders will be executed during the market open within the opening range. Market on close: These types of orders are executed on the market close. 10.6.5 Spread Order: It is an order in which two positions are taken, i.e. one long position and one short position with different months of maturity in the same commodity or in closely related commodities. The prices of the futures contract tend to go up and down and by entering the spread order, investor would have locked in the price and the amount of profit. The trader will unwind the position depending on the market movement 10.7 Margin requirements. (a) The initial security deposit paid by a member will be considered as his initial margin deposit for the purpose of allowable exposure limit. Initially, every member is allowed to take exposure up to the level permissible on the basis of such initial deposit. However, if a member wishes to create more exposure, he has to pay additional deposit. (b) If there is a surplus deposit lying with the Exchange towards margin, it is not refunded to the member, unless a written request is received from the member for refund. However, the member continues to get additional exposure limit on account of such additional/surplus deposit. In case of receipt of written request for refund of additional deposit, the same may be returned within 7 working days. Different types of margins collected by the Exchange are as follows: 10.7.1 Ordinary (Initial) Margin: Ordinary margin requirement is calculated by applying the margin percentage applicable for a contract on the value of the open position of a member in that contract. If a member has net position in various contracts of the same commodity running concurrently, he is required to pay margin separately on each of these contracts. Similarly, if a member has open position in various commodities, the total amount required is calculated as sum total of margin required in respective of each commodities and contracts separately. The computation methodology in respect of ordinary margin is as follows: Intra day During the trading session, the margin is calculated on the absolute difference between total sales in value terms and total buy in value terms in respect of all transactions executed in a contract during the day in addition to previous day s open position carried forward at the official closing price of previous day. End of day At end of the trading session, the margin amount is computed on net position in a contract in quantitative terms multiplied by the official closing price. 10.7.2 Special Margin: In case the price fluctuation in a contract during the trading session is more than 50% of the circuit filter limit applicable on that contract compared to the base price of the day, a special margin equivalent to 50% of the circuit filter limit is applied. Such
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Trading on commodity futures
special margin amount is immediately blocked out of available margin deposits of the members having outstanding position in that contract and in case the available margin of a member is not sufficient to cover such special margin required, then a margin call is sent to the member which is required to be remitted by the member immediately. In such case, since the available deposit is already exhausted, he is suspended from trading and such suspension continues during such trading session till collection of required margin amount is completed. If the price volatility reaches 100 % of the circuit filter limit, orders will be accepted by the system only upto the price level equivalent to such circuit filter. 10.7.3 Delivery Period Margin: When a contract enters into delivery period towards the end of its life cycle, delivery period margin is imposed. Such margin is applicable on both outstanding buy and sales side, which continues up to the settlement of delivery obligation or expiry of the contract, whichever is earlier. The delivery period margin is calculated at the rate specified for respective commodity multiplied by the net open position held by a member in the expiring contract. When a seller submits delivery documents alongwith surveyor s certificate, his position is treated as settled and his delivery period margin to such extent is reduced. When a buyer pays money for the delivery allocated to him, his delivery period margin is reduced on such quantity for which he has paid the amount. If delivery does not happen with respect to certain open position and is finally settled by way of difference as per the Due Date Rate, the delivery period margin is released only after final settlement of difference arising out of such closing out as per the Due Date Rate. In case a member submits documentary evidence so as to prove that the position held by him in a futures contract is totally hedge position, based on physical stock in his custody, or based on his export or import obligation, he can claim exemption from payment of special margin, if any, imposed on such contract. Provided that such exemption is allowed only in case it is proved beyond doubt to the satisfaction of the Exchange that it is totally a hedge position. In case of any failure in fulfillment of obligations on the part of a member, the Exchange is entitled to forfeit or utilize the margin deposits lying with the Exchange for meeting such obligations and in such a case, the total margin deposit of that member shall stand reduced to such extent. 10.8 Price in futures: How to interpret Contract Open Month Sept 262.75 Dec 266.25 High 263.50 267.50 Low 261.50 264.75 Settle 262.00 266.75 Lifetime High 270.50 268.00 Lifetime Low 238.00 235.50 Open interest 33922 141307
- Opening price: the open or opening price is the price or range of prices for the day s first trades, registered during the period designated as the opening of the market or the opening call. - Closing price: The closing price is the price of prices at which the commodity futures contracts are traded during the brief period designated as the market close or on the closing call - Highest price: The word high refers to the highest price at which a commodity futures contract is traded during the day.
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Trading on commodity futures
- Lowest price: Low refers to the lowest price at which a commodity futures contract is traded during the day. - Settlement price: This is abbreviated as settle in most of the pricing tables. - Lifetime high and low: They refer to the highest and lowest prices recorded for each contract from the first day it traded to the present. - Open interest: It refers to the number of outstanding contracts for each maturity month. 10.9. Matching Rules (a) The Exchange may launch more than one order book running either parallel or at different time spans, either with the same order matching rules or with different matching rules. The Exchange is also entitled to modify or change the matching rules relevant to any market or order books any time where it is necessary to do so (b) Without prejudice to the generality of the above, the order matching rules will have the following features: Orders in the Normal market will be matched on price -time priority basis. Best buy order shall match with the best sell order. (The best buy order would be the one with the highest price and the best sell order would be the one with the lowest price.) 11. CLEARING AND SETTLEMENT IN FUTURES CONTRACT 11.1 Types of settlement in futures contracts: Futures contracts have two types of settlements. Types of settlement
Daily settlement
Final settlement
Handle daily Price fluctuation for all trades (mark to the market) Daily process at end of the day
Dandles final settlement of all position On contract expiry date
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Trading on commodity futures
11.1.1 Daily settlement: mark to the market This is done to take care of daily price fluctuation for all traders. All open positions of the members are marked to market at the end of day and the profit/loss is determined as below: - On the day of entering into the contract, it is the difference between the entry value and daily settlement price for that day. - On any intervening days, when the member holds an open position, it is the difference between the daily settlement price for that day and the previous day settlement price. - On the expiry date if the member has an open position, it is the difference between the final settlement price and the previous day settlement price. Illustration: A clearing member buys one December expiration cotton futures at Rs> 6435 per quintal on December 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The member closes the position on December 19. The MTM profit/losses get added/ deducted from his initial margin on a daily basis. Date Dec 15, 2004 Dec 16, 2004 Dec 17, 2004 Dec 18, 2004 Dec 19, 2004 Daily MTM settlement flow Information to members- end of trade day T Settlement through designated clearing Bank Arrangement of funds in settlement A/c by member Collection and payment of fund T +1 Settlement Price 6320 6250 6312 6310 6315 MTM -115 -70 +62 -2 +5
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Trading on commodity futures
Exchange clearing house
Member
Margin
Daily MTM Settlement
Initial Margin Any special margin
Daily P/L For Positions closed out MTM of open position
Member s bank A/c
Settlement Client1
banking operations Broker A
Clearing bank (HDFC)
Exchange clearing house
Client 2
Broker B
11.1.2 Final settlement: The settlement done for open Buy and Sell positions on the contract expiry date is called final settlement.
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Trading on commodity futures
On the date of expiry, the final settlement price is the spot price on the expiry day. The prices are collected from the members across the country through polling. The polled bid/ask prices are bootstrapped and the mid of the two bootstrapped is taken as the final settlement price. The responsibility of settlement is on a trading cum clearing member (TCM) for all trades done on his own A/c and his client s trades. A professional clearing member (PCM) is responsible for settling all the participants trades, which he has confirmed to the exchange. 11.2 Settlement methods: Physical delivery of the underlying asset Closing out by offsetting position Cash settlement 11.2.1 Physical delivery settlement Members can give and take delivery of commodities by completing the delivery formalities and giving delivery information to the exchange. Entities involved in physical delivery: Accredited warehouse Approved registrar and transfer agents Approved assayer 11.2.2 Closing out by offsetting position In closing out the opposite transaction is effected to close out the original futures position. A buy contract is closed by a sell contract and a sale contract is closed buy a sell contract. For example, an investor took a long position in Gold futures contract on the January 30 2005 at Rs 6000 can close his position by selling gold futures contract on February 25 2005 at 5780. In this case, over the period of holding the position, he has suffered a loss of Rs 220 per unit. This loss would have been debited from his margin Account over the holding period by way of MTM at the end of each day. 11.2.3 Cash settlement: Contract held till the last day of trading can be cash settled. When a contract is settled in cash, it is marked to the market at the end of the last trading day and all positions are declared closed. The settlement price on the last trading day is set equal to the closing spot price of the underlying asset ensuring the convergence of future prices and the spot prices. For example an investor took a short position in five long staple cotton futures contracts on December 15 at Rs 6950. On 20th February, the last trading day of the contract, the spot price of long staple cotton is Rs. 6725. This is the settlement price for his contract. As a holder of a short position on cotton, he does not have to actually deliver the underlying cotton, but simply takes away the profit of Rs. 225 per trading unit of cotton in the form of cash.
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Trading on commodity futures
12, REFULATORY ISSUES FOR COMMODITY FUTURES TRADING 12.1 Government Policies on futures trading Various government policies still hinder the growth of commodity exchanges. Given the recognized need for India to have efficient exchanges in the face of liberalization and globalization, FMC should take the lead in coordinating with the responsible Ministries and other government entities a change of these policies. This would not necessarily reduce the government's possibilities to intervene in commodity markets, but would ensure that such intervention does not hinder, or even critically damage, commodity futures markets. A first issue is taxes. Different tax treatment of speculative gains and losses discourage many speculators from participating in official futures exchanges, thereby affecting the liquidity of the markets. Hedgers are affected as well: the necessary link between futures and physical market transactions is too rigidly defined. Tax issues need to be clarified so that futures losses can be offset against profits on the underlying physical trade and vice versa. A second problem is stamp duty. Stamp duties on trade in commodity futures exchanges should be nil, except when physical delivery is made. Now, stamp duty can be arbitrarily imposed by the state in which the futures exchange is located. Clarification from the Indian states in which there are exchanges that there will be no arbitrary position on stamp duty is recommended. Third, many institutions (particularly financial institutions but also, in a less direct manner, cooperatives) are not permitted to engage in commodity futures trade. The rules which prevent such engagement need to be modified. Finally, the role of government entities directly involved in commodity trade should be reconsidered. The direct purchasing practices of these entities now damage the potential of commodity exchanges. If a federal or state government wishes to continue direct interventions in commodity markets, it could, if it wished, pass through the commodity exchanges. This would ensure effective market intervention (the effect on prices will be immediate), and, as long as done within clear policy guidelines, does not destroy market mechanisms.
12.2 The forward contracts regulation Act. The forward contracts (regulation) Act, 1992, a central Act, governs commodity derivatives trading in India, The Act defines various forms of contract. The Act envisages a three-tier regulation. - Exchange: The exchange which organizes forward trading I regulated commodities can prepare its own Articles of Association, Rules and Regulations, byelaws and regulate trading on a day to-day basis. - FMC (Forward Markets Commission): The commission approves the rules and byelaws of the exchange and provides a regulatory oversight. It also acquires concurrent powers of regulation while approving the rules and byelaws of by making such rules and byelaws under the delegated powers.
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Trading on commodity futures
- Central Government: Ministry of Consumer affairs and Public Distribution under the Govt. of India is the ultimate regulatory authority. Only those associations, which are granted recognition by the Government, are allowed to organize forward trading in regulated commodities. Government has the power to suspend trading, call for information, nominate directors of the Exchange etc. Central Govt. has delegate most these powers to FMC. 12.3 Forward market commission Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory authority which is overseen by the Ministry of Consumer Affairs and Public Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952. The functions of the Forward Markets Commission are as follows: (a) To advise the Central Government in respect of the recognition or the withdrawal of recognition from any association or in respect of any other matter arising out of the administration of the Forward Contracts (Regulation) Act 1952. (b) To keep forward markets under observation and to take such action in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act. (c) To collect and whenever the Commission thinks it necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the act is made applicable, including information regarding supply, demand and prices, and to submit to the Central Government, periodical reports on the working of forward markets relating to such goods; (d) To make recommendations generally with a view to improving the organization and working of forward markets; (e) To undertake the inspection of the accounts and other documents of any recognized association or registered association or any member of such association whenever it considerers it necessary.
12.4 Regulation for Brokers in commodity futures trading Brokers should meet the following requirements: Mandated capital adequacy. The regulators should seek to minimize any risk to investors and threat to the stability of the market from the failure of an institution because it becomes unable to meet its liabilities. Currently, a broker's membership at the exchange is solely dependent upon fulfilling the financial requirements (in form of upfront payment or equity participation, membership, admission fees etc.) levied by the different exchanges. There is a need for mandated capital adequacy for brokers together with measures to monitor that the capital is, in fact, maintained. Licensing. In India, there is no requirement of any form of licensing. A broker can start trading once he fulfils the exchange requirements. There is no educational requirement. It is advisable that anyone dealing in futures for clients is registered. To be registered, one would need to:
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Trading on commodity futures
- Be a member/employee of an exchange - Pass a character assessment Pass an examination. As a transition phase, existing employees of members of exchanges who have actively participated in futures business over the [say] past 2 years [or shorter, subject to skill and experience being assessed by the exchange.] could be grand-fathered i.e. they will automatically be registered without having to do the exam. The regulators need to ensure that brokers follow Conduct of Business Rules. These rules seek to regulate the way in which authorised firms conduct their business with their customers. They are wide-ranging in their scope and because a breach of them can lead to civil liability or a claim for compensation, they are quite detailed in nature. The Rules regulate a number of different areas including advertising, customer agreements and the suitability of the products and services provided. Advertising. The Conduct of Business Rules insist that adverting must be fair and not misleading. Additionally, an investment advertisement must contain a risk warning relating to the risks associated with the investments being advertised. The unsolicited oral promotion of services or products, commonly known as cold calling , is also heavily regulated. Customer agreements. Before an exchange member can operate on behalf of a customer a client agreement should be in place. The exchange or the regulator may wish to define the minimum acceptable content of such an agreement. Suitability. A broker needs to check the capacities of his client before undertaking any agreement. Before opening any account for a customer the broker must satisfy himself of the bona fide commercial need for the customer to open the account. He must be satisfied that the customer s quality of management, commodity experience and commodity business knowledge together with their systems and staff will enable them to fulfill the obligations and commitments they undertake when they sign the agreement. Such agreements need to be reviewed regularly and the brokers will need to be sure that the customers continue, at all times, to demonstrate that they are fit and proper persons to be conducting derivatives business. A mechanism for settling customer complaints is also needed. Each exchange should have a first-line-of-defense complaint mechanism, and there also should be a national (well-advertized) mechanism. In order for customer complaints to be properly evaluated, it has to be obligatory for brokers to maintain client records. These should include details of when customer orders are given (time-stamping) and the exact details of the order. Furthermore they must record when the order was given to the floor trader and the time that the execution was confirmed back. Was it executed in full or piece by piece? Was the order cancelled? Was an error made and if so how was the error resolved? Such records should be maintained in writing and made available for inspection and stored as a permanent reference for a period of time (5-7 years, depending on legal convention) as with accounting records for example. Customers deposits and positions should be protected and kept separate from those of the members. Most countries separate clients assets from those of the firm to whom they are entrusted, either by national law or market regulation. The Client Money or Segregation regulations are intended to provide investors with additional protection in the event of a firm s insolvency. Member firms must prove that they e.g., no conviction of fraud. -
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Trading on commodity futures
maintain segregated assets at all times. Finally, it would be useful to have a customer compensation scheme, to which all brokers contribute. However, without properly regulated exchanges, any customer compensation scheme would rapidly become bankrupt which is why most schemes normally only protect a strict category of regulated firms and investors who deal through them. Compensation is not normally applied to investors operating outside a given regulated environment. For this reason, regulators also need an active policy to combat bucket shops. 12.6 Payment of sale tax/VAT in futures trading - Futures contracts are in the nature of agreement to buy or sell at a future date and hence are not liable for payment of sales tax. - If the futures contract is closed out and settled between the constituents prior to the settlement date without actually buying or selling the commodity, there is no liability for payment of sales tax. - When the futures contract fructifies into a sale and culminates into delivery, there would be liability for payment of sales tax. This liability will arise in the state in which the Warehouse (into which the goods are lodged by the constituent) is situated when the commodities are delivered to the buyer. The physical settlement in the case of commodities futures contracts involves issues concerned with sales tax. The fact that delivery could happen across various states, and these states have different sales tax rules, make the issue a little complicated. In case of settlements culminating into delivery, sales tax at the rats applicable in the state where the delivery centre is located will be payable. In many states, the sales tax laws, also provide for levy of additional tax, turnover tax, resale tax, etc. Which may or may not be recoverable from the buyer depending on the provisions of state sales tax law. 12.5.1 Responsibility of seller member: Furnishing information to the Exchange for settlement purposes Transaction number ST registration number, validity date Surcharge rate Turnover tax rate, resale tax rate 12.5.2 Responsibility of buying members furnishing information to the Exchange for settlement purposes Transaction number Name of the client Address of the client If sale tax exemption is sought then form number.
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13, FINDINGS 1, The client cannot take the benefits of hedge positions in the present online trading system because Calendar Spread positions are considered as separate positions and flat 20% margin is charged on these two different positions. The margin gets released only when the trades are settled. 2, In case of square off position too different buy limit and sell limit margin is charged. 3, In the present online trading terminal, the daily MTM loss incurred by the clients are shown and the net MTM position of the clients are calculated manually. This makes the margin calculation process more complicated.
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Trading on commodity futures
4, The volume traded is small to the prospect 5, Strike Price of commodity futures depend on supply and demand in general. Price of agricultural products depend on whether, seasons, climate etc. Price of Gold, silver, Oil depends on international market and the exchange rate because these commodities are imported for the domestic market. 6, At present, not many Indian people aware of futures trading and using online trading system. 7, Farmers don t know much about futures market to hedge their products
14, RECOMMENDATIONS: 1, Instead of charging 20% flat margin on the calendar Spread position, additional 2% margin should be charged as mentioned by NCDEX on these closed positions. So that the clients can avail the benefits of hedge strategy. The software should provide this facility. 2, Also in case of Square off position, different buy and sell limit are being charged. This should not be the case since the clients settle their trades the same day. 3, More promotional strategies need to be adopted in order to increase the volume of trade. 4, Instead of showing only notional loss incurred by the clients, the Net MTM should be shown for the convenience of clients.
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5, more terminals should be built across India so that more farmers, investors can participate in futures trading. 6, The Government should allow trading on commodity options. This would provide useful instruments for investors when trading in commodities.
15, RESEARCH QUESTIONAIRE FOR FUTURES TRADING 1, Are you aware of Commodity futures? Yes No
2, Have you ever done trading on commodities futures? Yes No
If No Why? . 60
Trading on commodity futures
. 3, In which commodities you trade the most? . . 4, Do you get proper guidance by our advisory department? Yes No
5, Are you familiarized with the usage of the online trading? Yes No
6, How convenient do you find to use online trading? Excellent Satisfactory Good Unsatisfactory
7, What is your problem when trading?
.. 8, What do you feel about the exposure limit provided to you? Excellent Satisfactory Good Unsatisfactory
9, Are you comfortable with the services provided by PRABODH GROUP Yes If No Why No
.. 10, Suggestions if any
..
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Trading on commodity futures
16, BIBLIOGRAPHY 16.1 Reference Books: NCDEX- A guide to Commodity Derivatives. NCFM Commodities market Module Work Book. NCFM Dealers Module on Capital markets Derivatives FAQs by Ajay Shah and Susan Thomas Introduction to futures and options markets by John Kolb BSE Training module on Capital Market 16.2 Company Literature 16.3 List of Websites
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www.indiainfoline.com/igame/mapr.html www.cochinstockexchange.com/cse/syllabus.htm www.nseindia.com www.ncdex.com www.mcxindia.com www.fmc.gov.in www.trade.motilaloswal.com www.thefinancials.com www.porfolioscience.com
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doc_316782255.docx
A commodity broker is a firm or individual who executes orders to buy or sell commodity contracts on behalf of clients and charges them a commission. A firm or individual who trades for his own account is called a trader. Commodity contracts include futures, options, and similar financial derivatives.
TRADING ON COMMODITY FUTURES
CONTENT
Page No 1, EXECUTIVE SYNOPSIS................................................................................. 4 2, INTRODUCTION TO THE PROJECT .4
3, SCOPE OF THE PROJECT............................................................................ 4 3.1 Objectives of the project.......................................................................... 4 3.2 Methodology.............................................................................................. 3.3 limitations of the study.............................................................................. 4, PROFILE OF PRABODH GROUP ................................................................ 4 5 5
4.1 Joining Hands For Mutual Growth......................................................... 6 4.2 Investment consultancy............................................................................. 6 4.3 Management consultancy ........................................................................ 6 4.4 Engineer house........................................................................................... 7 4.5 Image house................................................................................................ 7 4.6 Real estate................................................................................................... 7 4.7 Members of PRABODH Group................................................................ 8 5, INTRODUCTION ABOUT COMMODITIES AND THEIR ROLES.......... 8 5.1 What is a commodity? .............................................................................. 8 5.2 Commodity market in India..................................................................... 9 5.3 Different commodity exchange markets in the world 10 5.4 Structure of the commodity market in India .. 11 5.6 Participants in Commodities Market . 12 6, INTRODUCTION TO DERIVATIVES............................................................ 12 6.1 Derivatives definition: ............................................................................. 12 6.2 Products of Derivatives market: ............................................................. 12 6.3 Participants in Derivatives market. ....................................................... 13 6.4 Functions of derivatives: ......................................................................... 13 6.5 Derivatives markets: ............................................................................... 13 6.6 Differences between Spot transaction and forward/futures transaction................................................................... 14 7, INSTRUMENTS AVAILABLE FOR TRADING............................................ 14 7.1 Forward contract .................................................................................. 14 7.1.1: Advantages of forward markets............................................. 15 7.1.2: Limitations of forward markets............................................. 15 7.2: Futures: ................................................................................................ 15 7.2.1 Distinction between futures and forwards contracts.. ... 15 7.2.2 Futures terminology................................................................ 16 7.3 Introduction to options ........................................................................ 19 7.3.1 Option terminology................................................................ 19 7.4: Basic payoffs ....................................................................................... 20 7.4.1: Payoff for futures .................................................................. 20 7.4.2: Payoff for options.................................................................. 21
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Trading on commodity futures
8, COMMODITY FUTURES............................................................................... 23 8.1 Difference between commodity futures and financial futures ............................................................................. 8.2 Evolution of the commodity futures trading in India and present status....................................................... ................................. 8.3 The Indian scenario................................................................................. 8.4 Different commodity exchanges in India............................................... 8.5 Advantages when Investing in commodity futures 8.6. Role of commodity futures and prospect............................................. 29 8.7 Using of commodity futures: .................................................................. 8.7.1 Hedging....................................................... ........................... 8.7.2 Speculation. ............................................................................ 8.7.3 Arbitrage: ............................................................................... 8.8 Commodities in which futures trading is being conducted in Indian market: ....................................................... ................................. 9, TRADING OF SOME MAJOR COMMODITIES........................................ 37 9.1 Gold: ....................................................... ................................................ 37 9.2 Silver: ....................................................... ................................................ 39 9.3 Cotton: ...................................................................................................... 40 10, TRADING IN COMMODITY FUTURES...................................................... 42 10.1 Entities in the trading system................................................................ 42 10.1.1 Trading cum Clearing members........................................... 42 10.1.2 Professional clearing members............................................ 42 10.2 Methods of trading: .............................................................................. 42 10.2.1 Open outcry........................................................................... 42 10.2.2 Electronic trading................................................................. 43 10.3 Format for tickers: ................................................................................ 43 10.4 Contract specifications: ........................................................................ 43 10.5 Example of futures contract specifications for Rubber on NCDEX. 44 10.6 Types of orders in futures trading........................................................ 47 10.6.1 Time conditions order........................................................... 47 10.6.2 Price conditions orders.......................................................... 47 10.6.3 Limit order: ........................................................................... 47 10.6.4 Stop Loss order: .................................................................... 48 10.6.5 Spread Order: ....................................................................... 48 10.7 Margin requirements. ........................................................................... 48 10.7.1 Ordinary (Initial) Margin: ....................................................48 10.7.2 Special Margin: .................................................................... 49 10.7.3 Delivery Period Margin: ...................................................... 49 2 30 30 32 32 33 23 24 26 27 28
Trading on commodity futures
10.8 Price in futures: How to interpret ....................................................... 49 10.9. Matching Rules..................................................................................... 50 11, CLEARING AND SETTLEMENT IN FUTURES CONTRACT 11.1Types of settlement in futures contracts: ............................................ 11.1.1 Daily settlement: mark to the market................................... 11.1.2 Final settlement: .................................................................. 11.2 Settlement methods: ............................................................................. 11.2.1 Physical delivery settlement.................................................. 11.2.2 Closing out by offsetting position....................................... 11.2.3 Cash settlement: ................................................................... 50 51 51 52 53 53 53 53
12, REGULATOY ISSUES FOR COMMODITY FUTURES TRADING 54 12.1 Government Policies on futures trading.............................................. 54 12.2 The forward contracts regulation Act. ................................................ 54 12.3 Forward market commission................................................................. 55 12.4 Regulation for Brokers in commodity futures trading 55 12.5Payment of sale tax/VAT in futures trading......................................... 57 12.5.1 Responsibility of seller member: .......................................... 57 12.5.2 Responsibility of buying members......................................... 57 13, FINDINGS......................................................................................................... 58 14, RECOMMEDATIONS..................................................................................... 59 15, RESEARCH QUESTIONNAIRE FOR COMMODITY FUTURES 16, BIBLIOGRAPHY.............................................................................................. 62 16.1 Reference Books: ................................................................................ 62 16.2 Company Literature........................................................................... 62 16.3 List of Websites................................................................................... 62 60
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Trading on commodity futures
1, EXECUTIVE SYNOPSIS The summer project that I did with PRABODH Group was a learning based project with some analysis to be done on it. I was given a chance to learn about commodity exchange market in India, how products are traded online and many things helpful and new to me. The key learning of the project is: Functions of commodities Benefits of commodity futures Prospect of commodity futures trading Innovation in commodity trading (derivatives, futures, options) Commodity markets in India Structure of commodity markets in India Clearing and settlement of commodity futures Regulations on commodity futures trading Sale tax in commodity futures trading Trading commodities through PRABODH Group The learning made me realize that the gamut of commodities market is vast. It would be impossible for me to cover all the aspects in just two months. My attempt was to do a lot of readings to understand the mechanism of commodity trading in India especially futures trading. 2, INTRODUCTION TO THE PROJECT Title of the project: Trading on commodity futures Name of the organization: PRABODH Group, Pune Name of department: Commodity department Name of Project guide: Prof. R. Balachandran 3, SCOPE OF THE PROJECT 3.1 Objectives of the project Prime objective of the project is to understand and analyze the commodity trading system in India and also at Prabodh Group. This project has been undertaken to give an outlook on the potential growth of online (E-broking) Commodities trade in India. This project studies the current prospects of online commodities trading of Prabodh Group and critical issues faced by the company and also the functionality of the commodities market. Thus looking from both perspectives will help to get the clear picture of current scenario of commodity market, which will enable me to arrive at conclusion for the future potential growth. The secondary purpose of the project is to find out the expectation of clients of Prabodh Group in terms of trading on commodities futures. Thus providing better solution to the client s requirements. With the changing times it is important for an institution to withstand the competition by offering customer innovative and improved products, upgrading system. 3. 2 Methodology i, Research Design:
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Trading on commodity futures
Research design is the basic framework, which provides guidelines of research process once the problem of opportunity is identified. This study helps in collection and analysis of the data. ii, data collection In any report data is very important since it provides the information needed for analysis and interpretation. For this report two kinds of data are being used. They are: + Primary data + Secondary data Primary data: Primary data were collected from the most prominent category of participants related to commodity market. The list includes NCDEX, MCX, brokers, investor, customers etc. Personal interview and telephonic interview were also taken. To maintain the consistency they were asked similar set of questions and responses have been collected. Secondary data: Company profile, existing files, records and others (like company brochures etc) served as secondary data to the reports. Circulars, Articles and newspapers provided needed information. Also Books on commodity markets (NCDEX, MCX guide books) and websites are important sources. 3.3 Limitations of the study - Touching the real customer is the ultimate aim. Since the actual commodity traders in PRABODH GROUP are very few, I am unable to find the appropriate numbers of traders and failed to derive any logical conclusions from their response. This is also because the volume traded is very miniscule and the market is still in the infancy stage that it will take some time for the market to grow as in case of the Equity market. - The time factor was a major limitation. As time elapsed I realized that the future decisions aren t taken in isolation. There are numerous factors affecting the decision making which are dynamic in nature. It cannot be summarized in such a short span of time. 4, PROFILE OF PRABODH GROUP Prabodh Group was founded in 1988. Prabodh is a group of entrepreneurs who conduct a cluster of professional activities, the surplus generated from which is dedicated to the work of Jnana Prabodhini, an educational trust in Pune. Prabodh Group stands for a movement in the business field, which creates wealth but uses it predominantly for social purpose. Prabodh, the very name indicates its origin from the educational heritage of this innovative institution- Jnana Prabodhini, which means Awakening through Knowledge. The alma mater cherishes a life- long relationship with its students and puts forth a dream of solving problems of our country through man - making education. Financial autonomy is preserved by its alumni by offering Guru Dakshina - a devotional sum in gratitude, regularly. Prabodh Group was founded in 1988 with this very objective. There is a ceiling on the individual income, while the surplus goes back to the society.
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Trading on commodity futures
Having accomplished excellence in education, the Prabodh members acquired long professional experience in various fields. The multi dimensional activities as elaborated further, depict this versatility of the Prabodh Group. It, therefore, transcends the conventional concepts of modern business. Prabodh is a highly professional body in Print Expression, Manufacture, Investment and Consultation. Not only an efficient service is provided, but a hope for the future is incarnated in the endeavour. PRABODH Group includes Prabodh Sankul Pvt. Ltd. Prabodh Udyog Prabodh Vinimay Prabodh Sampada Prabodh Samwardhan Prabodh Nirman Pvt. Ltd. Prabodh Artha Sanchay Pvt. Ltd. Prabodh Artha Wardhini Ltd. Business of PRABODH Group 4.1 Joining Hands For Mutual Growth To achieve this, PRABODH Group commits in many things from compiling information, exploring together new business ideas and working in cohesive clusters. Autonomous in spirit and work culture, complementary in abilities and resources, this ' dream internet ' can lead to a bigger size comprising of suitable entities. Businesses of PRABODH Group related to any frontier field of science and technology, including Information Technology, Biotechnology, Multi - Media and others. 4.2 Investment consultancy - SHARE BROKERS Members of Pune Stock Exchange Members of National Stock Exchange Services of Bombay Stock Exchange. - FUND MANAGERS Mutual Fund of more than 400 Individual Investors. Present amount deployed is above Rs. 8 to 10 crores Corporate Funds of even larger size being handled through PRABODH GROUP . Inter - Corporate Deposits Bill Discounting facilities Funds Deployed in Share Market for Attractive Returns Funds fully secured against shares. - INVESTMENT SERVICES Portfolio Advice New Issue services Secondary Market Operations. 4.3 Managemetnt consultancy Project Management Project Formulation
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Trading on commodity futures
Appraisal for Bank Finance Social Organisation Services in Foreign Funded Projects. Training In HRD Training Courses for Industries in Communication , Motivation and Leadership Counseling to budding Entrepreneurs. Farmers' Organisations Field assignment of Water Users' Associations Awareness Building in Common Natural Resources 4.4 Engineer house - DESIGN & PROTOTYPES Special Purpose Machines Assembly Automation Mechanisation of Processes Computer controlled Stage Lighting Systems for studios Reciprocators for Painting Agitators Reliability Testing Equipment Components / Assemblies Centrifuges up to 5,000 G & Fuze Spinners upto 50,000 RPM. - MANUFACTURE & MARKETING Microprocessor based Controllers for Automation Industrial Washing Machines Glove Boxes Vice Lift Capacitor Foil Winding Machines. 4.5 Image house - IMAGE PROJECTION Marketing Literature Exhibition Displays Calendars, Diaries House Journals, Periodicals Packaging Materials Books and Publications. - CONFIDENCE BUILDING Annual Reports Industrial Manuals Pre- printed Continuous Stationery Stickers and Labels. 4.6 Real estate Agency Service Industrial Plots around Pune. Farm House Development. Land Developers & Managers Long Term Caretakers Horticulture Managers.
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Trading on commodity futures
Rural life Consultancy Dairy and allied Products Food Processing Projects. 4.7 Members of PRABODH Group - Mr .Mohan Chimanlal Gujarathi M.Com., M. B.A. Investment Consultancy, Portfolio Management Share Broker Financial Management - Mr.Anil Risbud B.E.(Mech.), MMS. MIE Chartered Engineering Management of Engineering Units Design of Special Purpose Machines, SAP, Computer Management Consultant - Prafulla Kulkarni B.Com. ,Grad. C.W.A. Multicolor Printing Finance Management System - N. N. Kanade D.I.T. , D.B.M. Offset Colour Printing Marketing of various Products - V. Y. Kulkarni B.E (Mech.) Precision Engineering Product Development - V. S. Gole B.E. (Mech.) Design & Devalopment of Special Purpose Machines - Ram Dimble M. A Real Estate Transactions Rural Development Projects - Subhash Deshpande M.A. , M.B.A. Human Resource Development Entrepreneurship Development
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Trading on commodity futures
5.INTRODUCTION ABOUT COMMODITIES AND THEIR ROLES 5.1 What is a commodity? Commodities are an integral part of our life - We can not live without the food we eat: Wheat and Rice - Cotton is the king of yarn - Gold and Silver are eternally attractive to mankind All the above are commodities. 5.2 Commodity market in India
Commodity market
Precious Metal
Other metals
Gold Silver
Aluminum, Zinc, Brass, etc
Agriculture
Energy
Cotton, Soya bean, Rapeseed.
Gas and Petroleum
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Trading on commodity futures
5.3 Different commodity exchange markets in the world
Country United States America
Exchange of Chicago Board of Trade (CBOT) Chicago Mercantile Exchange New York Cotton Exchange New York Board of Trade The London International Financial Futures Options Exchange The London Metal Exchange The Winnipeg Commodity Exchange Brazilian Futures Exchange Commodities Sydney Futures Exchange Ltd.
United Kingdom
Canada Brazil Australia
People s Republic of Beijing Commodity Exchange Shanghai China Metal Exchange Hong Kong Japan Malaysia New Zealand Singapore France Italy Netherlands Russia Hong Kong Futures Exchange Tokyo International Financial Futures Exchange Kuala Lumpur commodity Exchange New Zealand Futures and Options Exchange Ltd Singapore commodity Exchange Ltd Le Nouveau Marche MATIF Italian Derivatives Market Amsterdam Exchanges option Traders The Russian Exchange Petersburg Futures Exchange The Spanish Options Exchange Citrus Fruit and Commodity Futures Market of Valencia
Spain
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Trading on commodity futures
5.4 Structure of the commodity market in India
Ministry of Consumer Affairs, Food and Public Distribution
Forward Market commission
Online Exchanges
Open outcry Exchanges
NCDEX
NMCE
MCX
NBOT
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Trading on commodity futures
5.6 Participants in Commodities Market: Hedgers, speculators, investors and arbitragers Producers Farmers Consumers, refiners, food processing companies, jewelers, textile mills, exporters and importers Institutional proprietary traders ( currently disallowed)
6. INTRODUCTION TO DERIVATIVES 6.1 Derivatives definition: Derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other assets. 6.2 Products of Derivatives market: Derivative contracts are of different types. The most common ones are forwards, futures, options, warrant and swaps. Forwards: A forward contract is an agreement between two entitles to buy or sell the underlying assets at a future date, at today s pre-agreed price Futures: A futures contract is an agreement between two parties to buy or sell the underlying assets at a future date, at today s future price. Futures contracts differ from forward contracts in the sense that they are standardized and exchange traded. Options: There are two types of options Calls and Put. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying assets, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-date options are called warrants and are generally traded Over- the- counter Baskets: Basket options on portfolios of underlying assets. The underlying asset is usually a weighted average of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. 6. 3 Participants in Derivatives market. Participants who trade in the derivatives market can be classified under the following three broad categories: Hedgers, speculators and arbitragers. - Hedgers: Ones who offset the price risk inherent in any cash market position by taking the opposite position in the futures market. Hedgers use the market to protect their businesses from adverse price changes.
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Trading on commodity futures
- Speculator: One who tries to profit from buying and selling future contracts by anticipating future price movements. - Arbitragers: Ones simultaneously purchase and sale of similar commodities in different exchanges or in different contracts of the same commodity in one exchange to take advantage of a price discrepancy. 6.4 Functions of derivatives: The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. the derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. derivatives, due to their inherent nature, are linked to the underlying cash market. With the introduction of derivatives, the underlying market witness higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Speculative traders shift to amore controlled environment of the derivatives market. In the absence of an organized derivatives markets, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunity, the benefit of which are immense. Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity. 6.5 Derivatives markets: Derivatives can broadly be classified as commodity derivative market and financial derivatives markets. As the name suggest, commodity derivatives market trade contracts for which the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybean, cotton, etc or precious metals. Financial derivatives markets trade contracts that have a financial asset or variable as the underlying.
Derivatives markets
Financial market 13
Commodities market
Trading on commodity futures
6.6 Differences between Spot transaction and forward/futures transaction
Transactions
Spot transactions
Future transactions
Using the example of a forward contract, let us try to understand the difference between a spot and derivatives contract. Every transaction has three components: trading, clearing and settlements In spot transaction, the trading, clearing and settlement is the actual process of exchanging money and goods and at the spot. Consider this example. On 1st January 2004 B wants to buy some gold. The gold quotes at Rs 6,000 per 10 grams. B pay Rs12,000 and get the gold, this is spot transaction. In forward/future contracts trading happens today, but the clearing and settlement happenstat the end of the specified period. Now suppose B does not want to buy gold on the 1 January 2004, but wants to buy it a month later. The gold quotes Rs 6,015 per 10 gram. They agree upon the forward price for 20 gram of gold that B wants to buy and B leaves. One month later B pays Rs 12,030 and collects his gold. This is a forward contract. 7, INSTRUMENT AVAILABLE FOR TRADING 7.1 Forward contract A forward contract is a contract between two people who agree to buy/sell a specified quantity of a financial instrument/commodity at a certain price at a certain date in future. For example, Mr X and Mr Y. Mr X is a wholesale sugar dealer and Mr Y is the prospective buyer. Mr Y agrees to buy 30 kg of sugar at Rs 15 per kg after three months. The price is arrived at on the basis of prevailing market conditions and future perceptions about the price of sugar. If after three months, the market price of sugar is Rs 20 per kg, then Mr Y is a gainer. and if the price of sugar is Rs 10 per kg, then Mr X is a gainer. The salient features of forward contract are: - They are bilateral contracts and hence exposed to counter party risk - Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. - The contract price is generally not available in public domain. - On the expiration date, the contract has to be settled by delivery of the asset. - If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.
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Trading on commodity futures
7.1.1: Advantages of forward markets Use for hedging Use for speculation 7.1.2: Limitations of forward markets Lack of centralization of trading. - Illiquidity - Counterparty risk 7.2: Futures: Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contracts. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, and a standardized time of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. Standardized items in a futures contract are - Quantity of the underlying - Quality of the underlying - The date and the month of delivery - The units of price quotation and minimum price change - Location of settlement - Unlike Equity futures, the commodity future contract expires on the 20th day of the delivery month. 7.2.1 Distinction between futures and forwards contracts Forward contracts are often confused with futures contracts. However there are some differences between forward contracts and future contracts. Future contracts are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. A futures contract is an agreement between two parties to buy or sell a specified quantity and quality of asset at a certain time in future at a certain price agreed at the time of entering into the contract on the futures exchange. Forward contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. Forward contract is not traded on an exchange. Trading place: Futures contract is entered on the centralized trading platform of the exchange. Forward contract is OTC in nature. Size of the contract: Futures contract is standardized in terms of quantity as specified by the exchange. Size of the forward contract is customized as per the terms of agreement between buyer and seller. Transparency in contract price: Contract price of futures contract is transparent as it is available on the centralized trading screen of the exchange. Contract price of forward contract is not transparent, as it is not publicly disclosed.
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Trading on commodity futures
Valuation of open position and margin requirement: In case of futures contract valuation of open position is calculated as per official closing price on daily basis and Mark to Market margin requirement exist. In case of forward contract valuation of open position is not calculated on daily basis and thereis no provision of Mark to Market margin requirement. Liquidity: Futures contract is more liquid as it is traded on the exchange. Forward contract is less liquid due to customized nature and mutual trade. Counter party risk: In futures contract Clearing House becomes counter party to each transaction, which is called Novation, so counter party risk is nil. In forward contract counter party risk is high due to decentralized nature of the transaction. Regulations: A government regulatory authority and the exchange regulate futures contract. Forward contract is not regulated by any authority or exchange Settlement: Futures contract is generally cash settled but option of physical settlement is available. Forward contract is generally settled by physical delivery Delivery: Delivery tendered in case of futures contract should be of standard quantity and standard quality as per contract specification at designated delivery centers of the exchange. Delivery in case of forward contract is carried out at delivery center specified in customized bilateral agreement. Futures Trade on an organized exchange Standardized contract terms More liquid Requires margin payments Follows daily settlement Forward OTC (over the counter) in nature Customized contract terms Less liquid No margin payment Settlement happens at end of period
7.2.2 Futures terminology Arbitrage: The simultaneous purchase and sale of similar commodities in different markets to take advantage of a perceived price discrepancy. Basis: The difference between the current cash price and the futures price of the same commodity for a given contract month. Bear Market: A period of declining market prices. Bull Market: A period of rising market prices. Broker: A company or individual that executes futures and options orders on behalf of financial and commercial institutions and/or the general public. Cash (Spot) Market: A place where people buy and sell the actual (cash) commodities, i.e., grain elevator, livestock market, etc.
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Trading on commodity futures
Commission (Brokerage) Fee: A fee charged by a broker for executing a transaction. Convergence: A term referring to cash and futures prices tending to come together as the futures contract nears expiration. Cross-hedging: Hedging a commodity using a different but related futures contract when there is no futures contract for the cash commodity being hedged and the cash and futures markets follow similar price trends. For example, hedging cull cows on the live cattle futures market. Daily Trading Limit: The maximum price change set by the exchange each day for a contract. Day Traders: Speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day. Delivery: The transfer of the cash commodity from the seller of a futures contract to the buyer of a futures contract. Forward (Cash) Contract: A cash contract in which a seller agrees to deliver a specific cash commodity to a buyer at a specific time in the future. Fundamental Analysis: A method of anticipating future price movement using supply and demand information. Futures Contract: A legally binding agreement, made on the trading floor of a futures exchange, to buy or sell a commodity or financial instrument sometime in the future. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. The only variable is price, which is determined on an exchange trading floor. Hedger: An individual or company owning or planning to own a cash commodity - corn, soybeans, wheat, U.S. Treasury bonds, notes, bills, etc. - and concerned that the costs of the commodity may change before they intend to either buy or sell it in the cash market. A hedger achieves protection against changing cash prices by purchasing (selling) futures contracts of the same or similar commodity and later offsetting that position by selling (purchasing) futures contracts of the same quantity and type as the initial transaction and at the same time as the cash transaction occurs. Hedging: The practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Hedgers use the futures markets to protect their business from adverse price changes. Initial Margin: The amount a futures market participant must deposit into his/her margin account at the time he/she places an order to buy or sell a futures contract. Intrinsic Value: The difference between the strike price and the underlying futures price for an option that is in-the-money. Liquidate: Selling (or purchasing) futures contracts of the same delivery month purchased (or sold) during an earlier transaction or making (or taking) delivery of the cash commodity represented by the futures contract.
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Trading on commodity futures
Long: One who has bought futures contracts or plans to own a cash commodity. Maintenance Margin: A set minimum margin (per outstanding futures contract) that a customer must maintain in his margin account. Nearby (Delivery) Month: The futures contract month closest to expiration. Also referred to as spot month. Open Interest: The total number of futures or options contracts of a given commodity that have not yet been offset by an opposite futures or option transaction nor fulfilled by delivery of the commodity or option exercise. Each option transaction has a buyer and a seller, but for calculation of open interest only one side of the contract is counted. Purchasing Hedge (long hedge): Buying futures contracts to protect against a possible price increase of cash commodities that will be purchased in the future. At the time the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those that were initially purchased. Selling Hedge (short hedge): Selling futures contracts to protect against possible declining prices of commodities that will be sold in the future. At the time the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those that were initially sold. Short Position: One who has sold futures contracts or plans to sell a cash commodity. Selling futures contracts or initiating a cash forward contract sale without offsetting a particular market position. Speculator: A market participant who tries to profit from buying and selling futures and option contracts by anticipating future price movements. Speculators assume market price risk and add liquidity and capital to the futures markets. They do not hold equal and opposite cash market risks. Spread: The price difference between two related markets or commodities. For example, the April-August live cattle spread. Strike Price: The price at which the futures contract underlying a call or put option can be purchased (call) or sold (put). Also called exercise price. Technical Analysis: Anticipating future price movements using historical prices, trading volume, open interest, and other trading data to study price patterns. Time Value: The amount of money option buyers are willing to pay for an option in the anticipation that, over time, a change in the underlying futures price willcause the option to increase in value. In general, an option premium is the sum of time value and intrinsic value. Any amount by which an option premium exceeds the option's intrinsic value can be considered time value. Underlying Futures Contract: The specific futures contract that can be bought or sold by exercising an option. Volatility: A measurement of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.
18
Trading on commodity futures
Volume: The number of purchases or sales of a commodity futures contract made during a specified period of time, often the total transactions for one trading day. 7.3 Introduction to options - As the word suggests option is a contract that gives you an option, but not the obligation to buy or sell something. Unlike futures, there is an option writer who initiates the contract. An option writer is treated as the seller of the contract. The purchase of options requires an up-front payment. - Commodity options are totally prohibited in Indian market. 7.3.1 Option terminology Underlying - The specific security / asset on which an options contract is based Call Option: A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at a specified price on or before a specified time. The seller (one who is short call ) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Example: An investor buys 100 European call options on Infosys at the strike price of Rs3500 when the current price of the stock is Rs3400 at a premium of Rs100. If the stock price, on the day of expiry is more than Rs3600 (Strike Price + cost incurred in form of premium paid), lets us say Rs3800, the buyer of the call option will decide to exercise his option to buy the 100 Infosys shares. If the buyer sells the shares in the market immediately, he will earn Rs200 per share as profit (or Rs20,000 in the whole of transaction). The seller of the call will have the obligation to deliver the stock. In another scenario, if at the time of expiry stock price falls below Rs3500 say suppose it touches Rs3000, the buyer of the call option will choose to not to exercise his option. In this case the investor loses the premium paid which shall be the profit earned by the seller of the call option. Put Option: A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at a specified price on or before a specified time. The seller (one who is short Put) however, has the obligation to buy the underlying asset if the buyer of the put option decides to exercise his option to sell. Example: An investor buys 100 European put options on Reliance at the strike price of Rs300 when the current price of the stock is Rs280 at a premium of Rs15. If the stock price, on the day of expiry is less than Rs300 (Strike Price + cost incurred in form of premium paid), say Rs270, the buyer of the Put option will decide to exercise his option to sell the 100 Reliance shares. He will buy 100 shares of Reliance from the market @ Rs270 / share and sell the same at Rs300 / share, he will earn Rs15 per share (taking premium paid into consideration), as profit or Rs1,500 in the whole of transaction. The seller of the Put will have the obligation to buy the stock. In another
19
Trading on commodity futures
scenario, if at the time of expiry stock price rises above Rs300 (strike price), say suppose it touches Rs320, the buyer of the Put option will choose to not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid which shall be the profit earned by the seller of the Put option. Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment. Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or sell. Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless. Exercise Date - is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option) Open Interest - The total number of options contracts outstanding in the market at any given point of time. Option Holder - is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer. Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited. Option Class - All listed options of a particular type (i.e., call or put) on a particular underlying instrument. 7.4: Basic payoffs A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on X-axis ant the profits/loss on the Y-axis. 7.4.1: Payoff for futures Pay off for buyer of futures: Long futures The payoff for a person who buys a future contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
20
Trading on commodity futures
Profit +500
5500
6000
6500
Gold
-500
Loss
The Figure shows the profits/losses for a long futures position. The investor bought gold when gold futures were trading at Rs. 6000 per 10 gm. If the price of the underlying gold goes up, the gold futures price too would go up and his future position starts making profits. If the price of gold falls, the futures price falls too and his futures position starts showing losses. Payoff for a seller of futures: Short position. The payoff for a person who sells a future contract is similar to the payoff for a person who sells an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Profit
+ 500
6000 0
6500
7000
-500 Loss
21
Trading on commodity futures
The figure shows the profits and losses for a short futures position. The investor sold cotton futures at Rs. 6500 per quintal. If the price of the underlying cotton goes down, the futures prices also fall, and the short position starts making profits. If the price of the underlying cotton rises, the futures too rise, and the short position starts showing losses. 7.4.2: Payoff for options Pay of for buyer of call option: Long call Call option give the buyer the right to buy the underlying asset at the strike price specification in the option. The figure shows the profits/loss for the buyer of a three month call option on gold at a strike of Rs 7,000 per 10 gram, bought at premium of Rs 500.
profit 7000 gold 500
Loss Payoff for writer of call options: short call The figure shows the profits/loss for the seller of a three month call option on gold at a strike of Rs 7,000 per 10 gram, sold at premium of Rs 500 profit
500 7000 Gold
loss
Payoff for buyer of put options: Long put The figure shows the profit/loss for the buyer of a three month put option on gold at a strike of Rs 7,000 per 10 gram, bought at premium of Rs 500.
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Trading on commodity futures
Profit
7000 0 500 Gold
Loss
Payoff for a seller (writer) of put option: short put Profit 500 0 7000 Gold
loss
23
Trading on commodity futures
8, COMMODITY FUTURES 8.1 Difference between commodity futures and financial futures - The basic concept of a futures contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features which are very peculiar to commodity futures market. In the case of financial futures, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity market creates the need for warehousing. - Similarly, the concept of varying quality of asset does not really exist as far as financial underlying are concerned. However in the case of commodity, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. 8.2 Evolution of the commodity futures trading in India and present status Organized futures market evolved in India by the setting up of "Bombay Cotton Trade Association Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futures trading in oilseeds was organized in India for the first time with the setting up of Gujarati Vyapari Mandali in 1900, which carried on futures trading in groundnut , castor seed and cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds were functioning in Gujarat and Punjab. Futures trading in Raw Jute and Jute Goods began in Calcutta with the establishment of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd.,was set up in 1927 for organizing futures trading in Raw Jute. These two associations amalgamated in 1945 to form the present East India Jute & Hessian Ltd., to conduct organized trading in both Raw Jute and Jute goods. In case of wheat, futures markets were in existence at several centres at Punjab and U.P. The most notable amongst them was the Chamber of Commerce at Hapur, which was established in 1913. Other markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad and Barielly in U.P. Futures market in Bullion began at Mumbai in 1920 and later similar markets came up at Rajkot , Jaipur , Jamnagar , Kanpur, Delhi and Calcutta. In due course several other exchanges were also created in the country to trade in such diverse commodities as pepper, turmeric, potato, sugar and gur(jaggory). After independence, the Constitution of India brought the subject of "Stock Exchanges and futures markets" in the Union list. As a result, the responsibility for 24
Trading on commodity futures
regulation of commodity futures markets devolved on Govt. of India. A Bill on forward contracts was referred to an expert committee headed by Prof. A.D.Shroff and Select Committees of two successive Parliaments and finally in December 1952 Forward Contracts (Regulation) Act, 1952, was enacted. The Act provided for 3-tier regulatory system; (a) An association recognized by the Government of India on the recommendation of Forward Markets Commission, (b) The Forward Markets Commission (it was set up in September 1953) and (c) The Central Government. Forward Contracts (Regulation) Rules were notified by the Central Government in July,1954 The Act divides the commodities into 3 categories with reference to extent of regulation, viz: (a) The commodities in which futures trading can be organized under the auspices of recognized association. (b) The Commodities in which futures trading is prohibited. (c) Those commodities which have neither been regulated for being traded under the recognized association nor prohibited are referred as Free Commodities and the association organized in such free commodities is required to obtain the Certificate of Registration from the Forward Markets Commission. In the seventies, most of the registered associations became inactive, as futures as well as forward trading in the commodities for which they were registered came to be either suspended or prohibited altogether. The Khusro Committee (June 1980) had recommended reintroduction of futures trading in most of the major commodities , including cotton, kapas, raw jute and jute goods and suggested that steps may be taken for introducing futures trading in commodities, like potatoes, onions, etc. at appropriate time. The government, accordingly initiated futures trading in Potato during the latter half of 1980 in quite a few markets in Punjab and Uttar Pradesh. After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry liberalization in both the domestic and external sectors, the Govt. of India appointed in June 1993 one more committee on Forward Markets under Chairmanship of Prof. K.N. Kabra. The Committee submitted its report in September 1994. The majority report of the Committee recommended that futures trading be introduced in 1) Basmati Rice 2) Cotton and Kapas 3) Raw Jute and Jute Goods 4) Groundnut , rapeseed/mustard seed , cottonseed , sesame seed , sunflower seed , safflower seed , copra and soybean , and oils and oilcakes of all of them. 5) Rice bran oil 6) Castor oil and its oilcake
25
Trading on commodity futures
7) Linseed 8) Silver and 9) Onions. The committee also recommended that some of the existing commodity exchanges particularly the ones in pepper and castor seed , may be upgraded to the level of international futures markets. The liberalised policy being followed by the Government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management. The National Agriculture Policy announced in July 2000 and the announcements of Hon'ble Finance Minister in the Budget Speech for 2002-2003 were indicative of the Governments resolve to put in place a mechanism of futures trade/market. As a follow up the Government issued notifications on 1.4.2003 permitting futures trading in the commodities, with the issue of these notifications futures trading is not prohibited in any commodity. Options trading in commodity is, however presently prohibited. 8.3 The Indian scenario Commodity derivatives have had a long and a chequered presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over the years, there have been various bans, suspensions and regulatory dogmas on various contracts. There are 25 commodity derivative exchanges in India as of now and derivative contracts on nearly 100 commodities are available for trade. The overall turnover is expected to touch Rs 5 lakh crore (Rs 5 trillion) by the end of 2004-2005. National Commodity and Derivatives Exchange (NCDEX) is the largest commodity derivatives exchange with a turnover of around Rs 3,000 crore (Rs 30 billion) every fortnight. It is only in the last decade that commodity derivatives exchanges have been actively encouraged. But, the markets have suffered from poor liquidity and have not grown to any significant level, till recently. However, in the year 2003, four national commodity exchanges became operational; National Multi-Commodity Exchange of India (NMCE), National Board of Trade (NBOT), National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX). The onset of these exchanges and the introduction of futures contracts on new commodities by the Forwards Market Commission have triggered significant levels of trade. Now the commodities futures trading in India is all set to match the volumes on the capital markets.
26
Trading on commodity futures
8.4 Different commodity exchanges in India NO NAME AND ADDRESS
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.
National Commodity & Derivatives Exchange Ltd. Website: ncdex.com National Multi Commodity Exchange of India Limited. Website: nmcex.com Multi Commodity Exchange of India Ltd. Website: mceindia.com The Meerut Agro Commodities Exchange Co. Ltd., Meerut The Spices and Oilseeds Exchange Ltd. Ahmedabad Commodity Exchange Ltd. Vijay Beopar Chamber Ltd.,Muzaffarnagar India Pepper & Spice Trade Association.Kochi Rajdhani Oils and Oilseeds Exchange Ltd. Delhi National Board of Trade. Indore. The Chamber Of Commerce,Hapur The East India Cotton Association Mumbai. The Central India Commercial Exchange Ltd, Gwaliar. The East India Jute & Hessian Exchange Ltd. First Commodity Exchange of India Ltd, Kochi Bikaner Commodity Exchange Ltd., Bikaner. Esugarindia Limited. The Bombay Commodity Exchange Ltd.Mumbai Surendranagar Cotton oil & Oilseeds Association Ltd, The Rajkot Seeds oil & Bullion Merchants` Association Ltd Bhatinda Om & Oil Exchange Ltd., Batinda. Haryana Commodities Ltd., Hissar The Bullion Association Limited e-Commodities Ltd
27
Trading on commodity futures
8.5 Advantages when Investing in commodity futures - Commodity futures, which were traditionally developed for risk management purposes, are now growing in popularity as an investment tool. Most of the trading in the commodity futures market is being done by people who have no need for the commodity itself. They just speculate on the direction of the price of these commodities, hoping to make money if the price moves in their favour. The commodity futures market is a direct way to invest in commodities rather than investing in the companies that trade in those commodities. For example, an investor can invest directly in a steel futures rather than investing in the shares of Tata Steel. It is easier to forecast the price of commodities based on their demand and supply forecasts as compared to forecasting the price of the shares of a company - which depend on many other factors than just the demand - and supply of the products they manufacture and sell or trade in. - Also, futures are much cheaper to trade in as only a small sum of money is required to buy a futures contract. Let us assume that an investor buys a tonne of soybean for Rs 8,700 in anticipation that the prices will rise to Rs 9,000 by June 30, 2005. He will be able to make a profit of Rs 300 on his investment, which is 3.4%. Compare this to the scenario if the investor had decided to buy soybean futures instead. Before we look into how investment in a futures contract works, we must familiarize ourselves with the buyer and the seller of a futures contract. A buyer of a derivative contract is a person who pays an initial margin to buy the right to buy or sell a commodity at a certain price and a certain date in the future. On the other hand, the seller accepts the margin and agrees to fulfill the agreed terms of the contract by buying or selling the commodity at the agreed price on the maturity date of the contract. Now let us say the investor buys soybean futures contract to buy one tonne of soybean for Rs 8,700 (exercise price) on June 30, 2005. The contract is available by paying an initial margin of 10%, i.e. Rs 870. Note that the investor needs to invest only Rs 870 here. On June 30, 2005, the price of soybean in the market is, say, Rs 9,000 (known as Spot Price - Spot Price is the current market price of the commodity at any point in time). The investor can take the delivery of one tonne of soybean at Rs 8,700 and immediately sell it in the market for Rs 9,000, making a profit of Rs 300. So the return on the investment of Rs 870 is 34.5%. On the contrary, if the price of soybean drops to Rs 8,400 the investor will end up making a loss of 34.5%. If the investor wants, instead of taking the delivery of the commodity upon maturity of the contract, an option to settle the contract in cash also exists. Cash settlement comprises exchange of the difference in the spot price of the commodity and the exercise price as per the futures contract.
28
Trading on commodity futures
At present, the option of cash settlement lies only with the seller of the contract. If the seller decides to make or take delivery upon maturity, the buyer of the contract has to fulfil his obligation by either taking or making delivery of the commodity, depending on the specifications of the contract. In the above example, if the seller decides to go for cash settlement, the contract can be settled by the seller paying Rs 300 to the buyer, which is the difference in the spot price of the commodity and the exercise price. Once again, the return on the investment of Rs 870 is 34.5%. The above example shows that with very little investment, the commodity futures market offers scope to make big bucks. However, trading in derivatives is highly risky because just as there are high returns to be earned if prices move in favour of the investors, an unfavourable move results in huge losses. - The most critical function in a commodity futures exchange is the settlement and clearing of trades. Commodity futures can involve the exchange of funds and goods. The exchanges have a separate body to handle all the settlements, known as the clearing house. For example, the seller of a futures contract to buy soybean might choose to take delivery of soyabean rather than closing his position before maturity. The function of the clearing house or clearing organisation, in such a case, is to take care of possible problems of default by the other party involved by standardising and simplifying transaction processing between participants and the organisation. In spite of the surge in the turnover of the commodity exchanges in recent years, a lot of work in terms of policy liberalisation, setting up the right legal system, creating the necessary infrastructure, large-scale training programs still need to be done in order to catch up with the developed commodity derivative markets. 8.6. Role of commodity futures and prospect: Futures contracts perform two important functions: price discovery price risk management with reference to the given commodity. It is useful to producer because he can get an idea of the price likely to prevail at a future point of time and therefore can decide between various competing commodities, the best that suits him. It enables the consumer get an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. The futures trading is very useful to the exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and thereby secure export contract in a competitive market. Having entered into an export contract, it enables him to hedge his risk by operating in futures market. Other benefits of futures trading are: (i) Price stabilization-in times of violent price fluctuations - this mechanism dampens the peaks and lifts up the valleys i.e. price variation is reduced. 29
Trading on commodity futures
(ii) Leads to integrated price structure throughout the country. (iii) Facilitates lengthy and complex, production and manufacturing activities. (iv) Helps balance in supply and demand position throughout the year. (v) Encourages competition and acts as a price barometer to farmers and other trade functionaries. Futures trading is also capable of being misused by unscrupulous speculators. In order to safeguard against uncontrolled speculation certain regulatory measures are introduced from time to time. They are: a. Limit on open position of an individual operator to prevent over trading; b. Limit on price fluctuation (daily/weekly) to prevent abrupt upswing or downswing in prices; c. Special margin deposits to be collected on outstanding purchases or sales to curb excessive speculative activity through financial restraints; d. Minimum/maximum prices to be prescribed to prevent future prices from falling below the levels that are un remunerative and from rising above the levels not warranted by genuine supply and demand factors. During shortages, extreme steps like skipping trading in certain deliveries of the contract, closing the markets for a specified period and even closing out the contract to overcome emergency situations are taken Prospect: With the gradual withdrawal of the government from various sectors in the post-liberalization era, the need has been felt that various operators in the commodities market be provided with a mechanism to hedge and transfer their risks. India's obligation under WTO to open agriculture sector to world trade would require futures trade in a wide variety of primary commodities and their products to enable diverse market functionaries to cope with the price volatility prevailing in the world markets. 8.7 Using of commodity futures: Unlike Equity markets, commodity markets also give opportunity for all three kinds of participants: - Hedging - Speculation - Arbitrage 8.7.1 Hedging Illustration Hedging is a futures transaction that acts as a substitute for a later cash transaction. It is roughly equal and opposite to the position the hedger has in the cash market Let us take the example of Company A, which produces sugar and Company B, a consumer of sugar. Company A plans to sell 50,000 quintals of sugar in December 2005. It expects futures prices to be lower and feels that Rs 1,850 per quintal will be a good price to get in December. This will cover the cost of production and give a reasonable margin. The Strategy
30
Trading on commodity futures
So, Company A decides to lock in 50,000 quintals at a price of Rs 1,850 on the futures market for December contract. Scenario I The predictions of Company A has come true. Spot prices for December 1 st is Rs.1840 per quintal. Spot Futures Locked in at Rs 1,850 for 50,000 qtls. Price Rs 1,840 Current price @ Rs 1,840 Sells all of 50,000 qtlsSquares off 50,000 qtls @ Rs 1,840 Sales in the spot @ Rs 1,840 Gain of Rs 10 per quintal from spot Result Loss of Rs 10 againstagainst the budget. Bought @ Rs 1,840 budget and sold @ Rs 1,850 for 50,000 quintals Net No profit or No loss on the budgeted price of Rs 1,850 Scenario II The predictions of Company A has gone wrong. Spot prices for December 1 st is Rs 1,870 per quintal. Spot Futures Rs 1,870 Locked in at Rs 1,850 for 50,000 qtls. Sells all of 50,000 qtls inSquares off 50,000 qtls @ Rs 1,870 the spot @ Rs 1,870 Make Rs 20 profit asBought @ Rs 1,870 and sold @ Rs 1,850. Loss against the budget of Rs 20
Price Sales Result
Net result is that Company A has got an average price of Rs 1,850. Example on hedging with Futures by a sugar consumer The strategy The Company B buys 50,000 quintals of sugar for December Contract at Rs 1,850 since it expects the prices to go up in future. Scenario I The predictions of Company B has come true. Spot prices for December 1 st is Rs 1,870 per quintal. Purchase Buys all of 50,000 qtls inSquares off 50,000 qtls @ Rs 1,870 the spot @ Rs 1,870 Result Loss of Rs 20 as againstGain of Rs 20. Bought @ Rs 1,850 and sold @ the budget Rs 1,870.
31
Trading on commodity futures
Scenario II The predictions of Company B has gone wrong. Spot prices for December 1 st is Rs 1,830 per quintal. Spot Futures Price Rs 1,830 Locked in at Rs 1,850 for 50,000 qtls. Purchase Buys all of 50,000 qtls inSquares off 50,000 qtls @ Rs 1,830 the spot @ Rs 1,830 Result Gain of Rs 20 againstLoss of Rs 20. Bought @ Rs 1,850 and sold @ budget Rs 1,830 Net result is that Company B has got an average price of Rs 1,850. The Budgeted price of Rs 1,850 per quintal for 50,000 quintals is assured irrespective of the price fluctuation both in case of producer and consumer. What makes hedge work? Spot and Futures price for the same commodity tend to go up and down together. Losses in one side are cancelled out by gains on the other. 8.7.2 Speculation. Strategy for speculation: When futures price is overpriced: Buy spot sell at futures market When futures is underpriced: Buy futures sell at spot 8.7.3 Arbitrage: Investors can earn profit by simultaneously buying and selling at two markets without any risk.
32
Trading on commodity futures
8.8 Commodities in which futures trading is being conducted in Indian market: A, Fibres and Manufacturers 1. 2. 3. Kapas Hessian Indian Cotton A. S06 L S Cotton Ahmedabad B. CottonKadi C. J34 M S Cotton Bhatinda D. CottonAbohar Sttaple Fibre Yarn Sacking A. Jute (B twill-665 Gms) Kollata Gram A. Gram(Chana) - New Delhi cottonbales cottonseeds Long Staple Cotton Medium Stapple Cotton A. new Medium Stapple Cotton Silk A. Mulberry Raw Silk Bangalore B. Mulberry Green Cocoons Ramnagar Mulberry Raw Silk Mulberry Green Cocoons Coffee-Arabica Cotton Long Kadi Cotton Med Abohar Cotton Short Staple Sugar (S-30) Muatardseed Oilcake
4. 5. 6. 7. 8. 9. 10. 11.
12. 13. 14. 15. 16. 17. 18. 19.
B, Spices 1. Pepper Domestic-MG1 2. Turmeric A. Turmeric Nizamabad 3. Pepper Domestic-500g/l 4. Black Pepper Int'l-MLS ASTA 5. Black Pepper Int'l-VB ASTA 6. Black pepper Int'l FAQ 7. Pepper A. Pepper Dommestic-MG1. B. Black Pepper Int'l VB ASTA C. Black Pepper Int'l-MLS ASTA D. Black Pepper Int'l FAQ. E. Pepper Dommestic-500g/L
33
Trading on commodity futures
F. Pepper Kochi 8. Cardamom 9. Pepper 550 G/L 10. Red Chilly A. Chilli (Paala) Guntur 11. Jeera 12. Rubber RSS4 13. Jeera Unjha C, Edible Oilseeds and Oil 1. RBD Pamolein A. RBD P'Olein Kakinada 2. Groundnut Oil 3. Sunflower Oil 4. Rapeseed/Mustardseed A. Rapeseed 42 B. Rape/Mustard seed Jaipur 5. Rapeseed/Mustardseed Oil 6. Rapeseed/Mustardseed oil-Cake 7. Soy bean A. Soy bean Indore 8. Soy Meal A. Soy Meal Indore B. Yellow Soybean Meal (Export) 9. Soy Oil A. Ref Soya oil Indore 10. Copra 11. CottonSeed A. Cottonbales 12. Safflower 13. Groundnut 14. Castor oil-Int'l 15. Coconut oil 16. Copra cake 17. Groundnut oilCack 18. Cottonseed oil 19. Sesamum (Til or Jiljili) A. Whitish Sesame Seed Rajkot 20. Sesamum oil 21. Sesamum OilCake 22. Safflower OilCake 23. Rice Bran 24. Rice Bran Oil 25. Rice Bran OilCake 26. Safflower Oil 27. Sanflower OilCake 28. Sunflower Seed 29. Crude Palm Oil
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Trading on commodity futures
30. Cottonseed Oilcake A. Cotton Seed Oilcake Akola 31. Vanaspati 32. Soybean Oilcake 33. Linseed 34. Linseed Oil 35. Linseed Oilcake 36. Coconut Oilcake 37. Mustard Seed 38. Mustard Seed Jaipur 39. Sesame Seed ( Natural 99.1) 40. Castorseed- Disa D, Metals 1. Aluminium Ingots 2. Nickel 3. Copper A. Copper Cathode 4. Zinc 5. Lead 6. Tin 7. Gold A. Gold-M B. Pure Gold Mumbai C. Kilo Gold D. Gold HNI E. SONA995MUM F. Pure Gold - Mumbai - 1 Kg 8. Silver A. Silver-M B. Pure Silver - New Delhi - 30 Kg (Mega) C. Pure Silver - New Delhi D. Silver HNI E. CHANDIDEL 9. Steel A. Steel Long B. Steel Flat C. Mild Steel Ingots Ghaziabad 10. Steel Long Bhavnagar 11. Steel Long Govindgarh E, Pulses 1. Masoor 2. Urad A. Urad Mumbai 3. Tur / Arhar A. Lemon Tur Mumbai B. Maharashtra Lal Tur Akola
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Trading on commodity futures
4. 5. Moong Yellow Peas A. Yellow Peas Chana
Mumbai 6.
F, Energy Products 1. Crude Oil 2. Brent Crude Oil G, Others 1. Gur A. Gur-chaku Muzaffarnagar 2. Coffee-Plantation A 3. Potato 4. Sugar A. Sugar M Grade Muzaffarnagar B. Sugar S Grade Vashi C. Sugar S Grade D. Sugar Grade M E. Sugar Grade S 5. Coffee-Robusta Cherry AB 6. Raw Coffee Arabica Parchment 7. Raw Coffee Robusta Cherry 8. Castorseed A. Castorseed-5 B. Castorseed Disa 9. Castor-oil 10. Coffee A. Coffee-Plantation A. B. Coffee-Robusta Cherry AB. C. Raw Coffee Robusta Cherry D. Raw Coffee Arabica Parchment E. Arabica Coffee Hassan F. Robusta Coffee Kushalnagar G. Arabica Coffee - Hassan (New) H. Robusta Coffee - Kushalnagar (New) 11. Guarseed A. Guarseed Jodhpur B. Guarseed BND 12. CastorOil Cake 13. Rubber 14. Rice A. Basmati Rice B. Grade A Parboiled Rice Delhi C. Common Parboiled Rice Delhi D. Grade A Raw Rice Delhi E. Common Raw Rice Delhi 15. Wheat
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Trading on commodity futures
A . Wheat - New Delhi SMQ B. Wheat Delhi (New) Raw Jute GuarGum A. GuarGum Jodhpur Guarseed Bandhani Maize A. Yellow Red Maize Nizamabad Guar Gum Bandhani CASHEW KERNEL W320 A. Cashew W 320 Kollam Sugar S Sugar M Sarbati Rice Coffee-Arabica Plantation A Cashews W-320-Kollam Mentha Oil Sugar (S30)
16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28.
9, TRADING OF SOME MAJOR COMMODITIES IN INDIA 9.1 Gold: Gold is primarily a monetary asset and partly a commodity. More than two thirds of gold's total accumulated holdings relate to 'value for investment' with central bank reserves, private players and high-carat jewelry. Less than one third of gold's total accumulated holdings is as a 'commodity' for jewelry in Western markets and usage in industry. Gold market is highly liquid and gold held by central banks, other major institutions and retail jewelry keep coming back to the market. Due to large stocks of Gold as against its demand, it is argued that the core driver of the real price of gold is stock equilibrium rather than flow equilibrium. Economic forces that determine the price of gold are different from, and in many cases opposed to the forces that influence most financial assets. South Africa is the world's largest gold producer with 394 tons in 2001, followed by US and Australia. India is the world's largest gold consumer with an annual demand of 800 tons. - Gold functions as a monetary instruments, as a financial asset and as a raw material used in jewelry & decorative Items. - Gold is used as a hedge against inflation and as a reliable store of value during times of political, social or economic distress. As an investment, gold can provide individual and institutional investors alike with a portfolio safety net against sharp downward spikes in complementary asset such as stock and bond
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Trading on commodity futures
Basic structure of the gold market World Gold Markets London as the great clearing house New York as the home of futures trading Zurich as a physical turntable Istanbul, Dubai, Singapore and Hong Kong as doorways to important consuming regions Tokyo where TOCOM sets the mood of Japan Indian Gold Market Gold is valued in India as a savings and investment vehicle and is the second preferred investment after bank deposits. India is the world's largest consumer of gold in jewellery as investment. In July 1997 the RBI authorized the commercial banks to import gold for sale or loan to jewelers and exporters. At present, 13 banks are active in the import of gold.
Mining Coms
Central Banks
Investors
Bullion Banks
Fabricator
Jewelers
Central bank lends gold to bullion banks at an interest rate known to them, Bullion Banks in turn sell the gold to fabricators, jewelers etc, and use the proceeds for investment. Bullion banks are international banks with specified skill in bullion trading. Bullion Banks go long in the forward market & the counter-party is a gold mining company, investor or speculator.
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Trading on commodity futures
9.2 Silver: Silver's unique properties make it's a very useful 'Industrial Commodity', despite it being classed as a precious metal. Demand for silver is built on three main pillars; industrial uses, photography and jewelry & silverware accounting for 342, 205 and 259 million ounces respectively in 2005. Just over half of mined silver comes from Mexico, Peru and United States, respectively, the first, second and fourth largest producing countries. The third largest is Australia. Primary mines produce about 27 percent of world silver, while around 73 percent comes as a by-product of gold, copper, lead, and zinc mining. The price of silver is not only a function of its primary output but more a function of the price of other metals also, as world mine production is more a function of the prices of other metals. The tie between silver and economic activity is strong, given that around twothirds of total silver fabrication is in the industrial and photographic sectors Often a faster growth in demand against supply leads to drop in stocks with Government and investors Economically viable primary silver mine is a function of the world silver price level. World Silver Supply from Above-ground Stocks Million Ounces Implied Net Disinvestment Producer Hedging Net Government Sales Sub-total Bullion Scrap Total Indian Scenario 2004 -9.5 18.9 87.2 96.6 182.7 279.3 2005 20.9 -24.8 71.3 67.4 184,9 252.3
Silver imports into India for domestic consumption in 2004 was 3,400 tons down 25 % from record 4,540 tons in 2003. Open General License (OGL) imports are the only significant source of supply to the Indian market. Non-duty paid silver for the export sector rose sharply in 2004, up by close to 200% year-on-year to 150 tons. Around 50% of India's silver requirements last year were met through imports of Chinese silver and other important sources of supply being UK, CIS, Australia and Dubai. Indian industrial demand in 2004 is estimated at 1375 tons down by 13 % from 1,579 tons in 2003. In spite of this fall, India is still one of the largest users of silver in the world, ranking alongside those Industrial giants, Japan and the United States.
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Trading on commodity futures
By contrast with United States and Japan, Indian industrial offtake for fabrication in hardcore industrial applications like electronics and brazing alloys accounts for only 15 % and the rest being for foils for use in the decorative covering of food, plating of jewelry and silverware and jari.
In India silver price volatility is also an important determinant of silver demand as it is for gold. India Industrial Fabrication , 2004 Percentage Pharmacy & Chemicals Foil Plating Solders & Brazing Electrical Photography Jari World Markets London Bullion Market is the global hub of OTC (Over-The-Counter) trading in silver. Comex futures in New York is where most fund activity is focused Frequency Distribution of Silver London Fixing Volatility from 1995 till date
22.4 9.0 13.7 5.4 13.5 0.85 17.1
Percentage Change Daily Number of times Percentage times Weekly Number of times Percentage times
> 7% 7 0.3 9 21
5-7% 10 0.5 15 3.4
3 - 5% 85 3.9 50 11.4
<3% 2086 95.3 363 83.1
9.3 Cotton Cotton is among the most important non-food crops, which occupies a significant position both- from agricultural and manufacturing sectors' points of view. It is the major source of one of the basic human need- 'clothing' apart from other fibre sources viz. jute, silk and synthetic. Hence, it is one among the most cultivated and most traded commodities of the World. USA, China, Sudan, Egypt, Australia and India are the major producers of cotton. The table below provides a snip shot of global supplydemand scenario of cotton.
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Trading on commodity futures
(in million tons) 2000-01 Production Imports Consumption Exports Ending Stocks 19.18 5.77 19.89 5.75 9.22 2001-02 21.17 6.29 20.24 6.30 10.16 2002-03 19.43 6.64 20.78 6.58 8.90
While US, China, Sudan, Turkey, Egypt and Australia are the major players in the international export trade, the player on the import scene are EU, US, Brazil, India and the Middle-East. US is a major exporter of raw cotton, and at the same time, one of the largest importers of ready-made garments. The Indian scene. Cotton accounts for more than 75% of India's annual fibre consumption in the spinning mills and more than 58% of its annual fibre consumption in the textile sector. Textile industry in India (major share of which is constituted by cotton ) currently adds about 14% to the industrial production and 4% to the gross domestic product (GDP). It provides employment to about 35 million persons. Together with allied agriculture sector, it provides employment to over 90 million people. The contribution of this industry to the gross export earnings of the country is over 30% while it adds only 7-8% to the gross import bill of the country. At the average price of Rs 45/kg of over 170 lakh bales (average annual consumption, 1 bale = 170 kg) raw cotton traded in the country, the market size of raw cotton in India is over Rs 130 million. India's cotton supply and demand trend (in lakh bales of 170 kg)
Particulars Opening Stock Production Imports Total Supply
98-99 23.50 0.50
99-00 39.20 0.30
00-01 30.40 4.00
01-02 30.00 7.90
02-03 36.50 22.00
03-04 40.50 22.13
04-05 29.00 22.00
170.20 177.90 158.00 165.00 156.00 140.00 158.00
194.20 217.40 192.40 202.90 214.50 202.63 209.00
Domestic Consumption 154.30 170.20 158.90 165.30 173.40 173.03 173.00 Exports Total Demand Carryover stock 8.00 16.80 3.50 1.10 1.50 0.60 1.00
162.30 187.00 162.40 166.40 174.00 173.63 174.00 31.90 30.40 30.00 36.50 40.50 29.00 35.00
Maharashtra, Gujarat, Andhra Pradesh, Haryana, Punjab, Rajasthan and Karnataka, are among the major producing States of the country. Bengal Deshi, V-
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Trading on commodity futures
797, Jayadhar, J-34/ bikaneri NarmaSg, Y-1, NHH-44, LRA-5166, H-4/MECH-1, S6/4, MCU-5, DCH-32, 26 mm cotton are among the various varieties of cotton cultivated across the country. 'Short', 'Medium' and 'Elongated Long' Staple Length cotton are major grades, which is based on the staple length of the fibre. Among several other reasons, it is 'the lack of availability of desired quality cotton' that has made many Indian buyers (particularly the export oriented units) to opt for purchases of foreign cotton despite enough domestic supplies. Most importing mills in India are ready to pay 5-10% premium for foreign cotton due to its higher quality (less trash, uniform lots, higher ginning out turn) and better credit terms (3-6 months vs. 1530 days for local). Mills using ELS have been pleased with US Pima and its fibre characteristics. US has emerged as an important supplier in the last two seasons. Apart from US, India is also importing from Egypt, West Africa, the CIS countries and Australia on account of lower freight and shorter delivery periods offered to Indian buyers. Indian cotton farmers were producing enough to meet the domestic demand till 1998-99. Failure of monsoon in the main producing regions of Gujarat and Maharashtra during the two consecutive years of 1999 and 2000 pulled down the country's output during the corresponding years. Imports rose by an astounding 278.48% during 1999-00 (over the previous year). Similar quantum of imports continued into the subsequent years, turning the status of India from 'exporter' to 'importer' in the international cotton trade scene. Trading centres of Mumbai, Saurashtra region of Gujarat and Rajasthan serve as reference markets for prices of cotton traded across the country. Currently, raw cotton prices in upcountry markets across the country is ruling in the range of Rs 41-89/kg for various varieties/grades. Cotton prices in India are influenced by various demand-supply factors operating with the country, and the international raw cotton prices and demand for finished ready-made garments. 10,TRADING IN COMMODITIES FUTURES 10.1 Entities in the trading system 10.1.1 Trading cum Clearing members TCMs can trade and clear either on their own account or on behalf of their clients including participants. Each TCM has an unique ID and can has more than one user 10.1.2 Professional clearing members PCMs are members of NSCCL. The PCM membership entitles the members to clear trades executed though Trading cum Clearing Members both for themselves and/or on behalf of their clients. 10.2 Methods of trading: 10.2.1 Open outcry Open outcry trading is a face- to-face and highly activated form of trading used on the floors of the exchanges. In open outcry system the futures contracts are traded in pits. Normally one type of contract is traded in each pit.
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Trading on commodity futures
10.2.2 Electronic trading Electronic trading: Electronic trading systems have become increasingly popular in the past decade. The driving factor for the rise in the popularity of these systems is their potential to improve efficiency and lower the cost of transactions. In addition, electronic trading systems make exchanges available to remote investors in real time, which is an important benefit in the present situation of increased trading from remote locations. Components of the system: - Computer terminals, where customer orders are keyed in and confirmations are received - A host compute that processes trade. - A network that links the terminals to the host computer. 10.3 Format for tickers: XXXYYYZZZ XXX: Three letters for the commodity YYY: three letters for the grade ZZZ: Three letters for the location E.g: SYOREFIND: SYO:Soy oil REF: Refined IND: indore Instrument Type is to denote whether the ticker is a future contract or a spot price being disseminate or an options contract. E.g: COMDTY- Used for commodity spot price dissemination FUTCOM- Used for future on commodity OPTCOM- Used for options on futures on commodity.
Contract expiry for futures contract will be written as 20mmmYYYY mmm - denotes the month, e.g. DEC, JAN etc. YYYY denotes the year e.g. 2005, 2006 etc For spot price, no expiry will be displayed or required 10.4 Contract specifications: Contract specifications for commodity futures are vital and it is necessary for making a market efficient. The standard contracts traded on exchanges have number of criteria like type of contract, name of commodity, ticker symbol, trading system, unit of trading, delivery unit, quotation/base value, tick size, quality specification, quantity variation, delivery center, additional delivery centers, hours of trading, due date/ expiry date, delivery specification, closing of contracts, price limit, position limit, quality allowance, etc Commodity exchanges need to have standardized contracts which in turn help in trading in physical market also. It will improve market liquidity and transparency in the price formation.
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Trading on commodity futures
When the delivery of the commodity takes place, there must be a proper procedure / system in place. The exchange fixes reputed assessor to assess the quality of the product tendered for delivery. It is difficult for traders and processors to inspect each of lot of goods delivered. They always accept the certificate issued by the warehouse keeper, which will correspond to the physical product. The products delivered will command a premium or discount. Accordingly, the delivery prices will also be altered. The exchange fixes the range of delivery locations. It is normally at the seller s option for agri products. The exchange must strike a balance between making the delivery practices practical and reducing the scope for price manipulation. If there are many delivery locations, the market manipulation will not be possible. The buyer may incur transport cost if it is not in the convenient location. The exchange neutralizes the impact of it by adding or subtracting the cost of transport depending on the place of delivery. To avoid taking delivery, some of the users close their positions in the futures market, if it is advantage for them or close the contract and take fresh position for the next month. Timing of the contract is important. Experience has shown that the best time to launch a contract is that when the prices are volatile. There should not be any frequent changes in the contract specifications as it will affect the market. When the contract is launched, it should be as close as to reality. All the parameters and procedures must be tested before launching it. The exchange prepares the contract, test it and get it approved by the Forward Markets Commission (FMC) before launching it. 10.5 Example of futures contract specifications for Rubber on NCDEX Rubber Futures Contract Specifications. Type of contract Futures Contract Specifications Name of commodity Ticker symbol Trading system Rubber RBRRS4KTM NCDEX Trading System As per directions of the Forward Markets Commission from time to time, currently (with effect from April 25, 2005) Mondays through Fridays : Hours of Trading 10:00 AM to 05:00 PM Saturdays : 10.00 AM to 2.00 PM The Exchange may vary the above timing with due notice.
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Trading on commodity futures
RSS 4 (Ribbed Smoked Sheet 4 ) ex designated warehouse Kottayam exclusive of all taxes 1000 Kgs. (=1 MT) 1000 Kgs. (=1 MT) Rs per Quintal Re 1 Limit 10%. Quality Specifications as provided under Part II Section 1 of the "Green Book" as detailed below: Nothing but coagulated rubber sheets, properly dried and smoked can be used in making these grades: block, cuttings or other scrap or frothy sheets, weak, heated or burnt sheets, air dried or smooth sheets not permissible Slight resinous matter (rust) and slight amounts of dry mould on wrappers, bale surfaces and interior sheets, found at the time of delivery will not be objected to. Should "rust" or "dry mould" in an appreciable extent appear on more than 20% of the bales sampled, it shall constitute gr ound s for rejection. Medium sized bark particles, bubbles, translucent stains, slightly sticky and slightly over-smoked rubber are permissible to the extent as shown in the sample. Oxidized spots or streaks, weak, heated, under-cured, over-smoked (in excess of the degree shown in the sample) and burnt sheets are not permissible. The rubber must be dry, firm and free of blemishes, blisters, sand, dirty packing and all other foreign matter other than those specified above as permissible. Quantity variation No. of active contracts Delivery center Opening of contracts +/- 2% Maximum 12 monthly or minimum 2 monthly contracts running concurrently. Kottayam and Kochi Trading in any contract month will open on the 21st day of the month.If the opening day happens to be a non-trading day, contracts would open on the next
Basis Unit of trading Delivery Unit Quotation/Base Value Tick size Price Band
Quality specification
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Trading on commodity futures
trading day. Due date 20th day of the delivery months. If 20th happens to be holiday then the previous trading day. a. For all contracts with expiry dates till December 2005 Upon expiry of the contracts, if any seller with open position desires to give delivery at a particular delivery center, then the corresponding buyer with open position as matched by the process put in place by the Exchange shall be bound to settle by taking physical delivery b. For all contracts with expiry dates from January 2006 onwards Upon expiry of the contracts, any seller with open position shall give delivery of the commodity .In case of a failure to give delivery, it would be treated as default as per the Bye laws and Regulations of the Exchange from time to time. The corresponding buyer with open position as matched by the process put in place by the Exchange shall be bound to settle by taking physical delivery Member-wise: Max (Rs. 20 crore, 15% of open interest) Client-wise: Max (Rs. 10 crore, 10% of open interest) None
Delivery specification
Position limits
Premium / Discount
Normally range of futures contracts will be in place. In the case of NCDEX, all contracts expire on the 20th of expiry month. The new contracts will be introduced on the trading day following the expiry of the near month contract. The following figure shows the contract cycle over the time.
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Trading on commodity futures
10.6 Types of orders in futures trading With electronic trading, a lot of flexibility is available to investors in executing various types of orders. They must familiarize themselves with the various types. The orders can be categorized into time conditions, price conditions and other conditions. 10.6.1 Time conditions order Day order: The order is valid for the day on which it is entered. If the order is not executed during the trading session, the system itself will cancel the order at the end of the day. Fresh order has to be entered for the next day. Good till cancelled: It remains in the system till the order is cancelled by the user. The maximum number of days the order will remain in the system will be notified by the Exchange. Good till date: The order will remain in the system up to the date the user has specified, if it is not executed. Immediate or cancel: An immediate or cancel order allows the user to buy or sell a contract as soon as it is entered into the system. If it is not matched or partial match has been done, any balance portion of the contract will be automatically cancelled. All or none order: It is a limit order in which the order will be executed in its fully entirety or not executed. Fill or kill order: Like the previous one, it is a limit order. It should be executed immediately and if the order is not executed, it gets cancelled. 10.6.2 Price conditions orders 10.6.3 Limit order: This is an order to buy or sell the futures contract of a commodity at a specified price. 10.6.4 Stop Loss order: Stop Loss order is a facility given to the traders/clients to use it to limit their amount of loss, if the futures contracts move against their position. It is an order to buy or sell when the market price reaches the specified level. When the price reaches the point, the order gets triggered and it becomes a market order. For example, a trader has purchased gold futures at Rs.7,000/-. He is uncertain about the market movement. He plans to limit his loss, if the prices go down. He will place a stop order if the price falls less than Rs.6900/-. When the market goes down, the stop order gets executed at this price Other conditions
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Trading on commodity futures
Market Price: Market orders are those for which no price is specified at the time of entering the order. Market on open: This kind of orders will be executed during the market open within the opening range. Market on close: These types of orders are executed on the market close. 10.6.5 Spread Order: It is an order in which two positions are taken, i.e. one long position and one short position with different months of maturity in the same commodity or in closely related commodities. The prices of the futures contract tend to go up and down and by entering the spread order, investor would have locked in the price and the amount of profit. The trader will unwind the position depending on the market movement 10.7 Margin requirements. (a) The initial security deposit paid by a member will be considered as his initial margin deposit for the purpose of allowable exposure limit. Initially, every member is allowed to take exposure up to the level permissible on the basis of such initial deposit. However, if a member wishes to create more exposure, he has to pay additional deposit. (b) If there is a surplus deposit lying with the Exchange towards margin, it is not refunded to the member, unless a written request is received from the member for refund. However, the member continues to get additional exposure limit on account of such additional/surplus deposit. In case of receipt of written request for refund of additional deposit, the same may be returned within 7 working days. Different types of margins collected by the Exchange are as follows: 10.7.1 Ordinary (Initial) Margin: Ordinary margin requirement is calculated by applying the margin percentage applicable for a contract on the value of the open position of a member in that contract. If a member has net position in various contracts of the same commodity running concurrently, he is required to pay margin separately on each of these contracts. Similarly, if a member has open position in various commodities, the total amount required is calculated as sum total of margin required in respective of each commodities and contracts separately. The computation methodology in respect of ordinary margin is as follows: Intra day During the trading session, the margin is calculated on the absolute difference between total sales in value terms and total buy in value terms in respect of all transactions executed in a contract during the day in addition to previous day s open position carried forward at the official closing price of previous day. End of day At end of the trading session, the margin amount is computed on net position in a contract in quantitative terms multiplied by the official closing price. 10.7.2 Special Margin: In case the price fluctuation in a contract during the trading session is more than 50% of the circuit filter limit applicable on that contract compared to the base price of the day, a special margin equivalent to 50% of the circuit filter limit is applied. Such
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Trading on commodity futures
special margin amount is immediately blocked out of available margin deposits of the members having outstanding position in that contract and in case the available margin of a member is not sufficient to cover such special margin required, then a margin call is sent to the member which is required to be remitted by the member immediately. In such case, since the available deposit is already exhausted, he is suspended from trading and such suspension continues during such trading session till collection of required margin amount is completed. If the price volatility reaches 100 % of the circuit filter limit, orders will be accepted by the system only upto the price level equivalent to such circuit filter. 10.7.3 Delivery Period Margin: When a contract enters into delivery period towards the end of its life cycle, delivery period margin is imposed. Such margin is applicable on both outstanding buy and sales side, which continues up to the settlement of delivery obligation or expiry of the contract, whichever is earlier. The delivery period margin is calculated at the rate specified for respective commodity multiplied by the net open position held by a member in the expiring contract. When a seller submits delivery documents alongwith surveyor s certificate, his position is treated as settled and his delivery period margin to such extent is reduced. When a buyer pays money for the delivery allocated to him, his delivery period margin is reduced on such quantity for which he has paid the amount. If delivery does not happen with respect to certain open position and is finally settled by way of difference as per the Due Date Rate, the delivery period margin is released only after final settlement of difference arising out of such closing out as per the Due Date Rate. In case a member submits documentary evidence so as to prove that the position held by him in a futures contract is totally hedge position, based on physical stock in his custody, or based on his export or import obligation, he can claim exemption from payment of special margin, if any, imposed on such contract. Provided that such exemption is allowed only in case it is proved beyond doubt to the satisfaction of the Exchange that it is totally a hedge position. In case of any failure in fulfillment of obligations on the part of a member, the Exchange is entitled to forfeit or utilize the margin deposits lying with the Exchange for meeting such obligations and in such a case, the total margin deposit of that member shall stand reduced to such extent. 10.8 Price in futures: How to interpret Contract Open Month Sept 262.75 Dec 266.25 High 263.50 267.50 Low 261.50 264.75 Settle 262.00 266.75 Lifetime High 270.50 268.00 Lifetime Low 238.00 235.50 Open interest 33922 141307
- Opening price: the open or opening price is the price or range of prices for the day s first trades, registered during the period designated as the opening of the market or the opening call. - Closing price: The closing price is the price of prices at which the commodity futures contracts are traded during the brief period designated as the market close or on the closing call - Highest price: The word high refers to the highest price at which a commodity futures contract is traded during the day.
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Trading on commodity futures
- Lowest price: Low refers to the lowest price at which a commodity futures contract is traded during the day. - Settlement price: This is abbreviated as settle in most of the pricing tables. - Lifetime high and low: They refer to the highest and lowest prices recorded for each contract from the first day it traded to the present. - Open interest: It refers to the number of outstanding contracts for each maturity month. 10.9. Matching Rules (a) The Exchange may launch more than one order book running either parallel or at different time spans, either with the same order matching rules or with different matching rules. The Exchange is also entitled to modify or change the matching rules relevant to any market or order books any time where it is necessary to do so (b) Without prejudice to the generality of the above, the order matching rules will have the following features: Orders in the Normal market will be matched on price -time priority basis. Best buy order shall match with the best sell order. (The best buy order would be the one with the highest price and the best sell order would be the one with the lowest price.) 11. CLEARING AND SETTLEMENT IN FUTURES CONTRACT 11.1 Types of settlement in futures contracts: Futures contracts have two types of settlements. Types of settlement
Daily settlement
Final settlement
Handle daily Price fluctuation for all trades (mark to the market) Daily process at end of the day
Dandles final settlement of all position On contract expiry date
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Trading on commodity futures
11.1.1 Daily settlement: mark to the market This is done to take care of daily price fluctuation for all traders. All open positions of the members are marked to market at the end of day and the profit/loss is determined as below: - On the day of entering into the contract, it is the difference between the entry value and daily settlement price for that day. - On any intervening days, when the member holds an open position, it is the difference between the daily settlement price for that day and the previous day settlement price. - On the expiry date if the member has an open position, it is the difference between the final settlement price and the previous day settlement price. Illustration: A clearing member buys one December expiration cotton futures at Rs> 6435 per quintal on December 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The member closes the position on December 19. The MTM profit/losses get added/ deducted from his initial margin on a daily basis. Date Dec 15, 2004 Dec 16, 2004 Dec 17, 2004 Dec 18, 2004 Dec 19, 2004 Daily MTM settlement flow Information to members- end of trade day T Settlement through designated clearing Bank Arrangement of funds in settlement A/c by member Collection and payment of fund T +1 Settlement Price 6320 6250 6312 6310 6315 MTM -115 -70 +62 -2 +5
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Trading on commodity futures
Exchange clearing house
Member
Margin
Daily MTM Settlement
Initial Margin Any special margin
Daily P/L For Positions closed out MTM of open position
Member s bank A/c
Settlement Client1
banking operations Broker A
Clearing bank (HDFC)
Exchange clearing house
Client 2
Broker B
11.1.2 Final settlement: The settlement done for open Buy and Sell positions on the contract expiry date is called final settlement.
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Trading on commodity futures
On the date of expiry, the final settlement price is the spot price on the expiry day. The prices are collected from the members across the country through polling. The polled bid/ask prices are bootstrapped and the mid of the two bootstrapped is taken as the final settlement price. The responsibility of settlement is on a trading cum clearing member (TCM) for all trades done on his own A/c and his client s trades. A professional clearing member (PCM) is responsible for settling all the participants trades, which he has confirmed to the exchange. 11.2 Settlement methods: Physical delivery of the underlying asset Closing out by offsetting position Cash settlement 11.2.1 Physical delivery settlement Members can give and take delivery of commodities by completing the delivery formalities and giving delivery information to the exchange. Entities involved in physical delivery: Accredited warehouse Approved registrar and transfer agents Approved assayer 11.2.2 Closing out by offsetting position In closing out the opposite transaction is effected to close out the original futures position. A buy contract is closed by a sell contract and a sale contract is closed buy a sell contract. For example, an investor took a long position in Gold futures contract on the January 30 2005 at Rs 6000 can close his position by selling gold futures contract on February 25 2005 at 5780. In this case, over the period of holding the position, he has suffered a loss of Rs 220 per unit. This loss would have been debited from his margin Account over the holding period by way of MTM at the end of each day. 11.2.3 Cash settlement: Contract held till the last day of trading can be cash settled. When a contract is settled in cash, it is marked to the market at the end of the last trading day and all positions are declared closed. The settlement price on the last trading day is set equal to the closing spot price of the underlying asset ensuring the convergence of future prices and the spot prices. For example an investor took a short position in five long staple cotton futures contracts on December 15 at Rs 6950. On 20th February, the last trading day of the contract, the spot price of long staple cotton is Rs. 6725. This is the settlement price for his contract. As a holder of a short position on cotton, he does not have to actually deliver the underlying cotton, but simply takes away the profit of Rs. 225 per trading unit of cotton in the form of cash.
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Trading on commodity futures
12, REFULATORY ISSUES FOR COMMODITY FUTURES TRADING 12.1 Government Policies on futures trading Various government policies still hinder the growth of commodity exchanges. Given the recognized need for India to have efficient exchanges in the face of liberalization and globalization, FMC should take the lead in coordinating with the responsible Ministries and other government entities a change of these policies. This would not necessarily reduce the government's possibilities to intervene in commodity markets, but would ensure that such intervention does not hinder, or even critically damage, commodity futures markets. A first issue is taxes. Different tax treatment of speculative gains and losses discourage many speculators from participating in official futures exchanges, thereby affecting the liquidity of the markets. Hedgers are affected as well: the necessary link between futures and physical market transactions is too rigidly defined. Tax issues need to be clarified so that futures losses can be offset against profits on the underlying physical trade and vice versa. A second problem is stamp duty. Stamp duties on trade in commodity futures exchanges should be nil, except when physical delivery is made. Now, stamp duty can be arbitrarily imposed by the state in which the futures exchange is located. Clarification from the Indian states in which there are exchanges that there will be no arbitrary position on stamp duty is recommended. Third, many institutions (particularly financial institutions but also, in a less direct manner, cooperatives) are not permitted to engage in commodity futures trade. The rules which prevent such engagement need to be modified. Finally, the role of government entities directly involved in commodity trade should be reconsidered. The direct purchasing practices of these entities now damage the potential of commodity exchanges. If a federal or state government wishes to continue direct interventions in commodity markets, it could, if it wished, pass through the commodity exchanges. This would ensure effective market intervention (the effect on prices will be immediate), and, as long as done within clear policy guidelines, does not destroy market mechanisms.
12.2 The forward contracts regulation Act. The forward contracts (regulation) Act, 1992, a central Act, governs commodity derivatives trading in India, The Act defines various forms of contract. The Act envisages a three-tier regulation. - Exchange: The exchange which organizes forward trading I regulated commodities can prepare its own Articles of Association, Rules and Regulations, byelaws and regulate trading on a day to-day basis. - FMC (Forward Markets Commission): The commission approves the rules and byelaws of the exchange and provides a regulatory oversight. It also acquires concurrent powers of regulation while approving the rules and byelaws of by making such rules and byelaws under the delegated powers.
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Trading on commodity futures
- Central Government: Ministry of Consumer affairs and Public Distribution under the Govt. of India is the ultimate regulatory authority. Only those associations, which are granted recognition by the Government, are allowed to organize forward trading in regulated commodities. Government has the power to suspend trading, call for information, nominate directors of the Exchange etc. Central Govt. has delegate most these powers to FMC. 12.3 Forward market commission Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory authority which is overseen by the Ministry of Consumer Affairs and Public Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952. The functions of the Forward Markets Commission are as follows: (a) To advise the Central Government in respect of the recognition or the withdrawal of recognition from any association or in respect of any other matter arising out of the administration of the Forward Contracts (Regulation) Act 1952. (b) To keep forward markets under observation and to take such action in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act. (c) To collect and whenever the Commission thinks it necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the act is made applicable, including information regarding supply, demand and prices, and to submit to the Central Government, periodical reports on the working of forward markets relating to such goods; (d) To make recommendations generally with a view to improving the organization and working of forward markets; (e) To undertake the inspection of the accounts and other documents of any recognized association or registered association or any member of such association whenever it considerers it necessary.
12.4 Regulation for Brokers in commodity futures trading Brokers should meet the following requirements: Mandated capital adequacy. The regulators should seek to minimize any risk to investors and threat to the stability of the market from the failure of an institution because it becomes unable to meet its liabilities. Currently, a broker's membership at the exchange is solely dependent upon fulfilling the financial requirements (in form of upfront payment or equity participation, membership, admission fees etc.) levied by the different exchanges. There is a need for mandated capital adequacy for brokers together with measures to monitor that the capital is, in fact, maintained. Licensing. In India, there is no requirement of any form of licensing. A broker can start trading once he fulfils the exchange requirements. There is no educational requirement. It is advisable that anyone dealing in futures for clients is registered. To be registered, one would need to:
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Trading on commodity futures
- Be a member/employee of an exchange - Pass a character assessment Pass an examination. As a transition phase, existing employees of members of exchanges who have actively participated in futures business over the [say] past 2 years [or shorter, subject to skill and experience being assessed by the exchange.] could be grand-fathered i.e. they will automatically be registered without having to do the exam. The regulators need to ensure that brokers follow Conduct of Business Rules. These rules seek to regulate the way in which authorised firms conduct their business with their customers. They are wide-ranging in their scope and because a breach of them can lead to civil liability or a claim for compensation, they are quite detailed in nature. The Rules regulate a number of different areas including advertising, customer agreements and the suitability of the products and services provided. Advertising. The Conduct of Business Rules insist that adverting must be fair and not misleading. Additionally, an investment advertisement must contain a risk warning relating to the risks associated with the investments being advertised. The unsolicited oral promotion of services or products, commonly known as cold calling , is also heavily regulated. Customer agreements. Before an exchange member can operate on behalf of a customer a client agreement should be in place. The exchange or the regulator may wish to define the minimum acceptable content of such an agreement. Suitability. A broker needs to check the capacities of his client before undertaking any agreement. Before opening any account for a customer the broker must satisfy himself of the bona fide commercial need for the customer to open the account. He must be satisfied that the customer s quality of management, commodity experience and commodity business knowledge together with their systems and staff will enable them to fulfill the obligations and commitments they undertake when they sign the agreement. Such agreements need to be reviewed regularly and the brokers will need to be sure that the customers continue, at all times, to demonstrate that they are fit and proper persons to be conducting derivatives business. A mechanism for settling customer complaints is also needed. Each exchange should have a first-line-of-defense complaint mechanism, and there also should be a national (well-advertized) mechanism. In order for customer complaints to be properly evaluated, it has to be obligatory for brokers to maintain client records. These should include details of when customer orders are given (time-stamping) and the exact details of the order. Furthermore they must record when the order was given to the floor trader and the time that the execution was confirmed back. Was it executed in full or piece by piece? Was the order cancelled? Was an error made and if so how was the error resolved? Such records should be maintained in writing and made available for inspection and stored as a permanent reference for a period of time (5-7 years, depending on legal convention) as with accounting records for example. Customers deposits and positions should be protected and kept separate from those of the members. Most countries separate clients assets from those of the firm to whom they are entrusted, either by national law or market regulation. The Client Money or Segregation regulations are intended to provide investors with additional protection in the event of a firm s insolvency. Member firms must prove that they e.g., no conviction of fraud. -
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maintain segregated assets at all times. Finally, it would be useful to have a customer compensation scheme, to which all brokers contribute. However, without properly regulated exchanges, any customer compensation scheme would rapidly become bankrupt which is why most schemes normally only protect a strict category of regulated firms and investors who deal through them. Compensation is not normally applied to investors operating outside a given regulated environment. For this reason, regulators also need an active policy to combat bucket shops. 12.6 Payment of sale tax/VAT in futures trading - Futures contracts are in the nature of agreement to buy or sell at a future date and hence are not liable for payment of sales tax. - If the futures contract is closed out and settled between the constituents prior to the settlement date without actually buying or selling the commodity, there is no liability for payment of sales tax. - When the futures contract fructifies into a sale and culminates into delivery, there would be liability for payment of sales tax. This liability will arise in the state in which the Warehouse (into which the goods are lodged by the constituent) is situated when the commodities are delivered to the buyer. The physical settlement in the case of commodities futures contracts involves issues concerned with sales tax. The fact that delivery could happen across various states, and these states have different sales tax rules, make the issue a little complicated. In case of settlements culminating into delivery, sales tax at the rats applicable in the state where the delivery centre is located will be payable. In many states, the sales tax laws, also provide for levy of additional tax, turnover tax, resale tax, etc. Which may or may not be recoverable from the buyer depending on the provisions of state sales tax law. 12.5.1 Responsibility of seller member: Furnishing information to the Exchange for settlement purposes Transaction number ST registration number, validity date Surcharge rate Turnover tax rate, resale tax rate 12.5.2 Responsibility of buying members furnishing information to the Exchange for settlement purposes Transaction number Name of the client Address of the client If sale tax exemption is sought then form number.
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13, FINDINGS 1, The client cannot take the benefits of hedge positions in the present online trading system because Calendar Spread positions are considered as separate positions and flat 20% margin is charged on these two different positions. The margin gets released only when the trades are settled. 2, In case of square off position too different buy limit and sell limit margin is charged. 3, In the present online trading terminal, the daily MTM loss incurred by the clients are shown and the net MTM position of the clients are calculated manually. This makes the margin calculation process more complicated.
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4, The volume traded is small to the prospect 5, Strike Price of commodity futures depend on supply and demand in general. Price of agricultural products depend on whether, seasons, climate etc. Price of Gold, silver, Oil depends on international market and the exchange rate because these commodities are imported for the domestic market. 6, At present, not many Indian people aware of futures trading and using online trading system. 7, Farmers don t know much about futures market to hedge their products
14, RECOMMENDATIONS: 1, Instead of charging 20% flat margin on the calendar Spread position, additional 2% margin should be charged as mentioned by NCDEX on these closed positions. So that the clients can avail the benefits of hedge strategy. The software should provide this facility. 2, Also in case of Square off position, different buy and sell limit are being charged. This should not be the case since the clients settle their trades the same day. 3, More promotional strategies need to be adopted in order to increase the volume of trade. 4, Instead of showing only notional loss incurred by the clients, the Net MTM should be shown for the convenience of clients.
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5, more terminals should be built across India so that more farmers, investors can participate in futures trading. 6, The Government should allow trading on commodity options. This would provide useful instruments for investors when trading in commodities.
15, RESEARCH QUESTIONAIRE FOR FUTURES TRADING 1, Are you aware of Commodity futures? Yes No
2, Have you ever done trading on commodities futures? Yes No
If No Why? . 60
Trading on commodity futures
. 3, In which commodities you trade the most? . . 4, Do you get proper guidance by our advisory department? Yes No
5, Are you familiarized with the usage of the online trading? Yes No
6, How convenient do you find to use online trading? Excellent Satisfactory Good Unsatisfactory
7, What is your problem when trading?
.. 8, What do you feel about the exposure limit provided to you? Excellent Satisfactory Good Unsatisfactory
9, Are you comfortable with the services provided by PRABODH GROUP Yes If No Why No
.. 10, Suggestions if any
..
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16, BIBLIOGRAPHY 16.1 Reference Books: NCDEX- A guide to Commodity Derivatives. NCFM Commodities market Module Work Book. NCFM Dealers Module on Capital markets Derivatives FAQs by Ajay Shah and Susan Thomas Introduction to futures and options markets by John Kolb BSE Training module on Capital Market 16.2 Company Literature 16.3 List of Websites
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www.indiainfoline.com/igame/mapr.html www.cochinstockexchange.com/cse/syllabus.htm www.nseindia.com www.ncdex.com www.mcxindia.com www.fmc.gov.in www.trade.motilaloswal.com www.thefinancials.com www.porfolioscience.com
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