Which Commodities are suitable for future trading

The year 2003 marked the real turning point in the policy framework for commodity market when the government issued notifications for withdrawing all prohibitions and opening up forward trading in all the commodities. This period also witnessed other reforms, such as, amendments to the Essential Commodities Act, Securities (Contract) Rules, which have reduced bottlenecks in the development and growth of commodity markets. Of the country's total GDP, commodities related (and dependent) industries constitute about roughly 50-60 %, which itself cannot be ignored.

Most of the existing Indian commodity exchanges are single commodity platforms; are regional in nature, run mainly by entities which trade on them resulting in substantial conflict of interests, opaque in their functioning and have not used technology to scale up their operations and reach to bring down their costs. But with the strong emergence of: National Multi-commodity Exchange Ltd., Ahmedabad (NMCE), Multi Commodity Exchange Ltd., Mumbai (MCX), National Commodities and Derivatives Exchange, Mumbai (NCDEX), and National Board of Trade, Indore (NBOT), all these shortcomings will be addressed rapidly. These exchanges are expected to be role model to other exchanges and are likely to compete for trade not only among themselves but also with the existing exchanges.

The recent policy changes and upbeat sentiments about the economy, particularly agriculture, have created lot of interest and euphoria about the commodity markets. Even though a large number of the traditional exchanges are showing flat volume, this has not weakened excitement among new participants. Many of these exchanges have been permitted with a view to extend the culture and tradition of forward trading to new areas and commodities and also to introduce new technology and practices.

The current mindset of the people in India is that the Commodity exchanges are speculative (due to non delivery) and are not meant for actual users. One major reason being that the awareness is lacking amongst actual users. In India, Interest rate risks, exchange rate risks are actively managed, but the same does not hold true for the commodity risks. Some additional impediments are centered around the safety, transparency and taxation issues

Raw materials form the most key element of most of the industries. The significance of raw materials can further be strengthened by the fact that the "increase in raw material cost means reduction in share prices". In other words "Share prices mimic the commodity price movements".

Industry in India today runs the raw material price risk; hence going forward the industry can hedge this risk by trading in the commodities market.

What is Margin trading

Margin is the amount of equity that must be maintained in a trading account to keep a position open. It acts as a good faith deposit by the trader to ensure against trading losses. A margin account allows customers to open positions with higher value than the amount of funds they have deposited in their account. 

Trading a margin account is also described as trading on a leveraged basis. Most online forex firms offer up to 200 times leverage on a mini contract account. The mini contract size is usually 10,000 currency unit, 1/200th of 10,000 equals to 50 currency unit, meaning only 0.5% margin is required for open positions. Compare to future contracts, which require 10% margin for most contracts, and equities require 50% margin to the average investor and 10% margin to the professional equity traders, foreign exchange market offers the highest leverage among the other trading instruments.

The equity in excess of the margin requirement in a trading account acts as a cushion for the trader. If the trader loses on a position to the point that equity is below the minimum margin requirement, meaning the cushion has completely worn out, then a margin call will result. Generally, in online forex trading, the trader must deposit more funds before the margin call or the position will be closed. Since no calls are issued before the liquidation, the margin call is better known as ‘margin out' in this case. The account will be margined out, meaning all the positions will be closed, once the equity falls below the margin requirement.

 

 

Types of Orders

The forex market provides different kinds of orders for trading. The following are some major types of orders that can be found on forex trading stations.

Market orders - A buy or sell order in which the forex firm is to execute the order at the best available current price. It is also called at the market.

Entry orders - A request from a client to a forex firm to buy or sell a specified amount of a particular currency pair at a specific price. The order will be filled once the requested price is hit.

Stop Loss orders - An order placed to close a position when it reaches a specified price. It is designed to limit a trader's loss on a position. If the position is opened with buying a currency pair, the stop loss order would be a request to sell the position when the price fall to the specified level. And vice versa. Traders are strongly recommended to use stop loss orders to limit their losses. It is also important to use stop loss orders when investors may enter a situation where they are unable to monitor their portfolio for an extended period.

Take Profit Orders - An order placed to close a position when it reaches a predetermined profit exit price. It is designed to lock in a position's profit. Once the price surpasses the predefined profit-taking price, the take profit order becomes market order and closes the position. 

Good Until Cancelled (GTC) - In online forex trading, most of the orders are GTC, meaning an order will be valid until it is cancelled, regardless of the trading session. The trader must specify that they wish a GTC order to be cancelled before it expires. Generally, the entry orders, stop loss orders and take profit orders in online forex trading are all GTC orders.

The above are the basic orders types available in most of them trading systems. Some trading systems may offer more sophisticated orders. Traders should be familiar with the different orders and make the most of them during trading.

What is Spread Trading in Currency

What is a spread?

In margin forex trading, there are two prices for each currency pair, a "bid" (or sell) price and an "ask" (or buy) price. The bid price is the rate at which traders can sell to the executing firm, while the ask price is the rate at which traders can buy from the executing firm.

For example, when you see the price quote of EUR/USD is 1.2881/1.2884 as in the above picture, the bid is 1.2881 whereas the ask is 1.2884. That means traders looking to sell must do so at 1.2881, those looking to buy must do so at 1.2884.

The difference between the bid and ask price is the spread, which constitutes the cost of the trade. In fact, all traded instruments - stocks, futures, currencies, bonds, etc. - have spread. If a trader buys at 1.2884 and then sells immediately, there is a 3-point loss incurred. The trader will need to wait for the market to move 3 points in favour of his/her position in order to break even. If the market moves 4 points in your favour, he/she starts to profit.

Many online trading firms like to promote margin forex trading as an almost cost-free instrument - commission free, no service charge, no hidden cost, etc. Traders should know that spread is the cost of trading, and in fact, it also represents the main source of revenue for the market maker, i.e. the forex trading company. 

The spread may appear to be a minuscule expense, but once you add up the cost of all of the trades, you will find it can eat away quite a portion of your account or your profit. If you check the price tag of a T-shirt before you buy it, do the same thing when you trade forex, look into the spread before you decide to trade. Your trade needs to surmount the spread (the cost) before it profits.

Know your expense: the spread

Spread is the cost to a trader. On the other hand, it is a revenue source of the firm who executes the trade. In the foreign exchange market, the spread can vary a lot depending on the executing firm and the parties involve. Inter-bank foreign exchange can have spread as tight as 1-2 pips, while the bank can widen the spread to 30-40 pips when dealing with individual customers. 

If you check out the spread of those small exchange shops nearby the tourists' sights, you may find the spread can go up to 400 to 600 pips.Thanks to keen market competition, the spread of online forex trading is getting tighter in the past few years. For major online forex companies, their spreads are essentially the same.

It is important for a trader to find the tightest spread as possible, but anything that is far lower than the typical spread is skeptical. The spread is the main source of revenue of a forex trading firm, if the firm cannot earn enough from the spread, there maybe some other hidden cost in the transaction.

Another point to note is that many market makers often widen the spread when market conditions become more volatile, thus increasing the cost of trading. For instance, if an economic number comes out that is off expectations, thereby creating a flood of buyers or sellers, the market maker may often widen the spread to restore the balance between buyers and sellers. 

As a result, traders should inquire about the execution practices of their clearing firm; firms with poor execution of orders and a tendency to widen spreads will ultimately result in higher trading costs for the end user

History and Trend of Currency Market

The recently technology advancement has broken down the barriers that used to stand between retail clients of FX market and the inter-bank market. The online forex trading revolution was originated in the late 90's, which opened its doors to retail clients by connecting the market makers to the end users. With the high-speed Internet access and powerful central processing unit, the online trading platform at home user's personal computer now serves as a gateway to the liquid FX market. 

Retail clients can now trade together with the biggest banks in the world, with similar pricing and execution. What used to be a game dominated and controlled by major inter-banks is becoming a common field where individuals can take the same opportunities as big banks do.

Technology breakthroughs not only changed the accessibility of the FX market, they also changed the way of how trading decisions were made. Research showed that, as opposed to unable to find profitable trading methodologies, the primary reason for failure as a speculator is a lack of discipline devoted to successful trading and risk management. 

The development of iron discipline is among the most challenging endeavors to which a trader can aspire. With the help of modern trading or charting softwares, traders can now develop trading systems that are comprehensive, with detailed trading plans including rules of entry, exit, and risk management model. Furthermore, traders can do backtesting and forward testing of a particular strategy on a demo account before commitment of capital.

When the system trading softwares were first introduced into the store of trading tools, traders would need programming skills and a strong background in mathematical technical analysis. With the effort of system trading software companies making their products more adaptable to mass market, the system trading softwares are now more user-friendly and simpler to use. At this point, non-programmers with basic understanding of mathematical technical analysis can enjoy the amusement of system trading.

While system trading might not provide the 'holy grails' of trading, it offers as prototypes or guidelines for beginners to starting trading with sound mathematical model and risk management. Over time, traders can develop trading systems that match their individual personality.

Nature of Forex Market

The Foreign Exchange Market is an over-the-counter (OTC) market, which means that there is no central exchange and clearing house where orders are matched. With different levels of access, currencies are traded in different market makers:

The Inter-bank Market - Large commercial banks trade with each other through the Electronic Brokerage System (EBS). Banks will make their quotes available in this market only to those banks with which they trade. This market is not directly accessible to retail traders. 

The Online Market Maker - Retail traders can access the FX market through online market makers that trade primarily out of the US and the UK. These market makers typically have a relationship with several banks on EBS; the larger the trading volume of the market maker, the more relationships it likely has.

Market Hours

Forex is a market that trades actively as long as there are banks open in one of the major financial centers of the world. This is effectively from the beginning of Monday morning in Tokyo until the afternoon of Friday in New York. In terms of GMT, the trading week occurs from Sunday night until Friday night, or roughly 5 days, 24 hours per day. 

Price Reporting Trading Volume

 

Unlike many other markets, there is no consolidated tape in Forex, and trading prices and volume are not reported. It is, indeed, possible for trades to occur simultaneously at different prices between different parties in the market. Good pricing through a market maker depends on that market maker being closely tied to the larger market. Pricing is usually relatively close between market makers, however, and the main difference between Forex and other markets is that there is no data on the volume that has been traded in any given time frame or at any given price. Open interest and even volume on currency futures can be used as a proxy, but they are by no means perfect

Fundamental Analysis

Fundamental analysis refers to the study of the core underlying elements that influence the economy of a particular entity. It is a method of study that attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors (to name just a few elements) within a business cycle framework. 

For forex traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events. Therefore, it is best to get a handle on the most influential contributors to this diverse mix than it is to formulate a comprehensive list of all "The Forex Fundamentals."

• Economic indicators of the currency
• Government Monetary policy
• Employment indicators, especially unemployment
• Consumer spending indicators
• Interest rates
• Inflation
• Social and political forces
• Economic growth rates

Cross Currency Swaps

A Currency Swap is the best way to fully hedge a loan transaction as the terms can be structured to exactly mirror the underlying loan. It is also flexible in that it can be structured to fully hedge a fixed rate loan with a combined currency and interest rate hedge via a fixed-floating cross currency swap.

In a non-deliverable swap (NDS) there is no physical exchange of the two currency flows. Instead, the USD equivalent of the local currency payment (determined at the spot rate on the date of the payment) will be set against the opposite USD payment, with the net paid to the appropriate party.

NDSs are used to avoid transfer risk and to avoid the cost of local market exchange. MFX will contract primarily on an NDS basis.

There are three components in a Cross Currency Swap and the mechanics are as follows: (Opposite USD cash flows will be settled on a net basis.)

For an MIV lending in local currency:

• Initial exchange: The MIV makes the initial loan in local currency or in dollars which the MIV immediately exchanges for local currency.

• Periodic Exchanges: The MIV receives local currency repayments (or the USD equivalent) on its local currency loan and pays them to MFX while retaining its profit spread. In exchange it receives a dollar payment at the agreed LIBOR rate.

• Final Exchange: The MIV receives the principal repayment in local currency (or USD equivalent) and pays it to MFX. MFX pays the MIV the dollar amount calculated at the initial exchange rate for the start of the contract.

For an MFI hedging hard currency exposure:

• Initial Exchange: The MFI exchanges the principal of the loan in hard currency for a local currency principal amount with MFX. The exchange of principal is done at market rates i.e. the spot rate as of the effective date of the swap.

• Periodic Exchanges: Over the life of the loan, the MFI makes interest payments on the local currency principal amount to MFX, and in exchange receives the interest amounts due on the hard currency loan.

• Final Exchange: At maturity, the MFI repays the principal amount in local currency to MFX and in turn receives the hard currency principal amount owed to its lender at the same exchange rate that is used for the principal at the inception of the swap.

Pricing: For a floating-floating currency swap where only the exchange rate is hedged, a market exchange rate (typically, the spot rate as of the effective date of the swap) is used to convert the payment amounts of the local currency into the target currency. The same exchange rate is used for the final principal exchange in the swap.

Interest rate swap terms (fixed for floating) are set so market participants are indifferent between paying (receiving) this fixed rate over time or paying (receiving) a rate that can fluctuate over time. Therefore at origination, the value of the swap equals zero and the present value of the two (expected) cash flow streams equal each other.

Currency SWAP

A currency swap is an agreement between two parties to exchange the principal loan amount and interest applicable on it in one currency with the principal and interest payments on an equal loan in another currency.

These contracts are valid for a specific period, which could range up to ten years, and are typically used to exchange fixed-rate interest payments for floating-rate payments on dates specified by the two parties. 

Since the exchange of payment takes place in two different currencies, the prevailing spot rate is used to calculate the payment amount. This financial instrument is used to hedge interest rate risks.

How Does a Currency Swap Work?

A currency swap agreement specifies the principal amount to be swapped, a common maturity period and the interest and exchange rates determined at the commencement of the contract. The two parties would continue to exchange the interest payment at the predetermined rate until the maturity period is reached. On the date of maturity, the two parties swap the principal amount specified in the contract.

The equivalent amount of the loan value in another currency is calculated by using the net present value (NPV). This implies that the exchange of the principal amount is carried out at market rates during the inception and maturity periods of the agreement.

Benefits of Currency Swaps

The benefits of currency swaps are:

• Help portfolio managers regulate their exposure to interest rates.

• Speculators can benefit from a favorable change in interest rates.

• Reduce uncertainty associated with future cash flows as it enables companies to modify their debt conditions.

• Reduce costs and risks associated with currency exchange.

• Companies having fixed rate liabilities can capitalize on floating-rate swaps and vise versa, based on the prevailing economic scenario.

Limitations of Currency Swaps

The drawbacks of currency swaps are:

• Exposed to credit risk as either one or both the parties could default on interest and principal payments.

• Vulnerable to the central government’s intervention in the exchange markets. This happens when the government of a country acquires huge foreign debts to temporarily support a declining currency. This leads to a huge downturn in the value of the domestic currency.

Risk Associated with Commodities Markets

No risk can be eliminated, but the same can be transferred to someone who can handle it better or to someone who has the appetite for risk. Commodity enterprises primarily face the following classes of risks, namely: the price risk, the quantity risk, the yield/output risk and the political risk. Talking about the nationwide commodity exchanges, the risk of the counter party (trading member, client, vendors etc) not fulfilling his obligations on due date or at any time thereafter is the most common risk.

This risk is mitigated by collection of the following margins: - 

·         Initial Margins

·         Exposure margins

·         Market to market of positions on a daily basis

·         Position Limits and Intra day price limits

·         Surveillance 

Commodity price risks include: - 

·         Increase in purchase cost vis-�-vis commitment on sales price

·         Change in value of inventory

·         Counter party risk translating into commodity price risk 

Key Factors for success of commodity market

The following are some of the key factors for the success of the commodities markets: - 

·         How one can make the business grow?

·         How many products are covered?

·         How many people participate on the platform? 

Key Factors For Success Of Commodities Exchanges

The following are some of the key factors for the success of the commodities exchanges: -

Strategy, method of execution, background of promoters, credibility of the institution, transparency of platforms, scaleable technology, robustness of settlement structures, wider participation of Hedgers, Speculators and Arbitrageurs, acceptable clearing mechanism, financial soundness and capability, covering a wide range of commodities, size of the trade guarantee fund, reach of the organisation and adding value on the ground. In addition to this, if the Indian Commodity Exchange needs to be competitive in the Global Market, then it should be backed with proper "Capital Account Convertibility".

The interests of Indian consumers, households and producers is most important, as these are the people who are exposed to risk and price fluctuations.

Key Expectations Of Commodities Exchanges

The following are some of the key expectations of the investor's w.r.t. any commodity exchange: - 

·         To get in place the right regulatory structure to even out the differences that may exist in various fields.

·         Proper Product Conceptualization and Design.

·         Fair and Transparent Price Discovery & Dissemination.

·         Robust Trading & Settlement systems.

·         Effective Management of Counter party Credit Risk. 

Self-Regulation to ensure: Overview of Trading and Surveillance, Audit and review of Members, Enforcement of Exchange rules.

Option Trading

An option is a contract written by a seller that conveys to the buyer the right — but not the obligation — to buy (in the case of a call option) or to sell (in the case of a put option) a particular asset, at a particular price (Strike price / Exercise price) in future. In return for granting the option, the seller collects a payment (the premium) from the buyer.

Exchange traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among large number of investors. They provide settlement guarantee by the Clearing Corporation thereby reducing counterparty risk. Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions.

OPTION TERMINOLOGY

· Index options: These options have the index as the underlying. In India, they have a European style settlement. Eg. Nifty options, Mini Nifty options etc.

· Stock options: Stock options are options on individual stocks. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement.

· Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

· Writer / seller of an option: The writer / seller of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

· Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

· Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

· Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

· Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

· Strike price: The price specified in the options contract is known as the strike price or the exercise price.

· American options: American options are options that can be exercised at any time upto the expiration date.

· European options: European options are options that can be exercised only on the expiration date itself.

· In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

· At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

· Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

· Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0,K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price. 

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

What is Derivatives?

Commodities whose value is derived from the price of some underlying asset like securities, commodities, bullion, currency, interest level, stock market index or anything else are known as “Derivatives”.

In more simpler form, derivatives are financial security such as an option or future whose value is derived in part from the value and characteristics of another security, the underlying asset.

It is a generic term for a variety of financial instruments. Essentially, this means you buy a promise to convey ownership of the asset, rather than the asset itself. The legal terms of a contract are much more varied and flexible than the terms of property ownership. In fact, it’s this flexibility that appeals to investors.

When a person invests in derivative, the underlying asset is usually a Commodity, Bond, Stock, or Currency. He bet that the value derived from the underlying asset will increase or decrease by a certain amount within a certain fixed period of time.

‘Futures’ and ‘Options’ are two commodity traded types of derivatives. An ‘options’ contract gives the owner the right to buy or sell an asset at a set price on or before a given date. On the other hand, the owner of a ‘futures’ contract is obligated to buy or sell the asset.

The other examples of derivatives are Warrants and Convertible bonds (similar to shares in that they are assets). But derivatives are usually contracts. Beyond this, the derivatives range is only limited by the imagination of investment banks. It is likely that any person who has funds invested, an insurance policy or a pension fund, that they are investing in, and exposed to, derivatives – wittingly or unwittingly.

Shares or bonds are financial assets where one can claim on another person or corporation; they will be usually be fairly standardised and governed by the property of securities laws in an appropriate country.

On the other hand, a contract is merely an agreement between two parties, where the contract details may not be standardised.

Derivatives securities or derivatives products are in real terms contracts rather than solid as it fairly sounds.

Financial New Resources

Top 7 News Sources for Financial Trader

Getting the latest important news is a vital requirement for every Forex, stocks or options trader. The Internet is full of various sites, but not all them feature financial news or provide such news in a timely manner. This list consists of top ten sources for the trader’s news that are updated often and are not mixed up with irrelevant news.

• Bloomberg — the ultimate news source about everything that is in any way related to the financial markets. Categorization by the regions helps in finding important international news.

• Forbes.com Breaking News — a great site to get the recent financial information, it also provides free news from several paid news sources (i.e. Associated Press). Stock market traders will like the coverage of almost all kinds of companies.

• Reuters Business & Finance — Reuters is one of the most professional informational companies in the world and they offer news as a free service to everyone.

• BusinessWeek — they may be too old-fashioned, but BusinessWeek still features some exclusive news content and the very professional analysis.

• Financial Times — I like FT for they are not as US-centered as some other financial news sites, they offer a pretty good world news outlook. Can be recommended as a source of Forex related news if you prefer trading exotic currency pairs.

• CNNMoney — opposite to FT, CNN prefers news from United States, but it’s still good because the majority of world stocks are concentrated on the Wall Street. It will also be useful to the Forex dollar traders.

• CNBC — a "must have" bookmark for every currency trader; news on foreign currency markets are delivered at the top quality level.