Wednesday, Dec 07, 2022

Should you invest in them?

Yes,provided you have the requisite knowledge. A look at the benefits and risks involved in commodity trading using derivative instruments....

Sugar prices are easily going to touch Rs 50 per kg next year if things remain the way they are and if the impasse between UP sugar mills and sugarcane farmers continues. Wheat prices are set to go down,thanks to last year’s record harvest (our granaries are full and we have a surplus) and the recent monsoon spell that bodes well for rabi crops. Gold,on the other hand,shows no sign of taking a breather. First,it was the Reserve Bank of India (RBI) and now the Mauritius government has shown faith in the noble metal (implying lesser faith in the US dollar). Silver,the poor man’s gold,has risen at a scorching pace in recent times. Turmeric has painted the commodities market,well yellow,with its fantastic rise,and chana too has been levitating without an end in sight!

As middle-class consumers,we are always at the receiving end of any price rise. Every year some new development throws our finances out of gear. Either the interest rates on our housing loans rise or the stock markets decline steeply. Sometimes we are hit by the meteoric rise in vegetable prices,and lately,high commodity prices have shrunk our wallet.

Why is the middle class never able to rise from its current morass and become rich? The answer lies in our attitude towards risk and education. In fact,because we are ‘uneducated’ in the field of investment and finance,we try to run away from risk. In the process,we end up living with it — without even being aware of it. It is about time we changed our perspective towards education and assuming risk.

A little knowledge about derivatives would help us reduce risk in a big way and ensure that we earn good returns. Let’s see how:

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Earning from price swings

In school we had learnt that Punjab and Haryana are the grain bowls of India where wheat is cultivated. We were also taught about kharif and rabi crops in school. The green revolution was one of the biggest developments in free India,but our school syllabus gave it a complete miss. And reading beyond the school syllabus is out of question (had we done that,we would not have been in the middle class any longer). Furthermore,not many people think of reading the newspapers,especially the pink papers,as something exciting. Just see how easy it is to make money with the help of applying common knowledge and assuming some risk deliberately.

If we had been reading the newspapers for the last one year or so,we would have been aware that India has ample supply of wheat,so much so that our granaries have 28 million tonnes of wheat where 11 million tonnes is the norm. This would have made it clear to us that wheat prices are set to fall going forward.

Secondly,India had rains in November and this proved to be a boon for wheat sowing. We produced 80.6 million tonnes last year and we are likely to produce 2 million tonnes more this year. This means more wheat supply in the country and hence lower wheat prices. We know that if we are able to sell wheat at Rs 1,450 per quintal and buy it back at Rs 1,380 per quintal,we will make Rs 70 per quintal. If we do it for 10 metric tonnes (MT) or 10,000 Kg (1 quintal = 100 kg and 1 MT= 1,000 kg,so 10 MT = 10,000 kg),we will make Rs 70*100 = Rs 7,000 profit.

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This is where commodity derivatives come into the picture. Although we don’t have 10 quintals of wheat to trade,commodity exchanges allow us to trade in wheat. By selling a wheat futures contract in November 2009,we can promise to sell 10 MT @ Rs 1,450/quintal (this was the actual price in November of the wheat futures contract on the NCDEX expiring in January 2010) at the end of three months. In the interim,when futures prices come down to,say,Rs 1,380 per quintal,we can buy back the wheat futures at the lower price. Thus,we have essentially promised to sell @ Rs 1,450 and promised to buy @ Rs 1,380; which means we have made a profit of Rs 70 per quintal in this deal.

Furthermore,derivatives are leveraged products. To transact in 10 MT of wheat,you don’t need Rs 1,450* 100 = Rs 1,45,000,but much less (around Rs 7,500). Now if you do the mathematics,you would realise that you make close to 100 per cent returns (Rs 7,000 earned on a margin of Rs 7,500) in a single month or even less.

Just a simple awareness about kharif,rabi,rains,wheat and our country’s current situation can help us earn

these returns.

It’s not risk-free

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First,many people confuse risk in derivatives with risk in investing without knowledge. As it is,derivatives are not a product class for those who cannot take risk. But equally true is that people many times don’t understand the concept of risk in the first place. Thus,it is imperative for investors to first understand that losing money,in an attempt to make it grow,is not the only definition of risk. Risk also means not making attempts to make money grow and being content (or being forced to remain content) by having less money in hand than you need.

If you look at the downside,then you could have lost money in the above exercise. Let’s say that instead of promising to sell @ Rs 1,450,you promise to buy at Rs 1,450 and the price goes down all the way to Rs 1,380. This means you have promised to buy something at Rs 1,450,which is otherwise available in the market today @ Rs 1,380. This means a loss of Rs 70 per quintal. So on an investment of Rs 7,500,you would have lost Rs 7,000!

In a nutshell,risk is a part of the game. You either assume it knowingly and have the chance to make money,or you lose money because of lack of knowledge,or do nothing and risk losing the purchasing power of your money due to rising prices.

Derivatives are risky,no doubt,but driving blindfolded (i.e.,investing without knowledge) on Dalal Street is riskier still. Above all,making no effort to make the money in your hand grow is the biggest risk of all.

The author is a professional financial trainer and proprietor of Nagpur-based Money Bee Institute.

Email: ashutosh@moneybee.info

First published on: 23-11-2009 at 03:13:45 am
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