Chapter 4: Understand the Commodity Indices in Detail

You might already be trading in the equity market regularly and investing in a number of instruments such as indices and stocks in the form of cash, Futures and Options. When it comes to equity index, the most popular indices are Nifty, Bank Nifty, Sensex and also a few sectoral indices such as Auto, Bank, IT, Metal, to name few. Likewise, the commodity market also has sectoral commodity indices such as BULLDEX, (comprising Gold and Silver), ENRGDEX (comprising Crude oil and Natural gas) and METLDEX (comprising Aluminium, Copper, Lead, Nickel and Zinc).

Indices are among the most effective investment tools for retail participants as an index captures the collective movement of its constituents. Considering the success of indices against individual securities in the stock market and upon demand from commodity market participants, the regulator permitted launching of sectoral commodity indices in 2019.  

In the following sections, you will learn all about commodity indices in detail.

What is Commodity index 

In India, commodity indices are different from equity indices as they are built using commodity Futures rather than the underlying Spot prices of commodities. Equity indices such as Nifty and Sensex are built using the cash market.

Commodity Index Future returns also need to take account of the return (or loss) that is made in moving from one Futures Contract to another, known as the ‘roll return’. This roll return (or loss) arises because a Futures Contract approaching expiry needs to be settled and a new position has to be opened in a contract with a longer term to maturity. This is required to maintain an exposure without accepting the physical delivery of the commodity. The difference in the values of the two contracts creates roll return, which may be added (or, in the case of a loss, subtracted from) the actual returns. When the next Futures Contract price is above the Spot price – a situation known as ‘contango’ arises – the roll return will be negative. When the Futures price is below the Spot price, this situation is known as ‘backwardation’. In this scenario, the investor receives a positive roll return.

Due to this, the commodity index features an excess return component. As a result, commodity indices are called as ‘Excess Return Indices’.

Following are some popular commodity indices across the world. These indices are mostly utilised for benchmarking the market. They are not actively tradable instruments.

1. S&P World Commodity Index
2. CME Commodity Index
3. Bloomberg Commodity Index
4. Thomson Reuters CRB Commodity Index
5. Rogers International Commodity Index
6. Dow Jones Commodity Index

After the merger of FMC with SEBI, the SEBI permitted the launch of sectoral indices for trading and accordingly, MCX launched their sectoral indices as follows:

1. BULLDEX
2. METLDEX
3. ENRGDEX   

Index construction and its constituents

After having understood the basics of commodity indices, you might be curious to know the composition of different commodity indices. All the above-mentioned commodity indices are formed on the basis of Futures Contracts in different underlyings traded at the MCX and not on the Spot market.

The securities market regulator, SEBI, vide its circular dated 18June 2019 provided a detailed guideline for construction of commodity indices at Indian exchanges. Please click here for the SEBI circular.

As mentioned above, MCX has launched three sectoral commodity indices. Let us look at the composition of these three indices.

As a retail participant, you may use the commodity indices effectively to trade in all the commodities that are part of the indices. Further, a number of trading strategies could be formulated using a commodity index and underlying commodity Futures.

Trading in index Futures

Indices are created using values derived from price changes in underlying securities, commodities, or contracts. The value of these indices is also affected by changes in prices of the underlying. Anything that has the potential for its value to change creates trading opportunities in derivatives such as Futures and Options.

Commodity index trading hours are the same as Futures Contracts of its constituent commodities and therefore, an unnecessary arbitrage opportunity does not arise. On the day of expiry of Index Futures, it will trade up to 5.00 pm.

Since commodity indices are constructed on Futures Contracts of commodities, they also have circuit breakers or Daily Price Limits (DPLs). DPLs are similar to that of underlying commodities. For example, the first level of DPL is 3% and if the market breaches this level, then a relaxation will be allowed up to 6% without any cooling off period in the trade.

After 5:00 pm on the day of expiry of Index Futures, the Final Settlement Price (FSP) of the index is decided. It is calculated using a weighted average traded price of its components' Future Contracts between 4:00 pm to 5:00 pm on the day of expiry.

Uses of index Futures

An index is a representation of the overall market level, as well as a specific subject or index level. NSE's Nifty and BSE's Sensex, for example, represent the large cap category, NSE's Pharma index denotes healthcare stocks, and NSE's Nifty 500 index represents the broad market at a composite level.

A strong commodity index, on the other hand, represents broad market levels and serves as a measure of market mood for underlying commodities/sectors. For example, the MCX BULLDEX measures sentiment in the precious metals market, while the NCDEX AGRIDEX measures movements in the listed agriculture market.

Indices are used for various purposes as mentioned below:

Portfolio diversification:

There are different asset classes available for investors to invest such as stocks, commodities, currencies and bonds. It is always advisable to diversify one’s investment to get maximum benefits as most of these asset classes are not strongly correlated with each other. Commodity indices provide an option to index-based traders to investing in commodities as well.

Hedging:

Hedging could be done with an index based on general sentiment levels within a market or market segment. For example, a construction company that requires various metals could hedge by buying each metal's Futures or buying metal Index Futures.

Institutional players:

Institutional players such as mutual funds and Portfolio Management Services (PMS) are allowed to create schemes that include commodity exposure. Only gold was authorised until recently, and it had to be listed as a Gold Exchange Traded Fund (ETF) after funds were mobilised in the schemes. Because index derivatives are now available, these players can gain direct exposure to commodities through Commodity Index Futures.

Investment in multiple commodities through single contract:

Since indices consist of many constituents, the price movement in different constituents or commodities is reflected by a single commodity index. This makes it easy for investors to invest hassle-free investments in multiple commodities through a single instrument. 

Risk diversification:

Rather than investing in single or multiple commodities, investors can opt for investing in the commodity index, thereby diversifying the risk.

Summary

• Commodity indices are among the most suitable derivative instruments for both a novice and an experienced retail participant.
• Commodity indices capture the collective price action of their constituents, making them effective trading instruments.
• Commodity indices could be used for portfolio diversification and hedging by institutional participants such as mutual funds.
• Since commodity indices are cash settled contracts, there is no risk of the position entering into delivery mode.
• Different types of trading strategies could be formulated using index, Futures and Options.
• MCX has launched three sectoral commodity indices namely BULLDEX, METLDEX and ENRGDEX.

In the next chapter, you will learn about clearing and settlement of commodity derivatives, entities involved in the process, the delivery process, premium/discount and delivery defaults.