What is a commodity index and how does it function?

A commodity Index is an investment tool that helps you track the price of a basket of commodities. The value of this index fluctuates based on the value of the underlying commodities. These commodities can be either agricultural commodities like cotton, rubber and crude palm oil or non-agricultural products like energy, metals and bullion. Just like equity indices, commodities can be traded on the exchanges. There are several major commodity indexes like the S&P Goldman Sachs Commodity Index (S&P GSCI), the Bloomberg Commodity Index and the Thomson Reuters CRB index. In India, the popular commodity indices are MCX iCOMDEX, MCX Bulldex, MCX Metldec and MCX Enrgdex. Trading on these indices happens both in future contracts and in options.

How does a commodity index differ from other indexes?

A commodity index is different as the total return is entirely dependent on the price performance or capital gains of the commodities in the market. Unlike bonds or mutual funds, which offer periodic returns in the form of dividends or interests, commodities do not have such an option. If the price of a specific commodity does not increase, the investor will get zero return on his investment.

The indices are weighted, meaning each commodity makes up a certain percentage of an index.

How is trading done on a commodity index?

In India, commodities trading is allowed in both future contracts and options. Earlier, the trading was available only in futures, but the Securities Exchange Board of India (SEBI) opened up the indices to options trading as well earlier this year. It is to be noted that in India, commodity options are on futures and not on spot prices.

As per the Multi Commodity Exchange (MCX) website, right now only European style commodity options trading is available in India right now. This means that the buyer can choose to exercise their option only on the date of expiration of the contract.

Apart from that, buyers can buy stocks of a company that invests in commodities, if they do not want to take part in futures or options trading but want to diversify their portfolio by investing in commodities.

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