Commodity Options: Learn the Basic Details

The Securities Exchange Board of India (SEBI) approved commodity options trading in 2017 after facing massive demand from investors and trading members. However, until then, investors could only participate in direct trading of commodity futures.It was hailed as a momentous decision, especially because commodity trading has been a crucial part of our economic history since immemorial. The commodity option is a relatively new financial product in the Indian market 

Here, we will explore the basic details of commodity options. Before getting straight into it, it is crucial to understand some fundamental aspects of options.

 What Are Options? 

Options are a type of derivatives, i.e. financial products whose value depends on the underlying instrument’s value. The example of underlying instruments ranges from stocks, a currency, an index, a commodity to any security. 

An options contract is a financial contract that provides the buyer with the right to buy or sell the underlying asset at a pre-fixed price within a specific period. Unlike futures, option holders have relatively low holding risk as the option gives them the right but not an obligation to fulfil the underlying terms.

The seller and buyer of an options contract are popularly referred to  as the ‘option writer’ and the ‘option holder’, respectively. Now that we understand what options are, let us explore commodity options.

What Are Commodity Options?

Commodity options provide the right to its holder to purchase or sell underlying commodity futures at a predetermined price and within a fixed time period prior to the expiry date. There are two main kinds of options based on the exercise date and the terms of exercise: American and European. 

People can exercise the right to sell or buy any time before the expiry date in the case of American options. But, when it comes to European options, one can buy or sell the options contract only on the expiry date. Commodity exchanges in India permit only the European style of options trading.

The first Indian commodity options contract was launched for gold on October 17, 2017. Soon after receiving SEBI’s permission, the Multi Commodity Exchange of India (MCX) introduced commodity options contracts in crude oil, silver, natural gas, copper, nickel and zinc.

MCX is India’s first recognised platform for commodity exchange and is owned entirely by the Government of India. Forward Markets Commission (FMC) was initially regulating MCX, and eventually merged with SEBI in September 2015. Since then, SEBI has been regulating this commodity exchange.

Features of Commodity Options

Listed below are the essential features of commodity options: 

• A commodity future is the underlying security of a commodity options contract.
• Commodity options come with an expiry date of three business days before the tender delivery period of its underlying commodity futures. In the case of natural gas and crude oil, however, options expire two days before the expiry of the underlying futures. 
• With the introduction of commodity options, commodity futures traders get to participate in the commodity markets through another avenue. 
• Commodity options carry less downside risk than commodity futures. For instance, only the premium amount will be at risk for the option buyer if they let the contract lapse. It encourages many small investors and traders to participate in the Indian commodities market. 
• Commodity options allow traders to create different hybrid products, for example,  a synthetic position that seeks to optimise the arbitrage between futures and options written on the same commodity underlying.

Rules of Commodity Options Trading in India  

Given below are a few essential rules that traders need to be aware of: 

• Commodity exchanges can offer commodity options only on those commodities who’s futures are actively traded.
• The options have to be squared off before the futures’ delivery period starts. Otherwise, In-the-Money (ITM) contracts will devolve into futures contracts.
• Agri-commodities must have a minimum turnover of ₹200 crore per day to be eligible for commodity trading. Non-Agri commodities must have a daily turnover of ₹100 crore. 
• Traders can reverse their position in commodity options by adopting a contrary position in the market. There are no limitations regarding reversing open commodity option positions during trading hours.

Commodity Call and Put Option 

Based on the nature of option holder’s rights, there are two types of commodity options — call and put options. 

1. Call Option

A call option gives an investor the right to purchase a financial instrument at a specified price within a particular timeframe. A call option buyer exercises his right when there is inherent value, i.e. when the strike price is significantly lower than the commodity future contract’s price. 

2. Put Option

On the other hand, a put option enables an option holder to sell off an underlying financial instrument at a specified price within the expiry date. It is lucrative for a put option holder to exercise his right to sell when the strike price is significantly higher than the spot price.

Benefits of Commodity Options Trading 

Listed below are the benefits of trading with commodity options:

• Commodity options can prove to be the most ideal hedge against inflation.
• Commodity options act as a hedge against the unpredictability and volatility of commodity markets, thereby limiting the magnitude of loss (if any). 
• They are useful risk-management tools for traders as options have lesser downside risks in comparison to other forms of direct exposure to underlying.
• Traders benefit from exposure to high trade values by placing a minimal amount as a margin. Therefore, even a small price change can lead to significant gains. 

Limitations of Commodity Options Trading 

Leverage facilities can play against you in the case of adverse market movements. Large losses through deployment of a small margin is how this manifests.

Does Commodity Options Trading Involve High Risk? 

Every investment involves a certain amount & distinct variety of risks, and commodity trading is no different. Financial experts have advised potential investors to assess their risk profile before beginning commodity trading. It involves high risk because of underlyings’ price volatility and margin facilities.

Commodity options trading is most suitable for experienced investors and traders who understand the market well. However, it is advisable for beginners to open a commodity trading account and learn the rules of position sizing of other things before trading. 

Final Thoughts 

Commodity options are a new financial product in the Indian market and are increasingly becoming popular among the larger mass of retail investors. Traders should assess their risk profile before getting into commodity options trading.

Frequently Asked Questions (FAQs)