What are Commodity Options?

Commodity options or commodities options are a fairly new product in India and came much after the advent of futures. The commodity options are essentially options on commodity futures, unlike stock options which are options on the spot. Let us look at what are commodity options and what the entire commodity options mean. Remember, when you use the commodity options definition, you are talking about options on futures and not options on the spot.

Commodity options are structured like any other option on an index or stock in that the buyer has limited risk and the seller of the option has unlimited risk. In India, commodities options are a new introduction and are currently offered as options on commodity futures. That is more because the current regulator of the commodity market is not permitted to offer options directly on spot commodities and hence it offers commodities options on the futures contracts. We will understand this commodity options interplay with commodity futures in much greater detail.

What are Commodity Options?

We have already spoken at length about the concept of commodity options and why these commodities options can add value. Here is a point-wise look at how these Commodity Options are a value addition for the clients…

1. Commodity options offer traders in the commodity futures market an additional avenue to participate in the commodity markets. For a long time, it was only futures and now they also have an add-on as options. Since its inception, commodity exchanges have been only permitted to offer commodity futures and this widens the offering. Remember, equity markets built their derivative volumes only after options were permitted in a big way.
2. Unlike futures which are symmetrical to the buyer and the seller, options have limited downside risk. For example, if you are the buyer of the option, then your loss is restricted to the premium paid. This will entice a lot of small traders and investors to participate more actively in commodities thus broadening the market.
3. Commodity options offer the facility of a variety of additional hybrid products. For example, a trader can create an arbitrage between the future and the option. The trader can also create a spread between two options having different maturities as well as pair trades. Eventually, it will also encourage the development of an arbitrage market between spot and options.
4. In the equity markets, options account for nearly 80% of the daily volumes. Volumes in the equity markets expanded only after options were introduced. The introduction of options could have a similar salutary impact on commodity markets too.

Getting a hang of options on commodities in India

The largest commodity exchange in India, MCX, has indicated that the exchange will be ready to launch commodity options within the next 3-4 months. It is necessary to understand the nuances of the product.

• SEBI has laid down strict guidelines for the inclusion of commodities in options. Commodity exchanges can only offer options on commodities where the underlying future is traded on that exchange. One of the conditions is that the commodity should be among the top-5 commodities in terms of volumes and value of the commodity contract in the last 12 months. That is the precondition for the inclusion of the commodity in options.
• The average daily turnover of the commodity must have been at least Rs.200 crore per day in the case of Agri commodities and Rs.1000 crore per day in the case of non-Agri commodities to be eligible for commodity trading. In addition, the average of the last 12 months' trade will be considered for this purpose.
• Each commodity will have 3 option contracts at the very minimum of which 1 will be out of the money (OTM), 1 will be at the money (ATM) and 1 will be in the money (ITM). All commodity options, to begin with, will only be European-style options. Just to recollect, these European options can only be exercised/devolved on the expiry date and unlike American options cannot be exercised at any time during the tenure of expiry.
• Like commodity futures, commodity options can also be reversed by taking a contrary position in the market. There are no restrictions on reversing commodity option positions in the market during trading hours. For example, if you are long on the call option, you can reverse the position by selling your call option. Similarly, if you have sold a put option, then you can reverse the position by buying a put option. Doing so will result in the net commodity options position becoming zero. This will, of course, be subject to the availability of liquidity in the market.
• The logic of margining commodity options positions will be broadly similar to equity options. On the one hand, the buyer of the option will only pay the premium margin but the seller of the option will be required to pay the initial margin as well as the mark-to-market margin daily depending on price movement.

Unique features about exercise and devolvement of commodity options

Reversing your commodity position is quite straightforward. If you are long on-call or put, just sell the option and it is closed. Similarly, if you have written a call or a put, then just buy it back and the position stands closed. However, an excise of options will be a lot more complicated and this process needs to be understood in detail about commodity options.

That is because commodities options will not devolve into the commodity but commodity futures. That is the difference. While SEBI regulates commodity futures, it does not regulate the spot market as it comes under the purview of the state government regulation. Hence all exercised commodity options positions will necessarily devolve into futures of the same commodity, with the options strike price as the theoretical futures price. This is the unique point about the devolvement of commodities options.

Here is how the devolvement would practically be in the case of commodity options. So if you are a long on-call option or short on the put option, then when exercised it will devolve into a long futures position on the same commodity. On the other hand, if you are long on a put option or short on the call option, then when exercised it will devolve into a short futures position. From that point onwards, all normal futures margins will apply to the position.

Commodity options expiry/devolvement creates the challenge of asymmetry

This is a unique challenge that is likely to come up in the case of commodity options. Since the exercised commodity options will devolve into commodity futures, the commodity options will require a separate expiry that will have to be scheduled before the commodity futures expiry. In addition, it must be remembered that any devolvement will lead to an increase in the open interest of commodity futures and will have to be unwound if the OI exceeds the prescribed limits. That is a unique challenge that it poses.

But the bigger challenge will be position asymmetry. Let us understand this a little better and what it means and implies! Consider a situation wherein a person buys a call option because they want to take limited downside risk and margin liability. When it devolves into a long future the trader is required to take up unlimited risk as well as margin liability. For a person who has sold a put option, margins may not be the issue as they are already paying margins on a short option position.

However, a trader sells a put option because they do not expect the market price to go below a certain level. Converting that view into a bullish long futures position will skew the trader’s original trading intent. The bottom line is that the devolvement may be discouraging for the long option holder and the option writer as it skews and diverges from their core view.

Commodity options mark a good start for commodity markets and they will broaden the availability of trading options to the traders. It gives a better hang of risk management to the traders. The onus is now on the exchanges and the brokers to take this product to the traders and gradually take it to the next level.

How to start option trading?

Here are a few simple steps to options trading.

• Open a trading account and activate online trading
• Ensure that F&O trading is activated in your trading account
• Identify and make a list of stock options/index options you want to trade-in
• Ideally start with index options that are easier to estimate and more liquid
• Then limit yourself to around 10-20 very liquid stocks
• Don’t go for very deep OTM options. Stick to ATM or just OTM options

Benefits of options trading?

Options trading gives the benefits of trading on margins by paying a small portion of the price. IT can help to replicate cash market positions at a much smaller upfront payment.