In a historic decision for the Indian commodity derivative market, in 2017, after a lot of demand from trading members, market regulator SEBI (Securities and Exchange Board of India) approved options trading in commodities (futures). In October 2017, options trading on gold (1 kg lots) futures were allowed, making it the first commodity option to be traded on Indian bourses. But what is commodity trade option or commodity option ?
Commodity Trade Option
To understand what a commodity option is, it first helps to understand what an options contract is.
Options are rights (and NOT an obligation) to buy or sell an underlying security at a prefixed price also called the strike price on a specific day, which is the day the contract expires. There are two types of options-American and European styled options-based on when the right to sell or buy can be exercised. While in American options one can exercise his/her buying or selling right before expiration, in European options , one can only exercise the right solely on the specific date that is the date on which the option contract expires. In India, only European style options are traded, and options contracts expire on the last Thursday of every month.
How do options work?
In options trading, the risk is limited for the buyer of the option and profit potential is unlimited. This is because, the buyer of an option can choose to exercise his/her right to buy an underlying asset at the strike price on the day the contract expires if the strike price is lower than the current market price, which limits his risk of losing money. If the buyer does exercise his right to buy at the strike price, then the seller must execute the trade at agreed terms.
For the seller or underwriter of an option contract, the profit comes from the premium charged for writing the option, which he pockets in any event, whether or not the buyer exercises his right to buy. The sellers or underwriters ride on the notion that most options contracts expire worthless without being executed by buyers.
What are Commodity Options?
Commodity trade options contracts are rights to buy (call option) or sell (put option) underlying commodity futures at predetermined prices on the date of contract expiry. It is important to note that, unlike in equity options where options involve rights to sell or buy shares of companies at pre-set prices, it works a bit differently for the commodity trading space.
In India, market regulators mostly exclusively allow options trading in the commodity futures market and not the commodity spot market because in India the spot or cash market in commodities is regulated by state governments while the SEBI only regulates the commodity derivatives market.
What is a call option on trading commodities?
A call option gives the owner a right to buy the underlying commodity futures at a fixed price or the strike price on the date of the expiry of the contract. The buyer of an option is said to go long on an option. If the buyer chooses to exercise his right to buy, then on the date of expiry, the options contract devolves into the futures contract.
A buyer of a call option will only execute his right when there is intrinsic value; that is, the strike price is lower than the prevailing price of the commodity futures contract.
Commodity Option Pricing: How does a commodity call option work?
Let us understand commodity option pricing, especially a call option with an example.
Suppose trader G is bearish on the prices of one-month gold futures currently trading at Rs.1500 per lot, expecting the prices of underlier to fall. He enters into a one-month Gold Call Option at a mutually agreed strike price of Rs.1150. He pays a premium of Rs. 50 to the underwriter for the options contract.
Now on the date of contract expiry, trader G finds his bets have gone right. Because G would like to buy low, if the current price of the 1 month gold futures trades anywhere higher than Rs.1150, at say Rs.1350 per lot, trader G will go ahead and exercise his buying rights and convert the options to a one month futures contract at the strike price, while making a neat profit of Rs.200. The buyer of the option is said to be In The Money (ITM) when the strike price is lower than current market prices. The underwriter of the option in this event will be obliged to honour the contract.
In another market scenario, if the market price of one-month gold futures is trading even lower than the strike price of Rs.1150, at say, Rs. 1000, then the buyer of the option can choose not to exercise his right to buy at the strike price. The contract would expire worthless without being exercised. The only loss for trader G would be the premium he paid to the underwriter.
What is a commodity put option
A commodity put option gives the owner the right to sell underlying commodity futures at a preset price once the contract expires on a fixed date, which is last Thursday of the month.
One can also sell or underwrite a put option on commodity futures, which could expose him/her to pricing risks because if the buyer chooses to exercise his right to purchase the underlying contract, the underwriter will have to honour his side of the deal. But the underwriters’ reward lies in the premium they receive on such put option commodity trades since the belief is, most options contracts will go worthless on the date of expiry when the strike price is higher than current prices.
Commodity Option Pricing: How does a put option on commodity trades work?
Let us assume trader H is bullish on the prices of one-month gold futures and he expects prices to further rise from the current levels of Rs.1500 per lot. He could buy a one-month gold put option at a strike price of say Rs.1700 after paying a premium to the underwriter. The buyer of the option would always look at booking the option contract at a strike price that is on the higher end of his market expectations.
Now, much to trader H’s joy, one month after the contract was entered into, the trader finds that current prices of one-month futures are trading at Rs.1650. Then he would exercise his right to sell the underlying one-month gold futures at the strike price of Rs.1700 and pocket a gain of Rs. 50, which is the intrinsic value, over the prevailing market price of the futures. The trader is said to be In The Money on the put option when the strike price is higher than the current usual price, and the intrinsic value is greater than zero.
But what if the markets turn aggressively bullish and trader H finds on the date of options expiry, one-month gold futures trading at prices even higher than the strike price, at say Rs.1750? In that case, trader H can choose not to exercise his put option or the right to sell the underlying one-month gold futures at the strike price of Rs.1700 where he stands to make a notional loss of Rs.50. This way, by not exercising his right to sell, the owner minimised his losses. He only loses the premium amount.
What are the advantages of commodity trade options contracts?
- Since commodity option contract buyers pay a premium for these contracts, they are not required to maintain mark to market margins.
- Buying put options in commodity trades is a great way of taking a short position in the futures while minimising risk. One can choose not to exercise the right to sell if current prices of the futures contracts are higher than the strike price. The stakes are much higher in the futures as they involve compulsory delivery.
- Options work out cheaper than futures contracts in terms of returns and risk mitigation as one has only to pay the premium if the rights to buy or sell the underlying asset at pre-set prices are not exercised.
- Experts term options as a type of price insurance in a somewhat volatile commodity derivatives market where one can take advantage of the price volatility on both the directions to hedge one’s pricing risks.