All about options trading in commodities

All about options trading in commodities

Options trading in commodities is widespread globally with major exchanges like CME, NYMEX, LME and ICE offering options on commodities ranging from gold to oil to industrial metals. After a 13-year long gestation, Indian commodity markets launched options in Gold, opening new avenues for trading and hedging. However, it is important for traders/speculators and investors to understand options trading in commodity markets as the expiry process is different from that of equities and Forex.

Broadly, there are two types of commodity options, a call option and a put option, similar to what we have in equities and Forex. There are two sides to every option trade, a buyer and a seller. Each of these sides experiences the opposite outcome; if the option buyer is making money the option seller is losing money in the identical increment, and vice versa.

Talking about gold options – A refiner/ Jeweller can sell out of the money options against their inventory, if they are willing to accept considerable amounts of risk with the prospects of limited reward, can write (or sell) options, collecting the premium. The premiums might be small on an absolute basis – but your inventory can pay you returns and generate additional income. On the other hand, an option buyer is exposed to limited risk and unlimited profit potential, but faces inherent risk like with any form of speculation.

When to use Commodity Options?

A decision about buying or selling any option depends on your view of the market and your desired objective. A trader may look at options differently compared to a commodity producer looking to hedge his price risk. A hedger would be interested only in protecting his margins by mitigating price risk while a speculator is interested in profiting out of market moves.

Advantage of options

There is no mark to market margin calls for option buyers since they pay premium upfront to the option seller.

Cost is lesser than taking a futures contract, returns are relatively higher and maximum loss is limited to the premium or price of option, unlike in futures where returns are high and losses can be unlimited.

Options are also more flexible and an option holder can participate fully in any price movement

Options represent a form of price insurance, the cost of which is the option premium determined.

What’s different in commodity options?

Unlike equities, commodity options are on futures and not on spot. If you are trading Nifty options, your underlying is Nifty SPOT and not Nifty Future, and that the same for any equity stock option also, but in commodities, gold options are on MCX Gold futures and not gold spot prices. The underlying for MCX Gold Futures is gold price on the COMEX. So, we are actually trading a derivative of a derivative.

Strikes and Settlement

There will be a total of 31 strikes available for trading for every contract launched. Considering one ‘At the money strike’ (ATM), there would be 15 strikes above and 15 strikes below ATM. Expiry of option contract will happen three business days prior to the first business day of Tender Period of the underlying futures contract, with Settlement of premium on T + 1 day basis.

Exchange shall levy pre tender margin on the long buy positions entering the option tender period, which starts 2 days prior to option expiry day, and the settlement will happen on Daily settlement price (DDR) of underlying futures contract on the expiry day of options contract.

Exercise mechanism at options expiry

CE Option

Strike Price

Effect

ITM

29400

Shall be exercised automatically unless ‘contrary instruction’ given

ITM

29500

CTM

29600

Shall be exercised on ‘explicit instruction’ by the buyer

CTM

29700

DSP/ATM

29800

CTM

29900

CTM

30000

OTM

30100

Shall expire worthless

OTM

30200

Options to Future – the devolvement

ITM and CTM’s on expiry of the options can be converted / devolved into a Futures position. Margins will have to be topped up into your account to convert your ITM’s and CTM’s into futures called the Devolvement Margin. This will be in 2 tranches, one to be paid before the option expiry day and other on the expiry day.

On expiry of options contract, all open position shall devolve into underlying futures position:

long call position = Long Future

long put position = Short Future

short call position = Short Future

short put position = Long Future

Is Physical delivery Optional?

Yes, physical delivery is optional. Commodities like gold are deliverable on the MCX, if you choose to keep your position open when the tender period begins. But the option holder has a choice to square off the position and book gains/losses if any.

To sum it up, launch of options in Indian commodity markets will increase participation and enhance liquidity in the markets. Producers, traders and processors, exporters/importers get an online platform for price risk management. It provides a platform for producers to hedge their positions according to their view of the prices.