All you need to know about Commodity Options

The countdown has begun! Ever since the welcome announcement from SEBI permitting options on commodities, traders and hedgers across India have been keenly waiting for it to hit the market. Although options trading has always been an integral part of F&O market and equity market, for commodities, it was limited to just trading in futures. With the month of October finally looming closer, here is all that you need to know about Commodity Options Trading.

What are Options Contracts?

Let us first understand what a basic Options contract is, as Commodity Options contract is quite similar to it. Like futures contracts, Options are also a type of derivative contracts. This means that its value is derived from something else.

An options contract is basically an agreement between a buyer and a seller.

  • It gives the buyer a right (but not obligation) to sell or buy the underlying instrument at a specified price on the future date.

  • The underlying instrument can be stocks, commodities, index, real estate, interest rate etc. The price at which the underlying asset trades in the spot market is typically called as the underlying price.

  • The specified price at which the underlying can be sold or bought is called as the strike price. There are typically three types of strike prices, At the Money (ATM), In the Money (ITM) and Out of the Money (OTM).

  • The last day till the validity of the options contract is called expiry date.

  • An upfront fee that should be paid by the buyer to buy the right to exercise his option on the seller is called the premium.

Also Read: Insights into Commodity Trading

Types of Options Contracts

  • Based on the right of the holder, Options contracts are classified into Put option and Call option.

    • A Call option is an option to buy the underlying at a specific price on or before a certain date.

    • Put options are options to sell the underlying at a specific price on or before a certain date.

  • Based on the date on which the buyer can exercise his option, Option contracts are classified into European and American Style.

    • American Style option contract: Here, the buyer can exercise his option at any time from the purchase date to the expiry date of the option contract. They have a higher premium and gives greater flexibility.

    • European Style option contract: Here, the buyer of the option can exercise his option only on the expiry date of the contract.

Now that the basics of Options contracts are covered, let us focus more on the Commodity Options Trading.

Commodity Options: Important Characteristics You Should be Aware Of

Commodity options are quite like the regular options. However, there are also certain differences between the two of them. Below is a quick overview of the characteristics of commodity options.

1. Underlying: For regular options, the underlying is the spot price of that instrument. For example, if you are trading Nifty options, the underlying will be the value of Nifty 50 index.

However, Commodity Options are options on Futures and not the spot market. This means that it would be like the derivative of a derivative.

For example, if you are doing Commodity Options Trading of Crude oil, the underlying for the option is Crude oil Futures. The underlying of Crude oil futures is, in turn, the price of Crude Oil on NYMEX.

2. Premium Calculation: The calculation of the premium varies for regular options and commodity options. For regular options, the premium is calculated by Black & Scholes model. For Commodity Options, Black 76 model is used for premium calculations.

3. Lot Size: The lot size of Commodity options will be similar to the futures lot size as they are options on futures.

4. Exercise Style: European style

5. Devolvement: Whenever options contracts expire, they get devolved into the corresponding futures contract if they are not squared off.

   a. Long Call gets devolved into Long Futures

   b. Short Call gets devolved into Short Futures

   c. Long Put gets devolved into Short Futures

   d. Short Put gets devolved into Long Futures

6. Expiry: While the options and futures of equities expire on the last Thursday of every month, the expiration of commodity options would happen a few days before the expiry of the corresponding futures. This is done to help in the development of the commodity options into commodity futures. The last trading day of Gold will be 3 days before the last tender date. Gold options are expected to be launched by Diwali this year.

7. Option Moneyness: There are 4 option moneyness in the case of commodity options trading. They are At the Money (ATM), Out of the Money (OTM), In the Money (ITM), and Close to Money (CTM).

   a. ATM – The strikes closest to the settlement price is considered ATM

   b. CTM – Two strikes above and two strikes below ATM are considered CTM

   c. OTM – All call option strike above the ATM and all put option strikes below the ATM

   d. ITM – All call option strike below the ATM and all put option strikes above the ATM

8. Margins: Whenever the options get devolved into futures after expiry, the regular margins that are applicable in the case of futures trading would apply.

Also Read: How To Invest in Gold?

The Top Reasons Why Commodity Options Trading Is a Good Thing

The introduction of commodity options have quite a few benefits.

  • Options are better tools for trading and hedging compared to futures. This is because of the cheaper cost and limited losses for the buyer. Hence, they work as a great risk management tool.

  • Sophisticated investors can create a variety of hybrid payoffs by combining options trading and commodity futures.

  • Commodity Options writing offers an additional source of income for banks and institutions.

  • In the case of futures contract, you will need to pay an initial margin as well as mark-to-market margin according to the volatility in market price. This is not required for commodity options.

  • Commodity Options will bring in more investors and help in deepening the market. Thus, there would be improvements in the volumes, enabling better price discovery.

SEBI is starting off commodity options with just one agriculture and one non-agriculture commodity, whose numbers would later be expanded. However, the bottom-line remains that the introduction of Commodity Options Trading is the small first step to a great leap forward!

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