How Does Commodity Options Work?

Did you know that it has been more than a decade since futures contracts were introduced in the commodity market? Yet, the commodity options trading was not permitted till now. The very long wait for the Commodity Options seems to be over, as the Indian market regulator (SEBI) has finally given the go-ahead and issued trading and settlement guidelines for Commodity Options.

Many investors may be already familiar with options and futures. However, commodity options can be a little tricky, since it has certain unique characteristics. To learn more about how Commodity Options work, read on.

What are Hard and Soft Commodities?

Commodities are broadly classified into hard commodities and soft commodities. The soft commodities (like rice, wheat, cocoa, orange juice etc) are grown. Since they can get spoiled, their prices are usually volatile. The soft commodities are popular with producers as they want to lock in the prices.

On the other hand, hard commodities (like oil, natural gas, cotton, aluminium etc) are mined or extracted from other natural resources. Since they are easier to handle and integrate into an industrial process, they are popular with the investors.

Important Terms Of Commodity Options

For every commodity options contract, there will be a buyer and a seller. Following are some important jargons that are relevant to commodity options trading.

  • Option premium– this is the amount that a buyer pays for the option and the amount that the seller receives for granting the option.
  • Underlying– The underlying to a commodity options contract is a futures contract. For example, the underlying of the Gold options contract is the Gold futures contract.
  • Strike price– this is the pre-determined fixed price at which the buyer and seller of an option agree on a contract. It is basically the price at which a buyer can exercise a valid and unexpired option.
  • Expiration date– the specific date until which the commodity option is valid.
  • Money-ness: Moneyness helps option buyers to decide whether exercising will lead to a profit for them. There are 4 types of money-ness. They are In-The-Money (ITM), Out-Of-The-Money (OTM), At-The-Money (ATM) and Close-To-The-Money (CTM).

According to recent reports, SEBI will initially allow each of the three exchanges, MCX, NCDEX, and NMCE, to launch options trading in one commodity with futures trading on the particular commodity as underlying.

Also Read: All you need to know about Commodity Options

Puts and Calls: The Two Types Of Commodity Options

There are two types of commodity options, a call option, and a put option.

Calls – A call option gives the buyer the right to buy the underlying at the strike price on or before the expiration date. Buying a call option is basically a long position, as the expectation is that the underlying futures price will move higher.

For example, if Gold futures are expected to move higher, investors may buy a Gold call option.

Puts – A put option gives the buyer the right to sell the underlying at the strike price on or before the expiration date. Buying a put option is basically like taking a short position, as the expectation is that the underlying futures price will move lower.

For example, if Gold futures are expected to move lower, investors may buy a Gold put option.

Understanding Profit and Loss potential of Commodity Options

There are mainly 4 types of participants in commodity options trading. They are, Call buyer (holder), call seller (writer), put buyer (holder), and put seller (writer). Following are the profits and losses that each of them can incur.

Call buyer: A call buyer has unlimited profit potential as any amount of increase in price above strike price is profitable. The losses of a call buyer are limited, as the maximum loss that can happen is the amount of premium paid.

Call seller: A call seller has unlimited loss potential as any amount of increase in price above strike price causes losses. The profit of a call seller is limited, as the maximum profit is limited to the amount of premium paid.

Put buyer: A put buyer has unlimited profit potential as any amount of decrease in price below the strike price yields profits. The losses of a put buyer are limited, as the maximum loss that can happen is the amount of premium paid.

Put seller: A put seller has unlimited loss potential as any amount of decrease in price below the strike price increases losses. The profits of a put seller are limited, as the maximum profit that can happen is the amount of premium paid.

What Happens On Exercising the Options?

In commodity options trading, at expiration, the buyer has the right to exercise an option.

  • When the buyer of a call option exercises, he will receive a long position in the underlying. For example, on exercising call option of Gold, the investor will receive long positions in Gold futures.

  • When the owner of a put option exercises, he will receive a short position in the underlying asset. For example, on exercising put option of Gold, the investor will receive short positions in Gold futures.

The 2 parts of Commodity Options price

There are two parts of the price of an option, time value and intrinsic value. The sum of intrinsic value and time value must always add up to be equal to the options premium. This should be kept in mind when doing Commodity Options trading.

  • Intrinsic value can be defined as the money that would be credited to the traders account if the option was exercised and the underlying long futures position is immediately sold at the market price. An option will only have intrinsic value if it is in the money.

Example: Assume that a trader has a 1400 call with the underlying market trading at 1435. The intrinsic value of the option is Rs 35 (1435-1400).

Intrinsic Value (Call) = Underlying Price – Strike Price

Intrinsic Value (Put) = Strike Price – Underlying Price

  • Time value is what is left of the options premium. The more time option has from its expiration date, the more time value it will have. The closer the option gets to expiration, the more the time value will decrease.

If the 1400 call has a premium of Rs 5700, then the time value of the option is Rs 2200 (5700-3500).

Time Value = Premium – Intrinsic Value

Factors That Influence the Black 76 Model for Pricing of Commodity Options

A model called the Black 76 model is used for pricing the commodity options. The factors that influence the commodity options prices as per Black 76 model are Underlying price, time until expiration, interest rates, volatility, and strike price.

  • Underlying price

    • When underlying price increases, call prices will increase and put prices will decrease.

    • When underlying price decreases, call prices will decrease and put prices will increase.

  • Time until expiration

    • When there is more time until expiration, both call prices and put prices will increase.

    • When there is less time until expiration, both call prices and put prices will decrease.

  • Volatility

    • When volatility increases, both call prices and put prices will increase.

    • When volatility decreases, both call prices and put prices will decrease.

  • Interest rates

    • When interest rates increase, both call prices and put prices will decrease.

    • When interest rates decrease, both call prices and put prices will increase.

  • Strike price

    • When strike price is higher than the current price, call prices will decrease and put prices will increase.

    • When strike price is lower than the current price, call prices will increase and put prices will decrease.

Also Read: Discipline in Trading: Don’t let the Emotions Flow!

Uses of commodity options trading

Commodity options are used for hedging. It works like a risk management tool to insure against adverse price movement by paying a premium.

Commodity options can also be used for investment, as investors can simply pay a small premium and take exposure to a huge investment opportunity in the commodity.

Conclusion

Commodity options trading can be highly profitable when done with proper risk management. Once you gain the necessary knowledge on trading commodity options, you can also check out the various commodity options trading strategies available like bear put spread, straddle, bull call spread, and strangle.

 

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