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Commodity Options in Indian Derivatives Market

Updated : 2019-05-06 21:05:55

Introduction of commodity options created another milestone in the history of India’s commodity derivatives. On October 17, 2017, trading in options contract with Gold (1Kg) futures contract as the underlying was launched, which was India’s first commodity option contract. Later, other commodity options were also launched. Notably, launch of commodity options trading have come after persistent demands for product ever since the national commodity derivatives market was allowed in India. The same is also evident from the ever rising volume and turnover numbers of commodity options since its launch, with an average daily turnover surging up to 704.7 crores in FY19 from 90.5 crores in FY18. .

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Commodity option contract, with futures contract as its underlying is similar to a stock, interest rate or currency futures contract. A commodity option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell the underlying asset. As the option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. Therefore, option buyer/ holder will exercise his option only when the situation is favourable to him, but, when he decides to exercise, option writer would be legally bound to honour the contract.
Commodity option contract, with futures contract as its underlying is similar to a stock, interest rate or currency futures contract. A commodity option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell the underlying asset. As the option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. Therefore, option buyer/ holder will exercise his option only when the situation is favourable to him, but, when he decides to exercise, option writer would be legally bound to honour the contract.
To explain the concept though an example, assume an exporter wants to a buy huge quantity of a metal and he finalizes the deal at Rs 30,00,000, by paying a token amount or a security deposit of Rs 2,00,000 to the seller. He commits to pay the full amount after a month and take delivery. After a month he makes the full payment and takes delivery. However, if during the month, if he decides to dishonor the deal, because of fall in the price of metal, the initial token amount he paid to the seller will be retained by the seller.
To explain the concept though an example, assume an exporter wants to a buy huge quantity of a metal and he finalizes the deal at Rs 30,00,000, by paying a token amount or a security deposit of Rs 2,00,000 to the seller. He commits to pay the full amount after a month and take delivery. After a month he makes the full payment and takes delivery. However, if during the month, if he decides to dishonor the deal, because of fall in the price of metal, the initial token amount he paid to the seller will be retained by the seller.
In the above example, at the end of the month buyer had the option of buying or not buying but the seller was under an obligation to sell at the deal price. In the given example, during the month metal prices dropped. So, the buyer was ready to lose the initial token amount he had paid to seller and did not exercise his right. Assuming, if the price of metal would have surged, he would have certainly exercised his right and bought the metal at the deal price. Therefore, by paying the initial token amount, he got a choice/ option to buy or not to buy the metal after a month. Similarly, a commodity option contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset. While the option seller has the obligation in the contract.
In the above example, at the end of the month buyer had the option of buying or not buying but the seller was under an obligation to sell at the deal price. In the given example, during the month metal prices dropped. So, the buyer was ready to lose the initial token amount he had paid to seller and did not exercise his right. Assuming, if the price of metal would have surged, he would have certainly exercised his right and bought the metal at the deal price. Therefore, by paying the initial token amount, he got a choice/ option to buy or not to buy the metal after a month. Similarly, a commodity option contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset. While the option seller has the obligation in the contract.
Mainly two types of options contract traded across the globe, European style and American style. The European style is exercised only on maturity of the contract and the American style is exercised any time over the life of a contract.
Mainly two types of options contract traded across the globe, European style and American style. The European style is exercised only on maturity of the contract and the American style is exercised any time over the life of a contract.
In line with the current SEBI regulations only European style commodity options contracts are traded on Indian stock exchange. These options contracts devolve into the underlying futures contracts and all such devolved future positions open at the strike price of exercised options. Here a seller buys a put option and a buyer the call option to lock in the price.
In line with the current SEBI regulations only European style commodity options contracts are traded on Indian stock exchange. These options contracts devolve into the underlying futures contracts and all such devolved future positions open at the strike price of exercised options. Here a seller buys a put option and a buyer the call option to lock in the price.
Illustration: On 30th Sept’ 2016 Mr. Archit Mittal, a cable and wire manufacturer buys Rs320 November copper call option at a premium of Rs. 3, expecting a rise in copper price. As he had expected, prices of copper surged in Nov’2016. On 17th Nov’2016 he exited his option position by selling back the Rs.320 call, then trading at a premium of Rs.10. He made a profit of Rs. 7, from the difference between the option premium at the time of purchase and sale (Rs. 10 premium received when sold – Rs.3 premium paid when bought). However, had the prices of copper fallen in November, his loss would have remained limited to the premium he paid for buying the call i.e Rs.3, as the optioned would not have been exercised then.
Illustration: On 30th Sept’ 2016 Mr. Archit Mittal, a cable and wire manufacturer buys Rs320 November copper call option at a premium of Rs. 3, expecting a rise in copper price. As he had expected, prices of copper surged in Nov’2016. On 17th Nov’2016 he exited his option position by selling back the Rs.320 call, then trading at a premium of Rs.10. He made a profit of Rs. 7, from the difference between the option premium at the time of purchase and sale (Rs. 10 premium received when sold – Rs.3 premium paid when bought). However, had the prices of copper fallen in November, his loss would have remained limited to the premium he paid for buying the call i.e Rs.3, as the optioned would not have been exercised then.
Commodity options are useful risk management tools, especially for the small stakeholders. Options contract come with several advantages along with ‘no mark to market margin’ calls for option buyers since they pay an upfront premium to the option seller. The cost is lesser than taking a futures contract, as the returns are relatively higher and a maximum loss is limited to the premium of the option. Options are more flexible, allows to take advantage of any price movement on either directions. The Option represents a form of price insurance, the cost of which is the option premium.
Commodity options are useful risk management tools, especially for the small stakeholders. Options contract come with several advantages along with ‘no mark to market margin’ calls for option buyers since they pay an upfront premium to the option seller. The cost is lesser than taking a futures contract, as the returns are relatively higher and a maximum loss is limited to the premium of the option. Options are more flexible, allows to take advantage of any price movement on either directions. The Option represents a form of price insurance, the cost of which is the option premium.
Commodity options contracts are presently available on two national level commodity exchanges in India. While MCX, country’s largest commodity exchange, offers options contract in gold, silver, crude oil, copper and zinc. Options contracts on Chana, Guargum, Guarseed, Soya bean and Soya refined oil are available on NCDEX.
Commodity options contracts are presently available on two national level commodity exchanges in India. While MCX, country’s largest commodity exchange, offers options contract in gold, silver, crude oil, copper and zinc. Options contracts on Chana, Guargum, Guarseed, Soya bean and Soya refined oil are available on NCDEX.
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