How to make the most of commodities options

SEBI has finally released the guidelines on commodity options.

Commodity options can provide depth to the commoditues market and bring in more participants because it is an effective hedging tool. Unlike futures, where losses can be unlimited, in options the buyer has potentially unlimited profits while limiting losses.

On the cost front too, options work out cheaper as the premium will be much lower than the initial margin paid on a futures contract. There will also be no mark-to-market margins in the case of options.

However, not all commodities traded in the futures segment will get an entry into options. Commodity options will be allowed only on those futures contracts where the average daily turnover is over ₹200 crore (if it is an agricultural commodity) and over ₹1,000 crore (if it is a non-agri commodity).

Soyabean, mustardseed and jeera in commodities and gold, silver, crude oil, copper and zinc contracts in non-agri commodities are eligible to trade in the options segment. However, each exchange, to start with, can launch options on only one commodity.

Any commodity option in an Indian bourse rests on a commodity futures contract. It will be an European-style option, which means it can be exercised only on the day of expiry. It helps, therefore, to understand how options work.

Options are derivative contracts that give the buyer the right to buy (call option) or sell (put option) a specific asset (a commodity) at a particular price (called the strike price) at a future date. The consideration for exercising the right, called the ‘premium’, will be paid upfront by the buyer.

There are two parties to an option contract: a buyer and a seller. By paying the premium, the buyer buys the right to exercise his option on the seller. The seller, on the other hand, is the one who receives the option premium and is obliged to fulfil the contract.

For a buyer in an option contract, be it call/put option, the loss is limited to the premium, while the profits are potentially unlimited. This is what adds to the attraction of the product.

An option with a futures contract as underlying makes the tool a bit convoluted for those who intend to use the options contract to take or give delivery of a commodity. On the expiry date, as the options contract transforms into a futures contract, the holder is exposed to price volatility in the futures market. His costs increase as he has to pay for all the margins in the futures market.

Assume, for example, that a farmer buys a put option to sell 10 tonne of maize at ₹1,500 per quintal, five months from now. If the price goes to ₹1,300 (contract becomes in-the-money), the profit of ₹200 (per quintal) will be automatically credited to the farmer’s bank account. As this happens, he will also get a ‘short’ position in the underlying: the maize futures contract at ₹1,300. Next day, as the futures market opens, the farmer will be charged the daily MTM margin on the futures contract based on volatility in the market. However, if he does not wish to keep his position open, he can square up the futures contract.

Now, say, if the price goes to ₹1,600 and the contract becomes out-of-the-money, the option contract will expire automatically. The farmer’s loss will be limited to the premium he paid for the contract.

So, on the date of expiry, all options contract will turn into a futures contract. All ‘long’ put positions and ‘short’ calls will become ‘short’ positions in the futures contract, and all ‘long’ call position and ‘short’ put positions will be ‘long’ positions in the underlying futures contract.

SEBI has clearly stated in its guidelines that in-the-money contracts shall stand exercised automatically unless the holders give contrary instructions.

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