Commodity vs equity options: What investors should know

Tune into this discussion in a dealing room at a broking house

The buzzword in the Indian financial markets space right now is ‘commodity options,’ with the MCX having launched gold options on October 17.

Commodity options, besides being an efficient tool for risk management, are also likely to become an important investment tool. In this context, let’s tune into a discussion in the dealing room at a broking house on the similarities between commodity options and equity options.

Chetan, planning to trade in commodity options, posed thus to Ram, a seasoned equity market expert, “Well, Ram, commodity options are quite similar to equity options. Our experience in trading equity options should come handy while trading in commodity options. As we all know, options are derivative instruments with a defined life-span, which gives the buyer the right to transact, but does not carry the obligation to end up with the transactions.”

Ram responded excitedly, “As understanding options is akin to learning a foreign language, we can take advantage of our knowledge of terms like strike intervals, number of strikes, premium, exercise, delta, time value, etc. and gain from having commodities in our portfolio. Besides, as in equity options, the MCX Gold option is a European option, which can be exercised only on the expiry date. So we don’t have the fear of ending up in delivery any time during the tenure of the option contract.”

Chetan intervened, “Well, Ram, despite our understanding of equity options, we need to take into account the differences between commodity options and equity options.”

Ram jumped to his feet, “Really? And what are these differences?”

“First and foremost, commodity options have futures market as the underlying, as against equity options or currency options that have the spot market as their underlying. This is particularly significant as it has a bearing on option pricing and the final settlement mechanism”, Chetan replied.

Ram responded, “Oh! In that case, commodity options track the futures price and not the spot market price, right?”

“Correct”, said Chetan, “ And so, there is a slight variation in theoretical option pricing model as well that is used for pricing commodity options compared to pricing model used for equity options. You are aware that the Black-Scholes model is used for pricing equity options; a variant of it, also known as ‘Black 76 model’, is used to price commodity options on futures. Since futures prices already encompasses the cost of carry component in its prices, the spot prices used under Black-Scholes model is replaced by discounted futures prices in Black 76 model, used for pricing commodity options.” “Further”, continued Chetan, “As commodity options will have futures as underlying, commodity options contract on expiry gets exercised by devolving into the underlying futures contract.”

“Devolving? What’s that?” enquired a puzzled Ram.

Happy to share his knowledge with an acknowledged options expert, Chetan explained, “The biggest difference between the functioning of options in commodity and equity markets is with regards to their treatment on expiry. As the underlying for commodity options are commodity futures, the exercising of an options contract results in creation of a position in the underlying futures contract on expiry. This can eventually be settled by physical delivery, if one desires so.

Alternatively, one can square up the futures position, prior to the commencement of tender/delivery period in the underlying commodity futures contract.”

“Devolving refers to the exercise of profitable options which results in creation of a suitable position in the underlying futures contract. While all long call positions and short put positions devolve (that is, result into) a long open position in underlying futures contract; all long put positions and short call positions devolve into short open positions.

All such devolved futures positions open at the strike prices of the exercised options. Interestingly, to take care of sudden margin requirements after the creation of futures position on devolvement, a type of margin called as ‘Devolvement Margin’ is levied on open option positions, applicable from a day prior to the Option Devolvement Date,” explained Chetan.

“On the other hand, since equity options are only cash-settled and not physically settled, concepts such as ‘devolvement’ and ‘devolvement margins’ don’t exist in equity options.”

“Further, because of devolvement of commodity options into underlying futures, open positions of a trader may exceed their position limits applicable for future contracts. For such traders, up to two trading days after the option expiry day is provided to bring their overall futures positions within the regulatory prescriptions for position limits.”

Ram was listening carefully all along, taking occasional notes. He remarked, “That’s all? Is there any other major difference?”

Summing it up, Chetan added, “While these are stark differences, there are indeed a few more between commodity options and equity options. But, at the end of the day, commodity options are, after all, an ‘option product’. You should read all the contract specifications and the exchange circulars on the product and risk management mechanism before you start building trade strategies.”

Shunmugam is Head – Research, Multi Commodity Exchange of India, and Niteen Jain, Senior Analyst, MCX

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