Query Corner

SEBI recently announced plans to launch options in commodities. Please explain how the settlement will take place on contract expiry.

Nilanjan Chakrabarti, Salt Lake, KolkataLet us first understand how an option works. There are two parties to an option contract — a buyer and a seller. The buyer, by paying the premium, 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. So, for all hedgers, say, farmers or commodity users, who will be buyers of a put or a call option, the risk (or loss) is limited to the premium, but profit is unlimited.

SEBI recently announced that it will introduce options in the commodity market. However, since the commodity spot market is not under its regulatory purview, it said that these contracts would be converted to a futures contract on expiry. But an options with a futures contract underlying means the buyer will be exposed to the volatility of the futures market too.

SEBI plans a model along these lines for commodity options: Assume, for example, that a farmer buys a put option to sell 10 tonnes of maize at ₹1,500 per quintal, five months from now. Later, if the price goes to ₹1,300, the farmer will exercise his option and ₹200 (per quintal) will be credited to his bank account. As this happens, he will also get a position in the underlying — the maize futures contract. Since he was holding a put option for ₹1,300, he will get a sell position in the futures market for ₹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. If he doesn’t wish to keep his position open, he can square up the futures contract. Or, if he wishes to give delivery, he can keep the position open till contract expiry. However, in any case, do note that as the option buyer moves to the futures contract, he will be exposed to some price risk, and take a cut on profits he has made.

Now, the other possibility is that the price can go up to ₹1,600. In that case, the farmer will not want to exercise his option, and the option contract will expire automatically. So, as always, an option buyer’s loss will be limited to the premium.

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