BASICS OF COMMODITY OPTIONS

Commodity options are blessings in disguise for Indian commodity traders and investors. These instruments provide a right to purchase and sell the financial instrument but not the obligation to honour the contract upon expiry of the contract. The commodity options are similar to stock options but three distinct features differentiate commodity options from stocks options and these are

• The underlying of a commodity options contract is commodity futures
• Expiry of the commodity options is three business days before commencement of the tender delivery period of underlying commodity futures and in case of crude oil and natural gas, options expire two business days before future expiry.
• Settlement of commodity options: If the options are not squared off before the commencement of the tender delivery period, then In The Money options contracts are devolved into a futures contract

Commodity options give the option holder the right, but not the obligation, to buy or sell commodities at a specified price and period. After taking over commodity market regulation from the FMC, the SEBI allowed commodity futures options trading. Indian commodity exchanges follow the European style of options where buyers are allowed to exercise options on the date of expiration of the contract. The first commodity options contract was launched in gold on 17^th October 2017 followed by crude oil options (15 May 2018); copper (21 May 2018); silver (24 May 2018); zinc (21 June 2018); silver mini (19 July 2021); nickel (13 December 2021); natural gas (17 January 2022) and gold mini (25 April 2022).

As per approval from the regulator, the Multi Commodity Exchange of India has launched commodity options in Gold, Gold Mini, Silver, Silver Mini, Crude Oil, Natural Gas, Copper, Nickel, and Zinc. The contract specifications of commodity options are provided as under.

Source: MCX of India

Options on commodity futures contracts traded on Indian commodity exchanges are available. When these commodity options are exercised, they become the underlying futures contracts. All devolved futures positions are opened at the strike price of the exercised options.

Commodity options are useful risk management tools, especially for small stakeholders, because the option buyer is not required to maintain margins. They are similar to price insurance for hedgers, which can be purchased for a one-time option premium.

Growth in commodity options

In fiscal 2022, the commodity options turnover had grown multi-fold as it had attracted many retail investors given the volatility in the underlying commodity futures, lesser money payable in the form of premium against margins in the futures contract, and no worry of contract entering into delivery mode. During the period from April 2021 to March 2022, the options turnover recorded a compounded annual growth rate of 23.20% while futures contracts registered a negative growth of -2.82%.

Source: SEBI Bulletin

In the financial year 2021-22, the total number of contracts—including futures and options—traded on MCX and NCDEX was 185 million contracts, which includes 156 million contracts of futures and 29 million contracts of options. The total number of options contracts traded in April 2021 was 0.46 million contracts, which grew to 5.02 million contracts by March 2022 thereby recording whopping growth. Like the volume of exchange, open interest also showcased a tremendous growth month over month thereby attracting more and more investors to trade in the commodity options.

Source: SEBI Bulletin

Participation

Commodity options are getting increased participation from financial market traders as the commodities are witnessing a good amount of volatility owing to various developments across the globe. Retail investors and hedgers are increasingly using the commodity options to take advantage of price movement with a lower premium. Exchange-Traded Commodity Options are growing because of price transparency with the nationwide online trading platform. 

Development of options into futures

This is a distinct feature of commodity options where all the in-the-money options are converted into a futures contract at the strike price if they are not exited before the commencement of the tender delivery period as mentioned above. Please refer to the table given at the beginning of this article to understand about devolvement of options contracts into a futures contract.

Summary

Commodity options are another feather in the Indian commodities market along with futures and index trading. The popularity of commodity options has been increasing month over month as it is attracting more participation from retail investors, who are not able to trade in high-margin commodity futures. Further, market participants are allowed to trade in options irrespective of market trends such as bullish, bearish, and neutral price trends. In the last couple of months, retail participation has been increasing in commodity options and the same is likely to continue in the future.

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