All you wanted to know about commodity options

Market regulator SEBI cleared the deck for commodity options in June by issuing trading and settlement guidelines. It allowed commodity exchanges to launch options in agri and non-agri commodity futures if they pass the minimum average daily volume requirement (over ₹200 crore in agri futures and over ₹1,000 crore in non-agri futures).

Options are derivative contracts that give the buyer the right to buy or sell a specific asset (a commodity here) at a specified price in future. The consideration for exercising the right will have to be paid upfront by the buyer; it is called the ‘premium’. There are two parties to an option contract — a buyer and a seller (also called the writer) and there are two types of options: ‘call’ (buy) and ‘put’ (sell). The buyer of an option is the one who by paying the premium buys the right to exercise his option on the seller.

The seller is the one who receives the premium and is obliged to buy (in a put option) or sell (in a call option) if the buyer exercises his right. So, for a seller in an option contract, the profit is limited to the premium amount but loss can be unlimited. For the option buyer though, who will be buying a put/call option, the risk will be limited to the premium — if prices are not favourable, they can leave the contract to expire. Commodity options will have the respective commodity’s futures contract as the underlying. This tool is primarily designed with hedgers in mind, be it farmers or commodity traders, who would find buying options useful.

Commodity market participants have been lobbying for options for a long time. It is seen as a tool that will deepen the market by bringing in more investors.

Currently, many of these participants hedge in markets outside the country. If institutions including banks and mutual funds are given a green flag to step into the commodities derivatives market, volumes can improve materially, and reduce impact cost for hedgers and traders. Recently, SEBI allowed some institutional investors to take positions in commodity derivatives. This should improve volumes and enable better price discovery.

Options are better hedging-and-trading tools than futures. Losses are limited for the buyer and costs are lower. In a futures contract, a trader will be required to pay an initial margin and also mark-to-market margin based on volatility in market price. In options, the outgo is limited to the premium the trader pays on the contract. So, if you want to lock-in to the price of a commodity you have or want to bet on, options offer a cheaper and safer choice.

You can hedge your price risk effectively with options. Say, you, as a farmer buy a put option to sell 10 tonnes of maize at ₹1,500 per quintal five months from now. If the price goes to ₹1,300 (contract becomes in-the-money) on contract expiry, the profit of ₹200 (per quintal) will be credited to your bank account.

As this happens, you will also get a ‘short’ position in the underlying maize futures contract at ₹1,300. If the price goes to ₹1,600 and the contract becomes out-of-the-money, the option contract will expire automatically and your loss will be limited to the premium you initially paid for the contract. Hedgers would do well to square off resultant futures positions as this could subject them to new price risk.

This option can give farmers a better future.

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