Markets

Will options benefit commodity exchanges?

Lokeshwarri SK | Updated on January 16, 2018 Published on September 28, 2016

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Options are superior to futures on various counts, and may improve liquidity in exchanges

Equity and commodity market regulator SEBI has been quite active in recent weeks, issuing a series of circulars aimed at bolstering risk-management practices, improving the trading environment and increasing participation in commodity exchanges.

The latest move to allow options to be traded on these exchangers is the most significant one made so far.

Indian commodity exchanges were allowed to trade only in futures contracts of agri and non-agri commodities until now. The introduction of options — once SEBI issues the guidelines and the exchanges make all the relevant changes to their by-laws and rules — will definitely help improve liquidity in the exchanges. This is because options are superior to futures on many counts.

Futures versus options

One, the initial outlay is much lower in options. While the initial and volatility margins that an investor pays could vary between 4 and 14 per cent of the contract value (translating to an outgo of ₹5,000 to ₹20,000 per contract), the premiums on options are much lower, sometimes a quarter of the initial margins paid on futures contracts.

Two, traders and investors have to shell out mark-to-market difference to the exchanges every day in future contracts, according to CP Krishnan, Director, Geofin Comtrade. This causes a huge hindrance to genuine hedgers as they have to keep making good the difference between the closing market price and the opening value of the contract to the exchanges. Hedgers can now use option contracts where there is no further outgo after the initial payment for the option premium.

Three, losses in options are limited to the premium paid whereas a trader who uses futures faces unlimited losses. Amateur investors and traders can lose all their capital in futures contracts while this is less likely with options.

Boost to volumes

The current turnover in commodity exchanges is not much to write home about. The largest commodity exchange, MCX, traded ₹5,84,659 crore in June 2016 while the second largest, NCDEX, traded ₹63,960 crore. The turnovers in other commodity exchanges such as NMCE and Rajkot Commodity Exchange are insignificant.

If we compare the monthly volume of commodity derivatives with equity derivatives, commodities transact only around 2 per cent of the value of equity derivatives traded on the NSE. With the introduction of options, the regulator perhaps thinks the jinx could be broken and trading in commodity derivatives too could pick up.

Road-blocks

While the recent move can help increase liquidity, there is an urgent need to increase market depth too. Since participation is limited, very few traders are currently able to influence price moves in commodities, thus causing steep movements in one direction. The next step that the regulator takes should be to increase participation by allowing banks and other mutual funds to participate in the commodity market.

The primary reason why many investors/traders/hedgers stay away from commodity exchanges is the frequent suspensions and banning of contracts.

The regulator needs to ensure that this practice stops, for it erodes the confidence of the users. Finally, a review of the commodity transaction tax will also help. It was this tax that stifled volumes on commodity exchanges.

Published on September 28, 2016
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