Commodity Analysis

A new Option to hedge price risk

Rajalakshmi Nirmal | Updated on January 16, 2018 Published on October 01, 2016


PO03_risk lead

SEBI’s move to allow options can help farmers tide over price volatility

MCX, India’s largest commodity exchange, saw its shares zoom last week following news of SEBI flagging off options trading. But wait, it could be not less than six months before the first option contract goes live, say sources in the know of things.

There are many reasons for this. First, a consensus has to be arrived at on commodities that can be allowed to trade in the options segment. The contract specifications — the underlying, the option style, the settlement procedure and trading cycle — have also to be decided. Further, the regulator will have to check the internal control systems of exchanges to see if their risk management system is robust. Time would also be required to educate market participants about the new product and see that there are enough option writers for market making so that the contracts are liquid. The SEBI circular that was released in the evening of September 28 was silent on the finer details of the new product. Business Line spoke to various commodity experts and members of SEBI’s Commodity Derivatives Advisory Committee to understand the likely framework for these option contracts.

What are Options?

Options are derivative contracts which give the buyer the right to buy (in case of call option) or sell (in case of put option) a specific asset (a commodity here) at a particular price (called strike price) in future. The consideration for exercising the right, paid upfront by the buyer, is called the ‘premium’. These contracts can be used for hedging by farmers, commodity processors and middlemen to hedge the price risk by taking a view on future price. There are two parties to an option contract — a buyer and a seller (also called the writer). The buyer of an option is the one who by paying the option premium buys the right to exercise his option on the seller. The seller of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises his right. So, clearly, the game is risky if you are a seller in an option contract- as your profit is limited to the premium amount but loss unlimited. But, for all hedgers – be it the farmers or commodity users who will be buying a put option or a call option the risk is limited to the premium. If prices are not favourable to them, they can leave the contract to expire. Say suppose, a farmer who is harvesting his crop wants to lock-in the current price fearing crash in prices in the harvest season, he can buy a put option.

Which commodities?

SEBI has not listed out commodities which will be allowed to trade in the options segment. Commodity broking houses say a few from the non-agri side including gold, silver, energy and metals and from the agri side, such as mustard seed, refined soy oil and guar may get the green flag. G Chandrasekhar, a commodity sector specialist, however, doubts if the regulator will hurry to open up the floor to more than two/three commodities. In non-agri sector, gold/silver or even crude oil may see options come in, but, in agri, the regulator is expected to tread more cautiously.


Options, being derivative contracts, should have an underlying. Vijay Sardana, a commodity market expert, says, “All commodity derivatives have to reflect the spot prices. In the US, commodity options follow futures price because there is no spot market as such. They don’t have a mandi system like we have here, so in CBOT the options follow futures price. But, our issue is, today the polling is done by exchanges and we have to review the process before we launch options that use this price. But unlike the US, since we have an option, the regulator may consider spot prices too…”


Settlement in options can be done through cash settlement or by delivery. But, experts feel that a delivery-based settlement will help the genuine users of the platform. In commodity futures currently, all open positions on the expiry date are settled compulsorily through physical delivery.


The regulator will also have to specify if the options will be American or European style. European options are those that can be exercised only on the expiration date. American options let the option holder exercise his right at any time during the contract. Gopal Naik, Professor of IIM Bangalore, also a commodity market expert, says, “We will have to try and see which style works out for us. To start with it may be as European options”.

How will it be useful?

For a farmer or a commodity processor who buys a put or a call option, the loss is limited - this is what makes this instrument more attractive than a futures contract for hedging price risks. For example, if a farmer growing maize can buy a put option to sell 10 MT of maize at ₹1,450 per quintal, five months from now. Two scenarios can out play for him. If the price of maize goes down to ₹1,325 per quintal, he can exercise his option, making a profit of ₹125 per quintal. This will offset the notional loss he will incur when he sells the product in the physical market. In the event of the price of maize going up to ₹1,520, he can choose to not exercise his option.

Published on October 01, 2016

A letter from the Editor

Dear Readers,

The coronavirus crisis has changed the world completely in the last few months. All of us have been locked into our homes, economic activity has come to a near standstill. Everyone has been impacted.

Including your favourite business and financial newspaper. Our printing and distribution chains have been severely disrupted across the country, leaving readers without access to newspapers. Newspaper delivery agents have also been unable to service their customers because of multiple restrictions.

In these difficult times, we, at BusinessLine have been working continuously every day so that you are informed about all the developments – whether on the pandemic, on policy responses, or the impact on the world of business and finance. Our team has been working round the clock to keep track of developments so that you – the reader – gets accurate information and actionable insights so that you can protect your jobs, businesses, finances and investments.

We are trying our best to ensure the newspaper reaches your hands every day. We have also ensured that even if your paper is not delivered, you can access BusinessLine in the e-paper format – just as it appears in print. Our website and apps too, are updated every minute, so that you can access the information you want anywhere, anytime.

But all this comes at a heavy cost. As you are aware, the lockdowns have wiped out almost all our entire revenue stream. Sustaining our quality journalism has become extremely challenging. That we have managed so far is thanks to your support. I thank all our subscribers – print and digital – for your support.

I appeal to all or readers to help us navigate these challenging times and help sustain one of the truly independent and credible voices in the world of Indian journalism. Doing so is easy. You can help us enormously simply by subscribing to our digital or e-paper editions. We offer several affordable subscription plans for our website, which includes Portfolio, our investment advisory section that offers rich investment advice from our highly qualified, in-house Research Bureau, the only such team in the Indian newspaper industry.

A little help from you can make a huge difference to the cause of quality journalism!

Support Quality Journalism
This article is closed for comments.
Please Email the Editor
You have read 1 out of 3 free articles for this week. For full access, please subscribe and get unlimited access to all sections.