Commodity Analysis

Advantages of Option in Goods

Rajalakshmi Nirmal | Updated on July 12, 2020 Published on July 12, 2020

Buyers can take or give delivery by paying premium; no margin or other extra cost

Options in commodities haven’t seen much traction on bourses because on expiry they devolve into futures contract and cost spiral up due to the margin requirements in futures.

But recently, regulator SEBI approved the launch of ‘Option in Goods’ with spot commodity as underlying. Here, we explain why this new instrument is a better tool for SMEs and MSMEs dealing in commodities for hedging price risk. BSE, NSE and MCX have option in goods in gold now.

Options —a hedging tool

Options are a better hedging tool. While in a futures contract, both the buyer and the seller are obliged to honour the contract upon expiry, in options there is no obligation on the part of the buyer to buy/sell the underlying.

Options are of two types — call and put; a call option gives the buyer the right to buy the underlying and a put option gives the buyer the right to sell. She/he can lock in to the price by paying a small premium and need not exercise the contract if the price movements are unfavourable.

Thus, the loss for a buyer in an option contract is limited to the extent of premium. For a seller, also called ‘writer’, the risk is unlimited: if she is a call writer, to the extent of increase in price above strike price; if he is a put writer, to the extent of price of the underlying becoming zero.

If you are an option buyer, your costs are low. Unlike in futures, only the seller has to park margins with the broker in option contracts. Also, in case of options, there is only a small upfront premium payment and there is no MTM (market-to-market) requirement. Let’s say you want to hedge for 100 grams of gold.

If you do this through a futures contract, you have to pay initial margin and additional margins (based on volatility). If the price is assumed at ₹48,000 per 10 gram, the margin would be about ₹44,400. But if you want to hedge the price risk on 100 grams of gold through an options contract, the premium of a put option of strike price ₹48,000 may be just around ₹5,000.

With spot underlying

In commodity options, there was only one choice offered — Options with Futures Underlying.

As it was a derivative of a derivative, it was complex to understand and costs were higher too, as on exercise, the option devolved into futures.

Sample this: A person is hedging 100 grams of gold by buying a put option with futures underlying. On the expiry day of the contract, as the position gets converted into a futures contract, the person will be charged CTT (Commodities Transaction Charge on the settlement value of the contract for both the option (@0.0001 per cent) and the futures (@0.01 per cent), plus all other applicable charges, which would add up to about ₹63.4. This would be in addition to the SEBI charges and stamp duty already paid on the option (of ₹0.15).

On the other hand, had the person bought a put option with direct commodity underlying, the cost on CTT and other charges would come to just about ₹0.87 (per lot of 100 grams).

Given that even SMEs/MSMEs in gold business trade multiple lots at one go, every additional cost matters.

Traders in gold can now, however, opt for Option on Spot prices in gold (on BSE, NSE and MCX) and Option on Spot prices in silver (on BSE).

Base metals and energy may also soon get Option on Spot. Given the lower costs, and simplified features and settlement procedure, it would be the ideal choice for traders big and small.

BSE’s gold options have been seeing good traction since launch. However, only after the LES (liquidity enhancement scheme) ends, one can gauge on the actual performance of the contract.

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Published on July 12, 2020
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