Classroom Corner. Commodity options

Futures and options are both derivative instruments that derive their value from an underlying security (a commodity here). In a futures or an options contract, a buyer and a seller agree to buy or sell an asset at a certain time in the future at a certain price. However, there is a fundamental difference between a futures and an options contract - in futures, while both the buyer and the seller have the obligation to fulfil the contract, in options, the buyer has the right but no obligation to fulfil it. Thus, for an option buyer, loss is limited (to the premium he pays for the contract) while profits are unlimited. This feature makes it an ideal hedging tool for small participants.

Recently, NCDEX launched its options on guar seed futures.

The following are some of the frequently asked questions:

The one who purchases a call/put option is called the holder. The seller of options contract is called the options writer.

When the options holder wants to invoke the right embedded in the options contract on the options writer, it is called exercising the contract. For instance, if on the options expiry date, the price of guar seed futures is ₹4,400 and a farmer has bought put options at ₹4,500 strike price, then he shall exercise the right embedded in the put options and consequently sell guar seed futures at ₹4,500 per quintal.

Premium is the cost of the options contract. Options buyer (holder) pays a premium to the options seller (writer).

It is the agreed price at which the parties get to exercise the options. The strike price for a call option is the price at which the contract can be bought; the strike price for a put option is the price at which the security can be sold. The strike price is also called the exercise price.

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