Commodity Analysis

F&O – Hedging tools you can use

Rajalakshmi Nirmal | Updated on September 06, 2020 Published on September 06, 2020

If businesses leave price risks unattended, costs will shoot up and may derail profits

Futures and Options are derivative contracts. Indian exchanges – MCX, NCDEX and ICEX and NSE and BSE – offer these contracts. To hedge the risk arising out of uncertainty in commodity prices, producers or traders, including SMEs and MSMEs that uses commodities as inputs, can use these instruments.

Prices of precious metals, crude oil, copper and lead have witnessed an annualised price volatility from a minimum of 15 per cent to a maximum of 30 per cent in past few years. So, if price risks are left unhedged, costs will shoot up for businesses and it may derail their profits. Here, we tell you about the basics on the two contracts to help you get started on hedging.

 

 

Futures

A futures contract is an agreement between two parties in which the buyer agrees to buy an underlying asset (a commodity here) from the seller at a future date at a price that is agreed upon today. Commodities, including gold and silver, crude oil, natural gas and wheat, chana, cotton, sugar, turmeric, jeera, palm oil, guar seed, guar gum and black pepper, are traded in the futures market in India. Both the buyer and seller of a futures contract are obliged to honour the contract upon expiry.

To take a position (buy/sell) on a futures contract, a fee, termed as ‘margin’, has to be paid to the exchange. An important point to note in the case of futures trading is that risks are unlimited. This is because when buying a futures contract you put only a little amount down; your loss (or profit) is not established until the contract's expiration date. Say you have taken a buy position on gold futures at ₹50,000 and at the time of expiry of the contract the price is ₹49,000. By squaring up (taking an opposite position on the contract) the contract to close it, you will make a loss of ₹1,000. The loss will increase depending on how low the price drops from your buy price. On the other hand, profits are also unlimited making it a game that speculators enjoy.

Options

Option contracts are different from futures. Here, the obligation to honour the contract is only on the seller, herein after referred as‘writer’. The buyer has the right to exercise the contract, but is not obliged to do so.

The consideration for exercising the right is paid upfront by the buyer and is called the ‘premium’. The writer receives the option premium and is obliged to sell the underlying commodity if the buyer exercises his right. For a writer, thus, the maximum profit is the premium, while loss in unlimited depending on how high or low the price goes.

While writing of option contracts is mostly done by speculators with deep pockets, producers/traders in business of commodities, usually are buyers of an option contract and have the benefit of being able to limit loss to the premium of the contract and at the same time enjoy unlimited profits.

The advantage with options is also that costs are relatively 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 initially.

Currently, not all commodities that are traded in futures market are available on options platform. Only, gold, silver, crude oil and base metals and some agri commodities are available in the options market.

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Published on September 06, 2020
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