Commodity Options

The biggest challenge will be liquidity and asymmetry…

The SEBI took a major step this week by announcing the regulatory and operational framework for commodity options. The largest commodity bourse by volumes, MCX, has already indicated that it will be ready to launch commodity options in the next 3-4 months. Before we get into the challenges, here are some of the key features of commodity options…

Commodity options: Key features… 

  • Commodity options will be allowed for 1 commodity per exchange to begin with and later extended.
  • For a commodity to quality for options, it will have to be among the top-5 most traded futures
  • Additionally, agri products will need minimum daily turnover of Rs.200 core and non-agri Rs.1000 crore
  • Commodity options can be either reversed, as in case of equity options, or exercised on expiry
  • Commodity options will have an expiry a couple of days earlier than commodity futures
  • All commodity options exercised will devolve into commodity futures on the day of expiry
  • The strike price of the commodity option will become the theoretical futures price for devolvement
  • Long calls and short puts will devolve into long futures while long puts and short calls will devolve into short futures. Normal margining will apply from that day onwards.

Challenge 1: Market liquidity… 

Sell-side liquidity in equity options comes from institutional traders and investors. But institutions have not yet been permitted into commodity markets though the proposal is already there. Unless there are institutions willing to write options, this market is unlikely to pick up in a big way. That is the equity options experience! 

Challenge 2: Risk Asymmetry… 

For the buyer of the put or call it will create a risk asymmetry on the expiry day. When you buy an option you only pay the premium margin and do not worry about MTM. But once that position devolves into futures, it attracts MTM and volatility margins. That will create a risk asymmetry for the buyer of the option.

Challenge 3: Return asymmetry…

The problem of return asymmetry will be relevant for the seller of the option. When you sell a call option your view is that the price will not go above a certain level. You are not betting on the price to go down. You are happy with the small return from selling options. However, on the expiry day, this short call will get converted into a long futures position. But that is not the return profile that you are expecting, creating an asymmetry. Despite the challenges, it is a good start for commodity markets! ©

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