What you should be knowing about commodity options…

With the SEBI giving the go-ahead for the launch of commodity options in the markets and the last SEBI board meet also laying down the broad guidelines, the stage is set for the commodity exchanges to take on the challenge. The Multi-Commodity Exchange (MCX) has confirmed that they will be launching commodity options in gold within 3 months. That will be the time required by the exchanges to get the requisite approvals from SEBI, working out the contours of the product specifications, testing their trading platform, back testing their software readiness and above all confirming that their risk management systems are in place. As markets ready to launch commodity options, here are 10 things you must know about commodity options in India…

10 things you must know about commodity options in India…

  1. To begin with, each exchange will be allowed to introduce commodity options only in one product. In case of MCX, it proposes to launch options on gold while the NCDEX may choose to launch options on options on an agri-commodity where they already have an advantage. For selecting a product for options, it must be among the top-5 commodities traded in terms of average annual rupee volumes. Also, the minimum daily turnover on such commodities must be Rs.200 crore in case of agri-commodities and Rs.1000 crore in case of non-agri products.
  1. Options on commodities will be European in nature. Each options contract will have 3 contracts at the bare minimum of which one contract will be in the money and one contract will be out of the money. The third contract will be Close-to-the Money, which is akin to ATM options in case of equities. As a European option, these commodity options can only be exercised on the expiry date and not before that.
  1. Like in case of equities, commodity options can be either reversed or they can be exercised on the expiry date. If you have bought a call option you can reverse by selling the call option. Similarly, if you have sold a put option then you can reverse by buying the put option. Of course, reversal of options is subject to availability of liquidity in the market.
  1. Margins on commodity options will be broadly similar to equity options. In case you buy commodity options then you will only have to pay the premium margins. However, if you have sold options then you will have to pay the initial margins, regular mark-to-market margins and additional volatility margins wherever applicable.
  1. There is a subtle difference between equity options and commodity options in terms of the underlying. In the equity market the underlying for the equity futures and equity option is the equity shares of the company. However, in case of commodity options, the underlying is the commodity future that is traded on the exchange. When you buy or sell commodity options, your underlying is the future on that commodity. That is because the SEBI and the exchanges do not have jurisdiction over spot markets in case of commodities.
  1. Commodity options will give added liquidity and hedging options to the traders and investors in commodities. With commodity options, traders can protect and hedge their positions more effectively at a lower cost and with lower downside risk. Commodity options will also facilitate the creation of high-end spread products and cash-futures arbitrage strategies.
  1. From the perspective of commodity markets, options will add liquidity, breadth and volumes to the market. Currently, options account for nearly 85% of the total volumes on the equity markets. If a similar trend plays out on the commodity markets too, then the impact on overall volumes of commodities can be huge. It can also make a huge difference to the economics of commodity brokers in India.
  1. The most important thing to understand in commodity options is the devolvement of options into commodity futures on expiry. All long call and short put positions will devolve into long commodity futures. On the other hand, all short call positions and long put positions will devolve into short commodity futures.
  1. The expiry of the commodity options will have to be a few day ahead of commodity futures as all the devolvement of options into commodity futures will increase the overall open interest of the futures. If the futures OI after the devolvement exceeds the MWPL limits as per the risk management requirements then positions will have to be squared off accordingly.
  1. Lastly, there is the asymmetry risk that traders need to be conscious with respect to commodity options. When you are long on a call and it devolves into a long future, you are required to pay up the initial margin and the additional MTM as required from time to time. If you are short on call, you are betting that the stock price will not rise above a certain threshold level. However, that gets converted into a short future which is a directional bet. This asymmetry is a risk in all devolvement of options into commodity futures.

The regulator has definitely made a start by triggering commodity options. To begin with options on just one commodity will be a difficult way to judge the efficacy of options. However, considering the sensitivity of commodity prices (especially agri-commodities); one needs to be prepared for a cautious stance from the government and the regulator. One hopes that commodity options also pick up rapidly similar to equity options in the last 10 years.

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