All About Commodity Options

Commodity options are sophisticated financial contracts that are essentially used to manage commodity volatilities and risks.

While the recent frenzy surrounding options trading has falsely fueled its myth as a short-term speculative vice aimed at people who enjoy an adrenaline rush, it is a critical component of global trade, adding value to buyers, sellers, and end users.

What Are Options Contracts?

An options contract is an agreement between two parties to facilitate the buying and selling an asset at a preset price and date.

An options buyer has the right, but not an obligation, to buy or sell an underlying asset, whereas the seller has to honor the contract if and when the buyer decides to exercise their rights.

Options are of two types, call options and put options. A call option gives the buyer the right to buy an underlying asset at a fixed price on a preset date, whereas a put option gives the buyer the right to sell an asset at a preset price and date.

For example, gold futures contracts expiring on the 5th of October currently trade at ₹51,630, with 1 contract costing ₹51 lakhs for a kilogram.

If you feel that the price will rise further in the coming months, you can buy a call option, which is quoted at ₹50,000, following which if the price of gold increases to ₹52 lakhs, you stand to make a gain of ₹1,000, while the options seller loses ₹1,000.

As the buyer of an options contract, you can square off the position at any time, on or before the expiry date, to pocket the gains, and the seller has no choice but to honor the contract.

Similarly, for a put option, the buyer stands to gain if the price of the underlying asset drops below the strike price on or before the date of expiry. On the other hand, options sellers, on the other hand, charge a premium for this service, which will turn a profit if the contract expires worthless at the time of expiry.

Stock Options Vs Commodity Options

While the overall mechanics of commodity options contracts remain similar to that of equities and index funds, the core difference lies in the underlying assets.

With stock options, the contract is struck based on the underlying spot prices of the stock in question. When trading NIFTY options, buyers and sellers deal with the underlying spot NIFTY and not Nifty Futures, but this isn't the case when it comes to commodities.

In commodity options, the contract deals with futures prices and not spot prices of the commodity. Options, in general, work out cheaper than futures contracts, especially considering the initial outlay, with the buyer only having to pay a small premium.

This is mostly an Indian construct and is often blamed for lacking depth in domestic commodity markets. However, as far as the core efficacy is concerned, commodity options remain quite vibrant, reflecting the various realities of the physical trade.

What Are Commodity Options Used For?

There are three main use cases for commodity options trading: hedging, income generation, and speculative activities.

All of these remain essential for functioning robust commodity exchange and complementing one another despite having different goals.

Hedging 

Commodity prices, in general, are known for their extreme volatility, which makes it difficult for producers, traders, and manufacturers to plan their operations effectively. 

A key intent of a futures and options market in commodities is to provide certainty for the players involved. For example, farmers can buy put options as insurance against dropping prices, giving them much-needed certainty when borrowing and investing during harvest seasons.

Similarly, procurement and production managers at factories can ensure a steady supply of essential commodities at the right price by entering into futures contracts while also insuring against inflationary scenarios by buying long-term call options contracts.

The global trade in commodities and finished goods would barely be a fraction of its current size without the growth of transparent and well-regulated commodities derivatives markets. 

Speculation

A significant chunk of volumes in commodity derivatives come from traders and speculators who have no intention of receiving the physical delivery of the commodity in question and are mainly interested in quick gains by identifying and taking advantage of gaps and inefficiencies in the market.

While speculation may seem eerily similar to gambling, it adds substantial value to the overall marketplace and other stakeholders. With extensive speculation, traders provide markets with much-needed depth, liquidity, and price discovery while smoothening out the explosive volatility this segment is known for.

Income

While options buyers can insure their positions and operations against unfavorable price movements, apart from trading gains from speculation, options sellers can generate steady income by collecting premiums from the buyers.

As discussed in the examples above, buyers of both call and put options pay a premium for their right to buy and sell at certain prices and periods. The seller provides this privilege by assuming substantial risks for a small premium payment.

Unlike buyers, whose losses are restricted to the premiums paid, options sellers expose themselves to massive downsides and thus perform their hedging and risk management activities, adding further depth and better price discovery to the broader marketplace.

Final Words

With Indian commodity markets being less than a decade old, they still represent substantial opportunities for traders, investors, and market makers. With the right tools, training, and understanding of the market, a nuanced operator can regularly generate steady gains by trading commodity options.

Most brokers offer an MCX and NCDEX account. Once you get your account up and running, the next step involves educating yourself on the workings and structures of the domestic commodities market, its correlations with stocks, global cues, and the broader economy and physical supply and demand of leading commodities.

There is a steep learning curve, but for anyone looking to put in the work, this can be a lucrative endeavor, with outsized gains and a steady flow of opportunities.