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What are Commodity Options?

What are Commodity Options?

What are options?

Options are defined as derivatives instruments that enable the buyer (holder or owner) of the instrument the right to buy or sell the underlying asset. The right to buy or sell is without any obligation. The seller of the option is, however, obligated to buy or sell, should the buyer exercise his or her right. 

Let us understand options with the help of an example.

Mr. Pandya wants to buy an apartment worth ₹ 50 lakh in Ahmedabad. He approaches GT Builders who agree to sell it to him, but this apartment will be ready only after 3 months.In order to book this apartment, Mr. Pandya will have to give ₹10,000 as the token amount. Here, Mr. Pandya has undertaken an options trade. By giving only ₹10,000, he has bought something worth ₹50 lakh.

Let us consider two scenarios.

Three months later, because of positive development in the area and positive news,the value of the apartment became ₹60 lakhs.So, if Mr. Pandya wants, he can sell the apartment and book a profit of ₹10 lakh.Mr. Pandya had given only ₹10,000 as a booking amount. So, by giving ₹10,000, he has made ₹10 lakh, in just 3 months.

Let us consider the other scenario.

After 3 months, if the price of apartments in that area falls, and the value of the apartment becomes ₹40 lakh.Mr. Pandya has a choice, he can choose to let go of the apartment. In this case, he will incur a maximum loss of ₹10,000. 

Now if Mr. Pandya had given ₹50 lakh for this apartment,he would have incurred a loss of ₹10 lakh at present. Here he incurred a loss of only ₹10,000 and could exit this position.

This is how an options trade works. As observed, after buying options if the market moves in your favour,then you can get very high returns. And if the market moves against you, you might incur a loss. But that will be limited to the amount that you have already paid.

Types of options

There are two types of options-American and European styled options-based on when the right to sell or buy can be exercised. 

  • American Options

Here one may exercise his/her buying or selling right before expiration.

  • European Options

In European options, one may only exercise the right solely on the specific date that is the date on which the option contract expires. 

Indian commodities exchanges list and trade only European style option contracts. The expiry of option contracts is different for all commodities and depends on the class of commodity.

For eg: Precious metals  futures expire on the 5th day of expiry month, if the 5th day is holiday then preceding day is considered as expiration date. The commodity options have futures as underlying, the options on precious metals expire three business days before futures expiration.

For Base metals the last day of the contract month is considered as expiration date for futures contract, the options expire three business days before futures expiration. Energy complex option contracts expire 2 days before futures contract expiration.

If the date of expiration is holiday, the expiry is moved ahead to preceding business day for all contracts. 

What are commodity options?

Commodity Options are derivatives contracts  that enable the buyer (holder or owner) of the instrument the right to buy or sell the underlying futures.

Unlike stock options, which are based upon shares, commodity options are based on the future contracts. 

So the buyer pays the seller a premium to acquire the options contract. The buyer then has the right to exercise the option if it is profitable for him or let it expire. The buyer here therefore has the right and not the obligation. 

The seller on the other hand has the obligation to fulfil the contract when the buyer chooses to exercise it.

Commodity options in India are available for a plethora of products. Crops such as: Channa, cotton,  petroleum products like natural gas, metals like gold, silver etc. They are traded on the Multi-Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange (NCDEX).

One month Gold futures contract is an example of Commodity Options. The traders may buy a call or put options on it.

Benefits of Commodity Options trading

  • Cost efficiency

Commodity options are more cost-efficient than a future contract, and the returns are considerably higher, and the loss is limited to the option’s price. In a future contract, the returns are significantly low, and losses can be high, if stop loss is not utilised.

  • Cost limited to premium paid

Option buyers don’t have to maintain mark-to-market margin calls since the premium is already paid for these contracts.

  • Used for hedging

Commodity options can be used for hedging your portfolio against volatile markets.

  • Used for diversification

During high volatility in the cash market because of  market fluctuations and distress like inflation, commodity options will help absorb the shock and have a balanced portfolio.