What you need to actually understand about Commodity Options…

The long sought after product, “Commodity Options” is finally likely to see the light of day. With the SEBI announcing the framework for commodity options, the onus is now on the commodity exchanges and brokers to start offering the product to the customers. Before we get into the nuances of the SEBI announcement on commodity options, let us first understand why Commodity Options are likely to add value to commodity clients…

Why Commodity Options are a value addition for the clients…

• Commodity options will offer traders in commodity futures an additional avenue to participate in the commodity markets. Since its inception, commodity exchanges have been only permitted to offer commodity futures and this widens the offering.

• Unlike futures, options have limited downside risk if you are the buyer of the option as your loss is restricted to the premium paid. This will entice a lot of small traders and investors to participate more actively in commodities thus broadening the market.

• Commodity options will offer the facility of a variety of additional hybrid products. For example, a trader can create an arbitrage between the future and the option. The trader can also create a spread between two options having different maturities as well as pair trades. Eventually it will also encourage the development of an arbitrage market between spot and options.

• In the equity markets, options account for nearly 80% of the daily volumes. In fact, volumes in the equity markets expanded only after options were introduced. The introduction of options could have a similar salutary impact on commodity markets too.

Understanding the nuances of options on Commodities…

The largest commodity exchange in India, MCX, has indicated that the exchange will be ready to launch commodity options within the next 3-4 months. It is necessary to understand the nuances of the product. Here is what you need to know about commodity options…

• SEBI has laid down strict guidelines for inclusion of commodities in options. Exchanges can only offer options on commodities where the underlying future is traded on that exchange. The commodity should be among the top-5 commodities in terms of volumes and value of the commodity contract in the last 12 months.

• The average daily turnover of the commodity must have been at least Rs.200 crore per day in case of agri commodities and Rs.1000 crore per day in case of non-agri commodities and the average of the last 12 months trade will be considered for this purpose.

• At the current juncture, the SEBI has only permitted the exchanges to offer commodity options on 1 commodity on a test basis. The permission to increase the number of options will be given based on the experience in terms of execution and risk management.

• Each commodity will have 3 option contracts at the very minimum of which 1 will be out of the money (OTM), 1 will be at the money (ATM) and 1 will be in the money (ITM). All commodity options to begin with will only be European styled options. A European option can only be exercised / devolved on the expiry date.

• Of course, there are no restrictions on reversing your commodity option position in the market during trading hours. If you are long on call option, you can reverse the position by selling your call option. Similarly, if you have sold a put option, then you can reverse the position by buying a put option. This will, of course, be subject to the availability of liquidity in the market.

• The logic of margining the commodity options positions will be broadly similar to equity options. While the buyer of the option will only pay the premium margin, the seller of the option will be required to pay the initial margin as well as the mark-to-market margin.

The complex area of exercise and devolvement of commodity options…

Reversing your commodity position is quite straight forward. However, excise of options will be a lot more complicated. That is because commodity options will not devolve in to the commodity but into commodity futures. While SEBI regulates commodity futures, it does not regulate the spot market as it comes under the purview of the state government regulation. Hence all exercised commodity options positions will devolve into futures of the same commodity, with the options strike price as the theoretical futures price.

So if you are long on call option or short on put option, then when exercised it will devolve into a long futures position on the same commodity. On the other hand, if you are long on put option or short on call option, then when exercised it will devolve into a short futures position. From that point all normal futures margins will be applicable on the position.

Challenge of Options Expiry and position asymmetry…

This is a unique challenge that is likely to come up in case of commodity options. Since the exercised commodity options will devolve into commodity futures, the commodity options will require a separate expiry that will have to be scheduled before the commodity futures expiry. This will also mean that any devolvement will lead to an increase in the open interest of commodity futures and will have to be unwound if the OI exceeds the prescribed limits.

But the bigger challenge will be of position asymmetry. Let us understand this better! A person buys a call option because they want to take limited downside risk and margin liability. When it devolves into a long future the trader is required to take up unlimited risk as well as margin liability. For a person who has sold a put option, margins may not be the issue as they are already paying margins on a short option position. However, a trader sells a put option because they do not expect the market price to go below a certain level. Converting that view into a bullish long futures position will skew the trader’s original trading intent.

Of course, these challenges will have to be addressed along the way. But commodity options mark a good start for commodity markets. The onus is now on the exchanges and the brokers to take this product to the traders.