What is Devolvement of Commodity ITM options contracts?

In the recent past, options trading on various commodities such as gold, oil, metals, etc. has gained popularity at a rapid pace since major exchanges like MCX, NCDEX, and ICE started offering it. But what is commodities options trading? Commodities options trading is a contract in which the buyer/seller has the right but not the obligation to buy (call option) or sell (put option) underlying commodities at a predetermined price on the expiry date. A few of the reasons for the growing popularity of options contracts are as outlined below:

1. No mark to market margin calls as the premium is paid upfront to the options seller
2. Returns may be higher than the futures contract
3. For call options contracts maximum loss is limited to the price
4. Offers more flexibility

However, you must note the points below before we go ahead.

1. Compulsory delivery contracts (Gold, Gold Mini, Silver, Silver Mini, Copper, Zinc, etc.) and non-deliverable commodities (Crude Oil and Natural Gas) are available for options trading
2. Options contracts for compulsory deliverable commodities expire 2 working days prior to the first day of the tender period* of the futures contracts
3. Options contract for non-deliverable commodities expire 2 working days prior to the expiry of the futures contract

*Tender period – A period that starts 5 working days prior to the expiry of the futures contract

Settlement method of commodity options contracts

The below table will give you a better idea of how different commodities options contracts are settled.

Now, let’s understand what Devolvement is.

What is Devolvement?

The process of conversion of options contracts into futures contracts at the date of expiry is known as Devolvement. Let’s understand this with an example – Assuming Copper futures contract is expiring on 25th February 2022 and Copper options contracts is expiring on 16th February 2022. Now, if you have open ITM (In-the-money) options positions of copper on 16th February, then after the closing on this day, your options will be converted into futures. This conversion on the day of expiry is known as Devolvement.

Following are the norms established by the exchange and your broker for carrying out the process of devolvement.

1. The exchange will devolve your options positions whether or not you have sufficient margin* at the time of conversion. In case you fail to maintain the required margin, you will face a margin shortfall attracting a penalty.
2. Angel One squares off your open ITM options positions as follows:
   1. For compulsory delivery commodities – Open ITM options positions for all the clients will be squared off
   2. For non-deliverable commodities – Open ITM options positions of the clients with an insufficient margin for conversion into futures contract will be squared off

*Margin here means the margin that is prescribed for that commodity’s futures contracts.

Devolvement of options positions into futures positions

At the time of expiry, open options positions will devolve into underlying futures positions as mentioned below.

 

Understanding the margin requirements for options positions settlement mechanism

If you hold an open ITM options position, you must note the following points related to the margin requirements:

1. 2 days prior to the expiry date, the exchange will charge an additional (Devolvement) margin on options contracts in order to carry out the conversion.
2. You have to maintain this margin by T+1 day (T day is considered as the day on which the margin is charged).

Continuing the example mentioned above – As your options contract is expiring on 16th February 2022 then the exchange will charge an additional margin on 14th February 2022. So, make sure you have a required margin in your account by 15th February (T+1) to avoid a margin shortfall penalty.

Conclusion

To diversify your portfolio and hedge in the commodities market, you have a wide range of commodities to choose from. Before you start trading in the commodities market, you must know how it is different from the equities market and the settlement process being followed for the commodities contracts. Devolvement is one of the most important settlement processes that you must know about. However, if you don’t want to devolve your options positions, make sure to settle them before expiry.