Commodity Options

Up until now, in all of the chapters and modules that dealt with commodities, we’ve only taken a look at the futures contracts. However, futures are not the only derivative contracts available for trade in the exchanges. In India, we also have the option to trade in commodity options. And that’s exactly what we’re going to look at in this chapter.

Commodity options: An overview

Here’s a fun fact for you. Right up to the start of October, 2017, commodity options were not in existence at all in India. We only had commodity futures to trade on. After much deliberation and insistence from the investor and trader community in the country, the first ever commodity option contract was introduced on October 17, 2017. The contract was a gold options contract with the gold futures contract as the underlying asset.

Since the introduction of commodity options more than three years ago, the average daily turnover has grown tremendously, signifying the popularity that the options contracts enjoy amongst the commodity trader community.

Commodity options: How do they work?

You’ll recall that we’ve already gone over the entire workings of an options contract in an in depth manner in the previous modules. They dealt with derivatives that had stocks as the underlying. As a matter of fact, commodity options are not very different from stock options. There are only a couple of differences between the two of them:

• The underlying asset 
• The expiry mechanism

When it comes to the underlying asset, for stock options, the underlying asset is a stock. On the other hand, for commodity options, the underlying asset is either a commodity or a commodity futures contract.

And regarding the expiry mechanism, in stock options, upon expiry, you receive the underlying stock. Whereas, in commodity options, upon expiry, you receive the futures contract of the relevant commodity. Confused? Don’t worry, here’s some information that can offer more clarity on the topic.

Since a commodity option devolves into a futures contract of the underlying commodity upon expiry, the expiry date of the said options is almost always two to three days prior to the expiry date of the futures contract.

For instance, let’s take up a crude oil options contract, with a crude oil futures contract as the underlying. Assume that the crude oil futures contract expires on March 19, 2021. Then, the crude oil options would expire around 2 days prior, which would be March 17, 2021. Clear about this part? Let’s move to the next one.

Now, on commodity options expiry, all the open positions get devolved into the underlying commodity’s futures contract. The logic that the exchanges follow for devolving options is given below.

• If you possess a long call option in a commodity, upon expiry, your position will devolve into a long position in the futures contract of the said commodity. 
• If you possess a short call option in a commodity, upon expiry, your position will devolve into a short position in the futures contract of the said commodity. 
• If you possess a long put option in a commodity, upon expiry, your position will devolve into a short position in the futures contract of the said commodity. 
• If you possess a short put option in a commodity, upon expiry, your position will devolve into a long position in the futures contract of the said commodity.

There’s also another logic that exchanges follow if you choose to exercise your options upon expiry.

• If you hold an ITM (in-the-money) option, you will receive the difference between the commodity futures price and the commodity option strike price in cash, along with the futures contract of the commodity.
• If you hold an OTM (out-of-the-money) option, the option will expire worthless.   
• If you hold a CTM (close-to-the-money) option and the strike price is higher than the futures price, you will have to pay the difference between the two in cash to receive the futures contract of the commodity.
• If you hold a CTM (close-to-the-money) option and the futures price is higher than the strike price, you will receive the difference between the two in cash, along with the futures contract of the commodity.

Now, since the settlement and exercise of commodity options is a more complicated affair than stock options, it is a good idea to square off all your positions before the date of expiry.

Commodity options: Examples

Okay, so now that you’ve gotten the hang of how a commodity option contract works, let’s take up a commodity options example to better understand the concept.

Assume that you have a bullish view on crude oil and you expect the price of crude oil to rally in the month of March, 2021.

The current trading price of crude oil futures contract on the MCX is Rs. 4,293. And since you have a bullish view, you would purchase a call option contract, right? Now, assume that you wish to purchase a call options contract with a strike price of Rs. 4,300. Here’s the current trading price of the crude oil call option contract with the expiry date set on March 17, 2021.

As you can see in the snapshot above, the call option is currently trading for Rs. 170. This price is the call option premium that you would have to pay for a barrel of crude oil. You’ll recall that we discussed option premiums in a chapter in an earlier module. The minimum lot size of a crude oil call option contract is 100 barrels.

If you remember from our previous chapter on crude oil, a single lot of crude oil futures is also worth 100 barrels of crude oil. The lot size of both commodity futures and commodity options tend to be the same.

Continuing on with our example, for purchasing 1 lot of crude oil call options, you would have to pay up around Rs. 17,000 (Rs. 170 x 100 barrels). Now this call option gives you the right to receive 1 lot of crude oil futures upon expiry. And since you are buying a call option, essentially making it a long call option, your position will devolve into a long position in the futures contract of crude oil upon expiry.

Let’s fast forward a bit to the expiry date of the options contract. There are three things that can happen.

1. The futures price goes up to Rs. 4,350

In this case, your long call option with a strike price of Rs. 4,300 becomes an ITM option. Going by the logic of the exchange, you will receive the difference between the futures price and the strike price in cash. 

• This comes up to Rs. 50 (Rs. 4,350 - Rs. 4,300) per barrel. 
• Multiplying this with the lot size will give you the true figure that you’re likely to receive, which is Rs. 5,000 (Rs. 50  x 100). 
• Along with this, your position will also devolve into a long position in the futures contract of crude oil.

2. The futures price stays at Rs. 4,293

In this case, your long call option with a strike price of Rs. 4,300 becomes a CTM option. Going by the logic of the exchange, since the futures price is higher than the strike price, you will have to pay the difference between the futures price and the strike price in cash.

•  This comes up to Rs. 7 (Rs. 4,300 - Rs. 4,293) per barrel. 
• Multiplying this with the lot size will give you the true figure that you would have to pay, which is Rs. 700 (Rs. 7  x 100). 
• Along with this, your position will also devolve into a long position in the futures contract of crude oil.

3. The futures price falls down to Rs. 4,200

In this case, your long call option with a strike price of Rs. 4,300 becomes an OTM option. So, your crude oil call options will expire worthless. Your loss would amount to the entire premium of Rs. 17,000 that you paid to acquire the said options.

As already mentioned above, the expiry and settlement process of commodity options is a bit complicated. And so, always ensure that you square off your positions in a timely manner before the expiry to avoid the hassle.

Commodity options: Where to trade?

As you already know, there are three primary commodity exchanges in India:

• The Multi Commodity Exchange (MCX)
• The National Commodity and Derivatives Exchange (NCDEX)
• The Indian Commodity Exchange (ICEX) 

The MCX offers commodity options in the base metals, energy, and the precious metals (bullion) segments. The NCDEX, on the other hand, offers commodity options for a wide variety of agricultural products. ICEX, however, doesn’t offer any commodity options.

In addition to these, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) have recently started to offer commodity options in the precious metals (bullion) segments as well.

Wrapping up

With this, we’ve come to the conclusion of yet another exciting chapter on commodities. Here’s a final note. If trading on commodity options is what you’re really after, then it is a good idea to first start off with a small investment till you get a good grasp of the options expiry and settlement process.

A quick recap

• Till the start of October, 2017, commodity options were not in existence at all in India. We only had commodity futures to trade on. 
• The first ever commodity option contract was introduced on October 17, 2017. 
• The contract was a gold options contract with the gold futures contract as the underlying asset.
• Long call options and short put options devolve into long positions in the corresponding commodity futures.
• Short call options and long put options devolve into short positions in the corresponding commodity futures.