My first commodity trade was pepper futures. This was around the end of 2005, or early 2006. Since then I have closely followed the development of India's commodities markets and commodities exchanges. The MCX has done a great job in promoting the Indian commodities market. They have introduced new contracts, and increased market depth. Since then, liquidity has also improved a lot. If I recall correctly, options were introduced to the commodity market in 2009. Needless to mention, I was very excited when I heard of this plan. I could imagine all the options one would have in trading commodity options.
Unfortunately, the commodity options were not introduced to the market. This topic of commodities options has been brought up a few times since then, but it has remained a market rumour.
It now looks like options on commodities may finally be available for purchase. SEBI approved the files for commodities options in June 2017.
Commodities exchanges have worked hard since then to create a framework for introducing commodities options. This is why I thought it would be useful to give a quick overview of what to expect and what you should look for in the commodity options market.
The options theory for commodities will remain the same as futures. It is important to focus on logistics. This chapter aims to do just that.
You should be aware that commodity options are only options on Futures , not the spot market.
If you take a look at a call option for Biocon, the underpinning is the spot price. The underlying for Nifty options is the spot Nifty 50 Index value. If you look at Crude Oil options, however, the underlying is not the spot Crude Oil price. This is because we don't have a spot market in India for Crude Oil, or any other commodities. We do however have a vibrant futures marketplace. The commodity options are therefore based on the futures market for commodity.
The following are some of the most important facts about crude oil options.
This can therefore be considered a derivative of a derivative. This should not be a problem if you trade. Only the way that the premium is calculated is different between regular options (with spot as an underlying) and options on futures. The premium can be calculated using a Black & Scholes regular model. For the latter, a Black 76 model is used.
These two models differ in how the continuous compounded rate of risk-free is treated. The details are beyond my scope. Keep in mind that there are many Black & Scholes calculators available online. Don't rush to enter the commodities variables into a standard B&S calculation to get the premium value or Greeks. It won't work.
We don't know yet how the exchanges will create the infrastructure for these options. We did however look at the mock framework and it is not too different.
Exchanges could begin by offering Gold options. They would gradually but surely offer options for other commodities. This is the best part.
Option Type Call and Puts
Lot size - These are futures options, so the lot size will be the same as the futures lot size
Order Types – All order types (IOC/SL, SLM/GTC, Regular, Limit), would be allowed
Exercise style -- Options are European in nature.
Margins SPAN + Exposure margin for option writing. Option buying requires full premium. This is where the concept of devilment margin comes into play. I have discussed it towards the end.
Last Trading Day (for Gold) 3 days before the final tender day
Strikes -- If you consider one "At the Money Strike" (ATM), then there would be 15 strikes above ATM and 15 below ATM, bringing the total strike count to 31.
Here is where things get a bit tricky. The following convention is used by equity option traders:
The commodities options will however introduce us to a new terminology, 'Close To Money' (CTM). This is how it will work.
Settlement –For Daily M2M Settlement in Futures, the exchange uses the commodity daily settlement price (DSP), as the reference value. For options, the reference value will be the DSP of the commodity at expiry.
Let's see how settlement works. Take this example: Let's say that the DSP for a commodity is 100. Consider this: A commodity has a strike interval of 10 points. Let's now identify the moneyness for strikes.
Long option holders who are 'CTM" will need to give an explicit instruction. A clear instruction will allow the option to be transferred into a futures agreement. The strike will result in the futures contract. If I have 80 call options, an "explicit instruction" will devolve the call option into a long futures position of 80. The 'explicit instructions' will likely be offered via the trading terminal, I believe.
Here's an important point: If you don't give explicit instructions to devolve your CTM options, the option will be considered worthless.
CTM and all ITM options will be automatically settled. Settlement in the options market uses devolving an option into a equivalent futures position. If you hold a non-CTM or ITM option, and you do not wish to have this settled automatically, you will need to issue a "Contrary instruction". Without this instruction, the contract will automatically be settled by devolvement.
The question is: Why would you want to use an ITM option?
In some cases, the ITM option you have might not be worth it due to taxation or other applicable charges. In this instance, it is better to not exercise your ITM option than to do so. This is when you can use the "Contrary instruction" privilege to opt out of your ITM option.
Assume you have an ITM option (including CTM), and the option will expire be converted or devolved into a Futures position. We all know that margins must be kept with the broker in order to hold a futures position. How can we account for this? This means that if I want to take a position on an option, I must pay for the premium. I wouldn't park any margin at the time I bought the option in the hope that it might be converted into a futures position.
This can be circumvented by the concept of the 'Devolvement Margins'. Let me cut through the technicalities to let you know what you can expect.
Here's a quick overview of how the options position will change.
|Option Position||Converted into|
|Long-Term Call||Long-Term Futures|
|A Short Call||Futures for the Short Term|
|Long Put||Short Futures|
|Shot put||Long-Term Futures|
As I see it, once the option contracts are released, we will gain more insight into the structure. This chapter will be updated with exact information when the commodity options are available.