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Commodity Futures and Option Makes Robust and Effective System

11 Mins 09 Dec 2022 0 COMMENT

Amongst the derivatives—futures and options—both play a vital role in development of an effective market ecosystem. Post introduction of options into the commodity derivatives market by the SEBI gave another trading avenue for Indian traders.

Unlike futures contract, where buyers and sellers are having an obligation of honouring the contract, options contract, as you know, gives the right not the obligation to honour the contract, which makes it easy for the market participants to trade.

Commodity options are gaining popularity over the futures contract because of its ease of trading in terms of premium payable against margins in futures contract, developing various trading strategies irrespective of market movement i.e., bullish, bearish and neutral.

An introduction of options on commodities futures is another feather in the history of the commodity derivatives market of India. For traders and investors in commodities in India, commodity options are a blessing in disguise. Although commodities options and stock options are similar, there are three key differences between both of them:

  1. Unlike in stock options where cash stock is underlying; in commodity options, the underlying is the commodity futures.
  2. In stock options, the expiry is the last Thursday of the contract expiring month while in commodity options it is 2 days before the commencement of the tender delivery period of underlying commodity futures.
  3. Stock options are settled in cash while the commodity options, if not squared off before the commencement of the tender delivery period those in the money options contracts are devolved into a futures contract.

Trading in commodity futures and options was permitted by the SEBI after the merger of FMC. The Indian commodity markets follow the European model of options, allowing buyers to exercise their options on the contract's expiration date.

The first commodity options contract was introduced on gold on October 17th, 2017, and was followed by crude oil options on May 15th, 2018, copper on May 21st, 2018, silver on May 24th, 2018, zinc on June 21st, 2018, silver mini on July 19th, 2021, nickel on December 13th, 2021, and natural gas on January 17th, 2022, and gold mini on 25 April 2022.

Options in commodity futures made investing easy for retail investors who were struggling to trade in futures by paying huge margins. After initial uncertainty about options on commodity futures due to distinct characteristics as mentioned above in three points, the investors started understanding the importance and working of options on commodity futures.

As the participation from traders increased, the options trading on commodity futures started gaining traction. Chart 1 below shows the growth of commodity futures and commodity options traded contracts on the exchange platform. The chart shows that volumes of commodity options increased every month and almost reached half of the futures volume thanks to market movement, volatility as well as the lower amount payable as a premium.

 

Commodity options have received an overwhelming response since their launch, and they have been performing well in several products. Analysis of volumes traded in futures and options, it shows that in August 2021, the volume ratio of commodity futures to commodity options was 84% to 16%, respectively, which transformed to 59% and 41%, respectively in July 2022. In August 2021, the number of futures contracts traded on Indian exchanges was 12.09 million contracts while options contracts were just 2.26 million contracts, which changed to 9.91 million futures contracts and 6.93 million options contracts in July 2022.

Commodity options are getting increased participation from financial market traders as the commodities are witnessing a good amount of volatility owing to various developments across the globe. Retail investors and hedgers are increasingly using commodity options to take advantage of price movement with a lower premium. Exchange-Traded Commodity Options are growing because of price transparency with the nationwide online trading platform. 

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What are Future and Options ?

Benefits of trading in commodity options

Portfolio Diversification:

Commodity options are best investment tools for portfolio diversification. Investors actively trading in stock options can look into commodity options for their portfolio diversification. Further, various trading strategies can be formulated using commodity options in various market condition such as bullish, bearish, and neutral.

Risk Management Tool:

Commodity options are useful risk management tools, especially for small stakeholders, because the option buyer is not required to maintain margins. They are similar to price insurance for hedgers, which can be purchased for a one-time option premium. Various value chain participants can use the commodity options for hedging their risk exposure along with futures contracts. For ex., Farmers expecting harvesting of his crop in 3 months can lock in his selling price by buying a put option just paying a premium against selling a futures contract with high margin.

Lower cost of trading:

The cost involved in trading commodity options trading is very less compared to futures trading, making is the most lucrative trading instruments amongst the market participants.

Impact of commodity options trading on the financial market

With the introduction of commodity options, the investor’s fraternity got one more avenue of trading which was restricted only to the futures contract. Further, because of its ease of trading, many retail investors are increasingly trading in commodity options, which is evident from the chart mentioned above. Given the higher price of commodities, which is resulting in a higher margin, commodity options are a blessing in disguise for retail investors.

Summary

Commodity options are another feather in the Indian commodities market along with futures and index trading. The popularity of commodity options has been increasing month over month as it is attracting more participation from retail investors, who are not able to trade in high-margin commodity futures. In the last couple of months, retail participation has been increasing in commodity options and the same is likely to continue in the future. These instruments are the best portfolio diversifier as well as risk management tool for buyers and sellers of commodities who are exposed to price risk. Further, market participants are allowed to trade in options irrespective of market trends such as bullish, bearish, and neutral price trends.

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