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Commodity options - crude oil and natural gas

18 Oct 2022 0 COMMENT

Energy derivatives encompassing crude oil and natural gas have been favourite amongst the commodity market segment because of their wide usage worldwide. Crude oil is considered the mother of the global financial market in general and the commodity market in particular, as this product contributes significantly to global economic development. A sharp increase in global crude oil prices causes higher inflation, prompting nations to look for alternative energy sources such as biofuels.

Crude oil prices are influenced by factors such as supply and demand, geopolitical tension, weekly oil inventories, international trade trends, adverse weather conditions in the Gulf of Mexico, and so on.

Natural gas, on the other hand, is primarily traded in North America and Europe. It is widely used in industries such as power generation, residential heating and cooling, and industrial and commercial purposes. Natural gas prices are influenced by factors such as supply and demand, as well as weather conditions in the United States.

India is the world’s third-largest consumer of crude oil after the United States of America and China and we are largely dependent on the import of crude oil to meet our consumption demand. The Multi Commodity Exchange of India has been the pioneer in the launch of energy derivatives with the commencement of the exchange way back in 2003.

For many years, MCX was offering futures trading in the commodities including energy and there were no options trading in the energy segment because of the absence of approval from the regulator as well as the absence of a settlement mechanism for options contracts. However, after taking over commodity market regulation from the erstwhile Forward Markets Commission, the present regulator Securities and Exchange Board of India allowed options trading in commodities with futures as underlying. Accordingly, MCX launched options trading in various commodities. The crude oil options were launched on 15 May 2018 and natural gas options were launched on 17 January 2022.

Energy options trading in India

Options are one of the best derivative products, and their product nature gives them an advantage over futures contracts. Because options provide the right to buy or sell an instrument but not the obligation to complete the transaction upon contract expiration by simply paying a premium to the counterparty. However, contracts in futures are a little larger and attract a large margin against a premium in options.

Energy options contracts are gaining popularity amongst commodity market participants because of the lower premium payable against margins for a futures contract, and the creation of various trading strategies irrespective of market trend.

Table: Options contract specification

Parameters

Crude Oil

Natural Gas

UNDERLYING

MCX Crude Oil (100 barrel) Futures Contract

MCX Natural Gas (1250 mmBtu) Futures

Expiry Day

(Last Trading Day)

2 business days before expiry of the underlying futures contract

2 business days before expiry of the underlying futures contract

Underlying Quotation / Base Value

Rs. per Barrel

Rs. per MMBTU

Strikes

40 ITM - 1 NTM - 40 OTM

30 ITM -1 NTM -30 OTM

Strike Price Intervals

Rs. 50

Rs. 5

Tick Size

(Minimum Price Movement)

Rs. 0.10

Rs. 0.05

Daily Price Limit

The upper & lower price band shall be determined based on the statistical method using the Black76 option pricing model and relaxed considering the movement in the underlying futures contract.

Settlement

On the expiry of the options contract, the open position shall devolve into the underlying futures position as follows: -

  • long call position shall devolve into a long position in the underlying futures contract
  • long put position shall devolve into a short position in the underlying futures contract
  • short call position shall devolve into a short position in the underlying futures contract
  • short put position shall devolve into a long position in the underlying futures contract

All such devolved futures positions shall be opened at the strike price of the exercised options

Source; Multi Commodity Exchange of India

Energy derivatives trend

Crude oil and natural gas futures have been on the commodity list since the inception of the nationalized commodity exchanges in India in 2003. Options on crude oil futures were launched in 2018 and the same on natural gas was launched in January 2022. Energy options have grown in popularity among investors over the years, and in fiscal 2021-22, energy options have grown multifold from a meagre 432 thousand contracts in April 2021 to 4886 thousand contracts in March 2022. The following chart depicts month-on-month growth in the energy futures and options. After the introduction of options on natural gas in January 2022, the options volume took over futures contract volume from February 2022 onwards and the growth story continues.

 

Summary

The energy sector is the second-largest turnover generator in the Indian commodity exchange, accounting for 37% of total volume. Both of these energy products' price movements were determined by their global benchmark, which was priced in Indian rupees. Energy options are gaining importance since their launch given the market volatility, and increase in futures margin.  All investment products in the energy sector, such as futures, options, and indexes, are cash-settled contracts, so traders do not have to worry about their open positions becoming mandatory delivery as they do with other commodities.

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. I-Sec is a Member of National Stock Exchange of India Ltd (Member Code :07730), BSE Ltd (Member Code :103) and Member of Multi Commodity Exchange of India Ltd. (Member Code: 56250) and having SEBI registration no. INZ000183631. Name of the Compliance officer (broking): Ms. Mamta Shetty, Contact number: 022-40701022, E-mail address: complianceofficer@icicisecurities.com. Investments in securities markets are subject to market risks, read all the related documents carefully before investing. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The securities quoted are exemplary and are not recommendatory. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investors should consult their financial advisers whether the product is suitable for them before taking any decision. The contents herein mentioned are solely for informational and educational purpose.