Commodity Options Vs Equity Options

Commodity options are blessings in disguise in the history of commodity trading in India. It is another investment instrument for equity options traders. Although commodities options and stock options are similar, there are three key differences between both of them:

Let us understand these three differentiating points in detail.

Underlying:

Being a derivative product, options in any of the asset class is built on the underlying product. As we all know that the equity options are having the spot equity index and individual cash stocks as underlying such as NIFTY Index Option, Bank Nifty Option, TCS Option, Infosys Option etc.

In case of commodity options, the underlying is the commodity futures contract. Since there is no cash online commodity market other than physical trading centres, the commodity options are built on commodity futures. There was a detailed deliberation at the regulator level before introducing options on futures as both of them are derivative products and finally, the regulator decided on allowing commodity options on futures contracts.

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.

Expiry:

Expiry is the most distinct feature of derivatives market where the contracted parties agreed to execute the contract on the expiry date. Commodity options are built on commodity futures, which also have an expiry. Moreover, commodity futures are deliverable contracts. Hence, in order to avoid the contracts entering into delivery mode, exchanges have specified 5 days prior to expiry of the futures contract as final date for squaring off or roll-over of the contracts. Since the commodity options are having futures as an underlying, exchanges have specified 2 days prior to commencement of tender delivery period as expiry date for the options. ATM and ITM contracts will be devolved into futures contracts if they are not squared off before expiry of the options contract while OTM contracts shall expire worthless. 

An illustration of devolvement, expiry pattern and End of Settlement (EOS) of cash-settled and non-cash-settled commodity derivatives at ICICIdirect:

Settlement:

Commodity options settlement is devolvement of ATM and ITM contracts if they are not squared off. All the ATM and ITM are devolved into futures contract at the strike price and investors are liable to pay futures contract margin. Options on commodity futures contracts traded on Indian commodity exchanges are available. When these commodity options are exercised, they become the underlying futures contracts. 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.

Commodity options performance

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 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. 

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 is very less compared to futures trading, making is the most lucrative trading instruments amongst the market participants.

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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