InvestorQ : How is the trading of commodity options unique in Indian context as compared to the case of other countries?
Tisha Malhotra made post

How is the trading of commodity options unique in Indian context as compared to the case of other countries?

user profile image
Moii Chavate answered.
7 months ago

The MCX currently options on Copper, Crude Oil, Silver, Gold and Zinc. NCDEX currently offers options only on Guar seeds. Here are some of the key challenges ahead for commodity options in India?

· There are strict guidelines for inclusion of commodities in options. Commodity options are only possible in contracts which are among the top-5 commodities in terms of volumes and value in the last 12 months.

· Average daily turnover condition of Rs.200 crore per day in case of agri commodities and Rs.1000 crore per day in case of non-agri commodities has also worked against the introduction of options on more commodities.

· In a way, it is a Catch-22 situation for commodity options. To build volumes you need participation but to build participation you need some volumes to begin with. That is where it is getting stuck. After the initial euphoria, the volumes are not really picking up in a big way. This requires a tipping point like the concessional STT was the tipping point for the big push in volumes to index options in India. Traders and hedgers still prefer to participate in a liquid market.

· Positions of a single trader are restricted to 5% of the Market Wide Position Limits. This is a big limitation for large traders to come and hedge in the market. For example, if Sterlite or Hindalco needs to hedge its copper risk using Copper Options then the 5% limit will be too small. This keeps most large traders out of the ambit.

One major difference in India is that commodity options devolve into futures not into commodities

This could change very soon but that is it is right now. This is where options differ from equities. The equity option is an option on the underlying stock while the commodity option is an option on the commodity future. Therefore, it becomes a double derivative. However, excise of options will be a lot more complicated. That is because commodity options will not devolve in to the commodity but into commodity futures. There is a reason for that. While SEBI regulates commodity futures, it does not regulate the spot market as it comes under the purview of the state government regulation. Hence all exercised commodity options positions will devolve into futures of the same commodity, with the options strike price as the theoretical futures price.

So if you are long on call option or short on put option, if exercised it will devolve into a long futures position on the same commodity. On the other hand, if you are long on put option or short on call option, then when exercised it will devolve into a short futures position. From that point all normal futures margins will be applicable on the position.

Now that really creates a unique problem of position asymmetry

Since the exercised commodity options will devolve into commodity futures, the commodity options will require a separate expiry that will have to be scheduled before the commodity futures expiry. Effectively, the commodity options expire 2 days earlier than commodity futures and that makes the options less valuable due to lower time value. This will also mean that any devolvement will lead to an increase in the open interest of commodity futures and will have to be unwound if the OI exceeds the prescribed limits.

The bigger challenge is of position asymmetry. Here is an example to understand this point better! A trader or hedger buys a call option because they want to take limited downside risk and margin liability. When it devolves into a long future the trader is required to take up unlimited risk as well as margin liability in terms of MTM margining. For a person who has sold a put option, margins may not be the issue as they are already paying margins on a short option position. However, a trader sells a put option because they do not expect the market price to go below a certain level. Converting that view into a bullish long futures position will skew the trader’s original trading intent. These are the practical problems that currently stand in the way of a big push to commodity options volumes.

The good news is that the regulator (SEBI) is now seriously looking at having commodity options directly linked to the underlying commodity rather than the underlying commodity future. Regulations need to be tweaked but that is something the government can always manage. Commodity options will be a boon as it gives income earning opportunities for the writer and lower cost hedging for the buyer of the option. Like in the case of equity and index options, there is a huge potential for it to take off.