InvestorQ : With the introduction of options on commodities, how is the commodity derivative landscape likely to change? Is it a big opportunity?
Anu Biswas made post

With the introduction of options on commodities, how is the commodity derivative landscape likely to change? Is it a big opportunity?

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Neelam Naik answered.
1 year ago

The market regulator, SEBI, recently permitted options on commodities on the two principal commodity exchanges in India viz. MCX and NCDEX. Both the exchanges launched commodity options in 2017 but only in specific commodities with case by case permission from SEBI on the same. This will be a new addition to the trader’s arsenal as it will offer a lower risk product to trade commodities with limited downside risk. The key question is; will commodity options really emerge as an effective hedging tool for traders and investors.

What is the role that commodity options can play for investors and markets?

The basic difference between futures and options is that in futures the downside risk can be unlimited whereas in options the downside risk can be limited to the premium paid. The introduction of options will broaden and deepen the market by introducing 3 new kinds of players in the commodities market. Firstly, it will allow the retail and small investors to invest in commodities by buying options. This will also help large businesses with commodity exposures to hedge their open positions with lower cost options. Secondly, traders will be able to earn monthly yields by selling options on overpriced contracts. Lastly, it also opens the door for more sophisticated traders to create covered positions and spread positions to make the best of mispricing opportunities.

Will commodity options reduce the volumes of commodity futures trading?

The one risk that exchanges like MCX and NCDEX will have to be conscious of is the risk of cannibalization. In the equity segment, options volumes grew to a multiple of futures volumes purely because of the lower cost entailed. Firstly, brokerage on options was charged at a fixed rate per contract rather than as a variable rate. This is in contrast to the futures market where the brokerage is charged on the value of the contract. Secondly, the Securities Transaction Tax (STT), which is a major cost for equity derivative trading, is also imposed on the value of premium in case of options. This makes trading in options substantially cheaper than trading in futures. The volume of index options on the NSE today accounts for over 80% of overall volumes on a daily basis. This is a likely risk in case of commodity options, at least on paper.

How have global markets experience been with the growth of commodity options?

Interestingly, commodity options has not really gained acceptance worldwide. According to recent statistics put out by the Futures Industry Association (FIA), options account for just about 5% of commodity derivatives transactions worldwide. In case of US Exchanges, the proportion is much higher at around 16%, which essentially means that in all the other global markets put together, the share of commodity options is almost negligible. That means, futures continues to be the overriding theme of global commodity markets. Of course, part of the reasons could be that China, which is one of the major markets for commodity trading, has not yet launched commodity options. The picture overall could change drastically once China also permits trading in options contracts. In the Indian context, SEBI is only permitting options on 2 commodities per exchange to begin with. Each exchange will be permitted to issue one contract on metals and one contract on an agricultural commodity. Hence, the entire launch of options may a longer time to pick up scale.

Commodity options could actually be a big thrust for the commodity exchanges

The real story could be that the 2 principal exchanges viz. MCX and NCDEX will have an opportunity to expand beyond their traditional base. While the NCDEX literally dominates the agricultural commodity futures space, it is MCX which dominates the precious metals futures space. In the futures space, it is difficult for both these exchanges to substantially change the existing equation. But options will be an opportunity. Both the NCDEX and the MCX will have an opportunity to look beyond their traditional strongholds and look at options to expand their market base in the missing link. Of course, the actual implementation will depend on the finer details that will be announced in course of time.

But some major challenges and open issue still remain for commodity options

There are a few issues which will have to be addressed. Firstly, commodity markets have been vulnerable to sudden bans on trading in certain sensitive commodities as well as special limits and margins to discourage trading. These kinds of changes will distort the risk-return of any trade and could be a challenge for a large-scale expansion of the options market. Secondly, the commodity markets are still too narrow with limited products to trade and fewer structures. Options will at least be a beginning in widening the product palette. Thirdly, India still does not have the global infrastructure to expand commodities trading. Globally, there are dedicated commodity funds, ETFs on specific commodities etc which go a long way in generating secondary demand for commodities. More importantly, the government needs to tighten regulation, monitoring and risk management to ensure that situation like NSEL in 2013 do not have their ripple effects on commodity markets. Commodity options are surely a good starting point. It is now up to the market to take it to its logical conclusion.