Options are derivatives with values that are influenced by underlying instruments – which can include currencies, indexes, stocks, commodities, and more.
Commodity Options revolve around underlying commodity futures. These contracts allow the holder to either buy or sell at a pre-fixed price and on a pre-determined date only. The commodity options market is different to equity options. Most Indian regulators now only allow option trades with commodity futures and not within the commodity spot market as the regulations for each differ.
Option contracts allow an investor to buy and sell the asset in question, but the price is pre-determined, and the purchase/sale must be completed within a set time frame. Option contracts include an option-to-buy rather than an obligation-to-buy. There are two sides to an option contract – the buyer and the seller. The buyer is often referred to as the holder, while the seller is called a writer.
There are two different options types – the American and the European. With American options, the contract can be triggered on any day before expiration. With European options, the contracts can only be triggered on one pre-determined day. European options are also the only ones on offer in India.
When it comes to using options for trading, the risks are minimal and the potential for benefits is huge. This is all thanks to that keyword, ‘option’. The holder of the options contract has the choice over whether they trigger the ability to buy/sell. Essentially, if the expiration day rolls around and the market price is higher than the strike price, the holder can trigger the options contract and get a good deal. But similarly, if the strike price is higher than the market price, they can choose against triggering the contract.
The writer of the options contract is looking to turn a profit by charging a premium for the contract itself. This price is charged when the contract is written up, regardless of whether it is triggered or not. The seller relies on most contracts expiring rather than holders triggering their option to buy/sell/trade.
A trader is looking at a futures trading at Rs. 1000. They believe the prices are going to fall but there is profit to be made. They enter into a call option contract with a pre-determined strike price of Rs. 750. In order to open this contract, they must pay Rs. 25 to the seller/writer. When the expiration date rolls around, the futures is trading at a market price of Rs. 900. Therefore, the trader triggers their option to purchase at the pre-determined price of Rs. 750. This gives them a profit of Rs. 125. (900-750 and the 25 fee). The seller/writer has no option but to agree to the contracted deal.
However, let’s say the expiration date rolled around and the futures was only trading at a market value of Rs. 500. The trader would then not want to trigger their option to purchase at Rs. 750 and would simply let the contract expire. In this case, their only cost would be the Rs. 25 fee to open the contract in the first place.
A commodity put option is a contract that grants a seller the chance to sell an underlying commodity futures for a pre-determined price on a pre-determined expiration date. This is typically the last Thursday of the relevant month. A put option can also be inserted into commodity futures, however, this does come with risk. If a seller does not want to trigger their option to sell the commodity because it has intrinsic value come the expiration date, the seller will lose out on whatever premium they paid to take out the put option.
Options allow a trader to take a short position while also cutting down on any trading risk. After all, you can choose not to trigger a put option if the market does not fall your way. In that case, all a trader would lose is whatever premium they agreed to pay in the first place. There is more risk when it comes to futures with obligations to sell. However, options are cheaper to write up and have less risk associated. You can think of commodity options contracts as price insurance in a volatile market.
Understanding commodity put options can be tricky, so let’s use an example to demonstrate how they can apply to real-world scenarios.
Trader 1 is expecting the price of particular futures to rise in the next month. The current market price is Rs. 1000. Trader 1 pays a premium of Rs. 50 to take out a put option with a strike price of Rs. 1250. One month later, when the expiration date rolls around, the market price for the futures is at Rs. 1100. Trader 1 would then trigger the right to sell at the pre-determined price of Rs. 1250 because it has intrinsic value. They paid Rs. 50 for the put option in the first place but gained Rs. 150 in intrinsic value, making for a profit of Rs. 100.
However, if the markets go the other way and the futures is trading at a market value of Rs. 1500 by the time of the expiration date, then Trader 1 would not want to sell. They would choose against triggering their contract and instead, let it expire. In this case, they would have made a small loss of Rs. 50 from the premium they paid for the put option in the first place.
