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While the systematic trading in commodity futures had ushered into India with the formation of the Multi Commodity Exchange (MCX) in 2003, the informal trading of commodity futures has been in existence in India for over 100 years. Let’s begin with understanding commodity futures, forwards and options.
Commodity futures are available on four broad categories of products in India:
To understand the concept of forwards as distinct from futures and options, let us look at a hypothetical illustration.
A farmer grows tomatoes during the season and supplies it to the ketchup factory which is situated about 60 KM away. The ketchup factory arranges to pick up the tomatoes from the farm and transports to the factory directly. The price at which the tomatoes are supplied is determined by the prevailing market prices on the date of supply. The contract is for 5000 kg of tomatoes. However, this opened up a price risk to both the farmer and the ketchup factory as neither were sure about the prevailing market prices on the day of supply. That is where a basic forward contract can come into existence.
A forward contract is an agreement to buy or sell an underlying commodity at a fixed price determined in advance for a particular date in the future.
Can a forward contract come into existence in the above case? Let us take a look.
Now the farmer and the ketchup factor can enter into a forward contract as under:
What happens on the date of maturity of the forward contract at the end of 3 months? There are 3 possibilities in this case.
The above example of forwards sounds very good on paper, but there are a lot practical difficulties. What happens if the farmer or the ketchup factory is unable to honour their side of the contract? It could be a deliberate default or it could be a genuine reason. Either ways, the other party will be put through a lot of pain. Of course, forward contracts are regulated under the Contracts Act and hence the contract can be enforced in the court of law. But, that is a very long and cumbersome process and the parties to a forward contract may have neither the time nor the wherewithal to pursue prolonged legal recourse.
There is another possibility. After entering into a forward contract, either the farmer or the ketchup factory may want to exit the contract for genuine reasons. However, they are obligated to the contract and they cannot exit the contract unless they can find another similar party who is able to honour their side of the contract. Since forward contracts are very unique to the specific circumstances, they tend to become illiquid. It is to address these problems that the concept of futures transaction came about.
Let us look at how futures differ from forward contracts.
Clearinghouse guarantees performance
Traded on organized stock exchange
Traded over the counter
As seen from the above table, the futures contract and forward contract are structurally the same. Both entail a contract to buy or sell an underlying commodity at a future date at an agreed price. In case of futures and in case of forwards, the buyer and the seller have unlimited profit and loss potential. However, futures differ from forwards on the following counts.
Do futures and forward contract entail a cost? Basically, forwards are private contracts so they operate on good faith. However, you get a real idea of costs when you get into an exchange traded futures contract. When you enter into a futures contract, there is an upfront margin that the exchange collects. The margins are defined by the exchange and are called the initial margin and it consists of VAR margin and Extreme Loss Margins (ELM). In addition, the exchange also collects mark-to-market (MTM) margins, in case the prices move against the parties. The initial margins are similar, irrespective of whether you are buyer or a seller in the futures contract. It is only the MTM margins that differ based on which side of the contract you are in. Like in the case of financial derivatives, commodity derivatives are also subject to trading and statutory costs. The only difference is that the exchanges charge commodity transaction tax (CTT) instead of STT in case of equity and index futures.
Understanding commodity options
Commodity options are a recent addition to the Indian commodity markets repertoire. While trading in commodity futures began in 2003 on base metals, precious metals, energy and agricultural commodities, options were only permitted from 2017 onwards. While future and forwards are a right and an obligation, options are a right without an obligation. Thus the option buyer has the right to buy (in case of call option) and the right to sell (in case of put option). On the other hand, the seller of the option has the obligation to buy or sell without the right. For this risk, they are paid the option premium.
Structurally, derivatives in commodities are exactly like derivatives in stocks and indices. However, there are some subtle differences between them.
|Equity Derivatives||Commodity Derivatives|
|In case of equity derivatives (futures and options), both the spot market and the derivatives market are regulated by SEBI.||In case of the commodity markets, only the futures and options trading is regulated by SEBI (formerly FMC). The spot market for commodities continues to be regulated by the respective states.|
|Equity derivatives are essentially meant to be cash settled. That means any profits or losses on the date of closure or expiry of the transaction is settled in cash. Futures or options in a stock do not lead to delivery in the stock.||In case of commodity futures, the holder of the contract can opt for settlement of the transaction in cash or as property delivery. The delivery is handled through authorized warehouses and vendors but regulated by the commodity exchange.|
|Commodity derivatives are currently offered on the NCDEX, MCX, NSE and the BSE; being the four principal exchanges for trading in commodity futures.||Trading in equity derivatives is offered on the NSE and the BSE. While the Metropolitan Stock Exchange also has equity derivatives, the volumes are very low.|
|In the case of equity and index options, all the trades are cash settled.||However, in case of commodity options, the settlement is different from commodity futures. The commodity futures can either be cash settled or they devolve into genuine commodity delivery. In case of options, the options contracts can either be cash settled or they will devolve into commodity futures contracts.|
Commodity Futures are available in four broad categories of products as under:
Precious Metals: Owing to their scarce availability in nature, most of the metals that have been categorised as “precious metals” have been historically considered as a form of currency. However, today they are regarded mainly as investment and industrial commodities.
The following are some of the principal products available under the head of precious metal futures in India.
Base Metals: Some of the key base metals on which commodity derivatives are available include:
Energy: Of the numerous forms of energy, crude oil and natural gas combined constitute more than half of the total primary energy consumed. The following energy contracts are available in India.
Agricultural Commodities: India is predominantly an agrarian economy and ranks second in farm production across the world. The following agricultural commodities are available for trading in futures:
MCX - Black Pepper, Cardamom, Castor Seed, Cotton, Crude Palm Oil, Mentha Oil, RBD Palmolein and Rubber
NCDEX – Barley, Chana, Maize Rabi, Maize Kharif, Wheat, Kapas, 29 MM Cotton, Guar Seed 1MT, Guar Seed 10MT, Guar Gum, Castor seed, Castor seed oil cake, soybean, refined soy oil, mustard seed, crude palm oil, sugar, pepper, turmeric, jeera and coriander.
In the Indian commodity markets, MCX has a leadership position in the trading of precious metals, base metals and energy products while NCDEX has leadership position in trading of agricultural products.
Commodity Options – Products available
Having seen commodity futures, let us also see what are commodity options and the products / contracts available under commodity options. Commodity option is a derivative contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying. For owning this right, the option holder pays a price (called ‘option premium’) to the seller of this right. The seller (writer) of option, on the other hand, bears the obligation to honour the contract should the buyer choose to exercise the option. The option buyer will exercise their option only when the price of the underlying is favourable to them, otherwise they will let the option expire worthless.
As per current regulatory norms, only European style commodity options are available in India at present. (European options can only be exercised on the expiry date as opposed to American options that can be exercised at any time on or before the expiry date). These commodity options, on exercise, devolve into the underlying futures contracts. All such devolved futures positions open at the strike price of exercised options. Commodity options are useful risk management tools, particularly for the small stakeholders, as the option buyer does not generally have to maintain margins. They are akin to price insurance for the hedgers which can be bought by paying only a one-time option premium. Commodity can also be useful to speculators for low cost trading.
MCX offers commodity options on Copper, Crude Oil, Silver, Gold and Zinc. NCDEX offers commodity options on Guar Seeds, Chana, Guar Gum, Soya Bean and Refined Soya Oil.
Like any market, the commodity market also has its mix of different classes of participants who combine to provide debt, breadth and liquidity to the markets. There are different players in the commodity markets with different needs and different commitments. It is this heterogeneous nature of the participants that creates a rational and objective market for commodities. Broadly there are 3 categories of participants in the commodity markets; each with its own unique risk appetite and return expectations.
Hedgers – Participants with an underlying exposure to the commodity:
Hedgers are commercial producers or consumers of a traded commodity. Examples are copper smelters, oil companies, farmers, and jewellers. A copper smelter may want to protect against higher copper prices. Jewellers may want to protect against a sharp rise in the price of gold. Farmers may want to ensure that they get a good price for their produce. Similarly, downstream oil companies may look to hedge their risk on input and output. Hedgers are normally exposed to commodity price volatility in the spot market and use futures or options to protect or reduce the risk. For example, if a jeweller has a requirement of 50 kg of gold after 3 months to cater to wedding season demand, the jeweller can hedge the risk by buying gold in the 3 month futures market. Similarly a pepper farmer can sell pepper futures to effectively lock in a profitable price, irrespective of the volatility in price movements later. Hedgers typically take delivery on the underlying and are low risk participants in the commodity markets.
Speculators – On the lookout for trading opportunities:
Speculators may not have any exposure to the spot market. To them, commodity futures are an investment and trading avenue, like the stock market. They try to make money by speculating on commodity prices. As a result, speculators never receive delivery of the physical commodity. They take a position in commodity futures and square it off before expiry. This means, they settle by buying or selling a contract that is exactly the opposite of the contract they currently hold. This only involves payment in cash and no delivery of the underlying commodities. Speculators can be on the short side or the long side i.e. sellers or buyers in the futures market. Speculators may either look at trading for a few days or may look to roll over positions for a couple of months or more. But these speculators are important as they provide liquidity and finer pricing in the commodity markets.
Arbitrageurs – The spot–futures people
The term arbitrage refers to profiting from price differentials or price inefficiency in two different markets. For example, a stockist holding commodities in spot can sell futures at a premium and lock in the profits. A person with idle stock can also do a reverse arbitrage by selling spot and buying in futures and then rectifying the position to take advantage of mispricing. Arbitrageurs try to profit from the difference in the prices of the same commodity in two different markets. The difference between the two prices is their profit. Arbitrage transactions are usually risk-free. Constant arbitrage reduces the price in the market where it is higher and increases it in the market where it is lower. Arbitrage stops when prices become similar in both markets. These arbitrageurs play a very important role in ensuring that the futures price and the spot price converge over a period of time. Most pricing anomalies are removed by the arbitrageurs and they make the market safer in the process.
Within each of the above categories there are many sub categories but their broad intent is the same. It is the combination of speculators, hedgers and arbitrageurs that makes the market a genuinely price discovery tool. The different categories of participants respond differently to a market development because of their differing risk-return preferences. These differing responses determine how the market price of a commodity will move.
Like any market place, the commodity markets also bring buyers and sellers together. To summarize, these commodity markets perform 4 key functions.
Assists in price discovery
Commodities markets facilitate the trading in bullion, base metals, energy products, agricultural products, and others. These markets help to establish prices for products in a scientific and systematic manner. The unique facet about commodities is that the prices are determined by the market forces of supply and demand. Prices reported from the commodities exchanges are communicated to all market participants and are used as the basis for numerous economic and political decisions. The presence of multi factor approach to pricing ensures that the price discovered is as close to the real situation as possible.
Commodity derivatives help in organizing markets
Forwards represent the unorganized markets where the contracts are largely over the counter and illiquid. Futures exchanges take commodities one step forward. They fulfil an essential economic function by providing organized marketplaces with standardized contracts. Each futures exchange maintains its own clearinghouse that fulfils all transactions and also provides a counter guarantee to eliminate the counterparty risk. This provides stability to the market as the clearinghouse acts as the other party in all transactions.
Gives the opportunity to hedge and manage the risk of the underlying commodity
Merchants, farmers and international firms use the futures exchanges to hedge future transactions. Take the case of a farmer who plans to sell his pepper produce 3 months down the line but is not sure of the price prevailing at that time. To remove the risk of price changes, he sells pepper futures contracts at planting time. When he sells his actual crop (spot) a few months later, he buys back the futures contract. This protects the farmer from any adverse price movements. Today traders and businesses with long commodity positions in the stock can hedge against a price fall by either selling equivalent futures or even by purchasing a put option entailing a much lower cost.
Trading and speculating makes the market function
Speculators fill the important economic function of providing liquidity to an exchange. With the money that speculators bring to the exchanges, the spread between bid prices and ask prices is much narrower than it otherwise would be. Had it not been for the speculators, commodity prices would fluctuate more erratically and in a much wider range. In a nutshell, the commodity markets bring in a greater degree of pricing genuineness to the entire commodity markets through more a scientific and democratic process of price discovery.