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Chapter 7

Options Trading in Commodities

Index of Contents:

Options on commodities are a recent addition and were introduced a full 13 years after commodity futures were introduced in India. An 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. Conceptually options on commodities are the same as options on stocks, indices and currencies.

OPTIONS TRADING IN COMMODITIES

The 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.

Like in case of any other option, commodity options also have calls (right to buy) and puts (right to sell). A call option on a commodity is bought by a trader who expected the price of the commodity to go up so as to cover the cost and the premium. The seller of the call options expects the price to top out and not go above a certain level so as to retain the entire premium as income.

A trader buys a put option when the price of the commodity is expected to fall enough to cover the cost of the asset and the premium on options. A put option is bought when the trader has a negative view on the commodity. On the other hand, the seller of the put option expects the commodity price to bottom out and not go below a particular price point so that the entire premium becomes income for him.

MERITS OF TRADING OPTIONS ON COMMODITIES

An option on commodities could be a call or a put i.e. a right to buy or a right to sell. It is a better way to take measured risks on commodities trading, unlike futures which can entail unlimited losses if the price movement is against you. Here are some of the key merits of options trading on commodities.

  • There is no mark to market margin calls for option buyers since they pay premium up-front to the option seller. Here we are referring specifically to the option buyer not the seller. The option seller has unlimited risk and hence their liability is unlimited like in the case of short or long futures.
  • Cost is lesser than taking a futures contract, returns are relatively higher and maximum loss is limited to the premium or price of option, unlike in futures where returns are high and losses can be unlimited. While futures are leveraged position to the extent of the margins paid, the options are right and hence are a bet on price movement.
  • Options are also more flexible and an option holder can participate fully in any price movement. The only condition is that the cost of the option (premium) must be covered. Anything beyond that is profit. Also commodity options can be used to create specific hybrid positions to create closed strategies with predictable losses and profits.

What’s different in commodity options?

There is one important thing to remember here. When you buy call options on Reliance or Tata Steel, it is an option to buy Reliance or Tata Steel. On the other hand, when you buy call options on Gold, you are not getting an option to buy Gold but to buy gold futures. Unlike in equity futures, the underlying asset in case of commodity options is the future contract and not the spot commodity. That is because, spot commodities are not regulated by SEBI and hence the logistics would be too complicated.

For example, if you are trading Nifty options, your underlying is Nifty SPOT and not Nifty Future, and that the same for any equity stock option also. However, in commodities, Gold options are on MCX Gold futures and not Gold spot prices. The underlying for MCX Gold Futures is Gold price on the COMEX. So we are actually trading a derivative of a derivative. That is why commodity options are also called second level derivatives unlike equity options which are first level derivatives.

PAYOFFS OF COMMODITY OPTIONS

Commodity options are rights without the obligation. The buyer of the commodity option gets the right to buy or sell the commodity future without the obligation. The payoffs refer to the profitability of the commodity option under different price conditions. Let us a consider a Crude Oil call options of strike Rs.4500 on MCX, when spot price is Rs.4440. The premium on the 16th May call options is Rs.92. How would the payoff table look like for this call option?

Crude Spot Price Call Strike Price Premium Paid ITM / OTM Profit on Call
4300 4500 92 OTM -92
4350 4500 92 OTM -92
4400 4500 92 OTM -92
4450 4500 92 OTM -92
4500 4500 92 ATM -92
4550 4500 92 ITM -42
4600 4500 92 ITM +8
4650 4500 92 ITM 58
4700 4500 92 ITM 108
4750 4500 92 ITM 158
4800 4500 92 ITM 208

As can be seen from the above table, the maximum loss for the buyer of the call is Rs.92, which is the premium amounts paid. Above the price of Rs.4592, the profits are limitless on this crude oil call option. However, on the downside irrespective of how low the price the price of crude oil goes, the loss for the buyer of the crude oil call options will be limited to Rs.92 only. The above call option becomes in-the-money (ITM) above Rs.4500. Between the levels of Rs.4500 and Rs.4592, it helps the buyer of the call option to reduce the loss of the premium paid. Above Rs.4592 (which is the breakeven point), the actual profits for the trader starts.

The above is from the point of view of the buyer of the call option. What happens to the seller of the call option? His cash flows will be the exact reverse of the buyer. For the seller of the call option, the maximum profit will be Rs.92, but the losses will be unlimited once the price of gold goes above Rs.4592.

Let us now consider a Crude Oil put option of strike Rs.4500 on MCX, when spot price is Rs.4550. The premium on the 16th May call options is Rs.80. How would the payoff table look like for this put option?

Crude Spot Price Put Strike Price Premium Paid ITM / OTM Profit on Put
4300 4500 80 ITM +120
4350 4500 80 ITM +70
4400 4500 80 ITM +20
4450 4500 80 ITM -30
4500 4500 80 ATM -80
4550 4500 80 OTM -80
4600 4500 80 OTM -80
4650 4500 80 OTM -80
4700 4500 80 OTM -80
4750 4500 80 OTM -80
4800 4500 80 OTM -80

As can be seen from the above table, the maximum loss for the buyer of the put option is Rs.80, which is the premium amounts paid. Below the price of Rs.4420, the profits are limitless on this crude oil put option. However, on the upside irrespective of how high the price of crude oil goes, the loss for the buyer of the crude oil put options will be limited to Rs.80 only. The above put option becomes in-the-money (ITM) below Rs.4500. Between the levels of Rs.4500 and Rs.4420, it helps the buyer of the put option to reduce the loss of the premium paid. Below Rs.4420 (which is the breakeven point), the actual profits for the trader starts.

The above is from the point of view of the buyer of the put option. What happens to the seller of the put option? His cash flows will be the exact reverse of the buyer. For the seller of the put option, the maximum profit will be Rs.80, but the losses will be unlimited once the price of gold goes below Rs.4420.

HOW ARE COMMODITY OPTIONS PRICED

Commodity options are priced on the basis of demand and supply in the market. But is there an underlying theoretical precept on which these prices are calculated. The guiding principle is the Black & Scholes model. Some of the key determinants of the price of an option are Spot Price of the Underlying Asset, Strike Price, Annualized Volatility, Time to Expiration and Interest Rate.

Let us look at these aspects with the help of a live illustration of a gold commodity option and how the valuation works out.

Type Calls Puts
Option 127.2907 72.5013
Delta 0.5972 -0.3990
Theta -1.6792 -1.6867
Gamma 0.0016 0.0016
Vega 4.7505 4.7505
Rho -0.0976 -0.0556
Source: MCX

What one needs to broadly remember is that the volatility and the time to expiry impacts the calls and puts in the same direction. An increase in spot price and interest rates is positive for calls and negative for the puts. On the other hand, an increase in the strike price is negative for calls and positive for puts. The above table also captures the option Greeks which measure of sensitive of option prices to various factors impacting option values.

OPTIONS EXPIRY: SETTLEMENT AND DEVOLVEMENT

The Settlement of premium happens on T+1 day. The final settlement is a lot more complicated in case of commodity options since they will devolve into futures. Here is what you need to know about final settlement and devolvement, which will happen 2 days prior to the futures settlement. Here are the key steps.

On expiry of options contract, the open position shall devolve into underlying futures position as follows:

  • Long call position shall devolve into long position in the underlying futures contract
  • Long put position shall devolve into short position in the underlying futures contract
  • Short call position shall devolve into short position in the underlying futures contract
  • Short put position shall devolve into long position in the underlying futures contract

All the above such devolved futures positions shall be opened at the strike price of the exercised options. Let us look at the exercise mechanism in greater detail.

OPTIONS EXPIRY: THE EXERCISE MECHANISM

All option contracts belonging to ‘Close to the money’ (CTM - Option series having strike price closest to the Daily Settlement) option series shall be exercised only on ‘explicit instruction’ for exercise by the long position holders of such contracts. All In the money (ITM) option contracts, except those belonging to ‘CTM’ option series, shall be exercised automatically, unless ‘contrary instruction’ has been given by long position holders of such contracts for not doing so.

The ITM option contract holders and the CTM option series holders, who exercised their options by giving explicit instruction, shall receive the difference between the Settlement Price and Strike Price in Cash as per the settlement schedule.

In the event contrary instructions are given by ITM option position holders (other than those belonging to CTM option series), the positions shall expire worthless. All CTM positions which are not exercised shall also expire worthless.

All Out of the money (OTM) option contracts, except those belonging to ‘CTM’ option series, shall expire worthless. In the event the OTM position holders, which are in CTM option series, exercise their option positions, shall be required to pay and settle the difference between strike price and settlement price as per the settlement schedule.

All devolved futures positions shall be considered to be opened at the strike price of the exercised options.

Price (DSP) of Futures shall be termed as At the Money (ATM) option series. This ATM option series along with two option series each having strike prices immediately above and below ATM shall be referred as ‘Close to the money’ (CTM) option series.

In case the DSP is exactly midway between two strike prices, then immediate two option series having strike prices just above DSP and immediate two option series having strike prices just below DSP shall be referred as ‘Close to the money’ (CTM) option series.

INTRINSIC VALUE AND TIME VALUE OF COMMODITY OPTIONS

We have already seen the concept of option value as calculated by the Black & Scholes Model. However, the option value can be further split up into two sub-components and these are extremely useful for the analysis of ITM and OTM options. Here is what you need to know about the intrinsic value of commodity options.

  • Option Value is the overall value as determined by the Black & Scholes model and even the market price can be taken as proxy for option value
  • Intrinsic Value of an option is the difference between the spot price and strike price of the underlying i.e.
    • Intrinsic Value of Call option = Spot Price - Strike Price
    • Intrinsic Value of Put option = Strike Price – Spot Price
  • Time Value of an option is the difference between its premium and its intrinsic value i.e. Premium – (Spot Price – Strike Price)

A call option or put option that is ATM and OTM has only time value. Usually, the maximum time value exists when option is ATM.

An ITM option is an option that would lead to positive cash flow to the holder, if it were exercised immediately. Call option is said to be in ITM when Spot price > Strike price (i.e. higher) whereas Put options is said to be ITM when Spot price < Strike price (i.e. lower/below)

At the money option: An ATM is an option that would lead to zero cash flow if it were exercised immediately i.e. Spot price = Strike price.

Out-of-the Money: An OTM is an option that would lead to a negative cash flow if it were exercised immediately. In case of Call option = Spot Price < Strike Price, then Put Option = Spot Price > Strike Price.

APPLYING BLACK AND SCHOLES TO VALUATION OF COMMODITY OPTIONS

Black & Sholes formula calculates the fair value of the option and helps you to find out if call and put options are underpriced or overpriced. The Black & Scholes formula is as under:

If the formula looks too complicated, don’t worry. It is basically a summation of five factors that impact the value of the option and that is what you need to know.

  • First is market price of the underlying stock. In case of call options, higher market prices increase the value of the options. The reverse is true in case of put options.
  • Second is strike price of the option. In case of a call option, a higher strike price reduces the fair value of the option. In case of a put option, the reverse is true.
  • Third is volatility of the stock price. Higher volatility higher is the value of the option. That is because; if the volatility is in your favour then the option is more valuable and if the volatility is against you then you just lost the premium. Higher volatility is positive for call options and for put options.
  • Fourth is time to expiry of the option. Greater the time to expiry, more the probability of that you will make money on the option. Longer time to expiry is positive for call options and also for put options.
  • Fifth is the risk free interest in the market. Why are interest rates relevant? Options strikes pertain to a future date and hence time value becomes material. Higher interest rates mean lower present value of the strike price and therefore higher option value in case of call options. The reverse is true in case of put options

These are the 5 variables that are used to calculate the fair value of the option and then to decide whether the option is underpriced or overpriced.

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