Commodity trade options contracts are rights to buy (call option) or sell (put option) underlying commodity futures at predetermined prices on the date of contract expiry. It is important to note that, unlike in equity options where options involve rights to sell or buy shares of companies at pre-set prices, it works a bit differently for the commodity trading space.
Options trading in commodities is widespread globally with major exchanges like CME, NYMEX, LME and ICE offering options on commodities ranging from gold to oil to industrial metals. After a 13 year long gestation, Indian commodity markets launched options in Gold, opening new avenues for trading and hedging. However it is important for traders/speculators and investors to understand options trading in commodity markets as the expiry process is different from that of equities and Forex.
Broadly, there are two types of commodity options, a call option and a put option, similar to what we have in equities and Forex. There are two sides to every option trade, a buyer and a seller. Each of these sides experiences the opposite outcome; if the option buyer is making money the option seller is losing money in the identical increment, and vice versa.
Gold options: A refiner/ Jeweler can sell out of the money options against their inventory, if they are willing to accept considerable amounts of risk with the prospects of limited reward, can write (or sell) options, collecting the premium. The premiums might be small on an absolute basis but your inventory can pay you returns and generate additional income. On the other hand, an option buyer is exposed to limited risk and unlimited profit potential, but faces inherent risk like with any form of speculation.
In India, market regulators mostly exclusively allow options trading in the commodity futures market and not the commodity spot market because in India the spot or cash market in commodities is regulated by state governments while the SEBI only regulates the commodity derivatives market.
A call option gives the owner a right to buy the underlying commodity futures at a fixed price or the strike price on the date of the expiry of the contract. The buyer of an option is said to go long on an option. If the buyer chooses to exercise his right to buy, then on the date of expiry, the options contract devolves into the futures contract.
A buyer of a call option will only execute his right when there is intrinsic value; that is, the strike price is lower than the prevailing price of the commodity futures contract.
- 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.
- There is no mark to market margin calls for option buyers since they pay premium upfront to the option seller.
- Options are also more flexible and an option holder can participate fully in any price movement
- Options represent a form of price insurance, the cost of which is the option premium determined.