Brief Introduction to Commodity Options Trading
Like every financial asset, commodities also have options contracts that you can trade for booking profits. However, unlike stock options, they operate a little differently. Let’s find out!
What Are Commodity Options?
Commodity options are derivative contracts that provide you with the right to buy or sell an underlying asset at a pre-set strike price and date of expiration.
Usually, there are two parties involved in the transaction – a buyer and a seller. The former has to pay the letter a premium to enter the agreement and has the right but not the obligation to purchase the underlying asset.
The individual can either decide to either exercise his/her right or let the contract expire. On the other hand, the seller is under obligation to honour the contract’s terms if the buyer chooses to exercise his/her right.
Now, unlike other options contracts, which generally have a security as their underlying asset, commodity options are a bit different. The underlying asset in this case is commodity futures.
In India, you can trade commodity options on the Multi Commodity Exchange (MCX) and the National Commodity & Derivatives Exchange Limited (NCDEX). Both of these entities are regulated by the Securities and Exchange Board of India (SEBI) and the options by default are European-style. That is, the option holder (buyer) can only exercise his/her right on contract expiry.
What Happens to Commodity Options After Expiry?
Commodity options generally expire before three business days of the underlying futures contract’s tender delivery. However, if the underlying futures is of natural gas or crude oil, the date of expiry is two business days before the futures contract expires.
Now, on expiry, the strike price of commodity options can be at three levels:
- At-The-Money (ATM) – The contract strike price that is the closest to the settlement price is the ATM.
- Close-To-Money (CTM) – Two strike prices, above and below the ATM are CTM.
- Out-of-The-Money (OTM) – Call options strike prices that are above the ATM value and put option strikes below it are OTM.
- In-The-Money (ITM) – Call options strikes below the ATM value and put option strikes above it are ITM.
Upon contract expiry, all open positions devolve into their underlying futures positions. They are as follows:
- Short put position devolves to a long position.
- Short call position devolves to a short position.
- Long put position devolves to a short position.
- Long call position devolves into a long position.
The exchange shall open all the devolved futures at the exercised options’ strike prices.
Moreover, on expiry, the broker will automatically settle all ITM options, except for the CTM ones. If you want to devolve your CTM option, you have to give specific instructions regarding it. Otherwise, it will expire worthless.
Benefits of Trading Commodity Options
Here are some of the advantages of trading commodity options contracts:
- Risk Management
Commodity options can serve as useful tools for risk management. They act similarly to insurance in which you need to pay a one-time premium. You can use these assets to hedge against market risks along with gaining exposure to the underlying futures contracts.
There is no need to maintain a margin and you only need to pay a premium for entering the agreement.
- Lower Trading Cost
Trading with commodity options requires a lesser amount of money in comparison to futures contracts. Moreover, their return rates are usually higher and the maximum loss is limited to the premium paid.
With commodity options investments, you stand a chance to profit regardless of price movements. Thus, even if the market trends are bullish or bearish, you can plan your positions accordingly and purchase a call or put option.
Purchasing commodity derivatives options is an excellent way to diversify your portfolio. You can frame trading strategies using them in any market scenario. They are also ideal for small stakeholders who want to gain exposure to the commodities market without taking much risk.
Frequently Asked Questions
Q1. How can I start trading in commodity options?
Ans. You can start trading commodity options by opening a trading account with your preferred broker. Ensure to activate the futures and options trading option and choose contracts with underlying assets that have high liquidity.
Q2. What are the best commodity options for beginners?
Ans. The best commodity options for beginners are the ones having high liquidity. In this regard, you can choose options with underlying assets related to oil and gold.
Q3. What is the trading time for the commodity derivatives market?
Ans. As of now, the trading hours for the MCX are 9:00 AM to 11:30 PM from Monday to Friday. For agricultural commodities, the timings are up to 5:00 PM and for internationally referenceable agricultural commodities, it is up to 9:00 PM.
Q4. Can I place orders outside market hours for commodity derivatives?Ans. Yes, you can place orders for commodity derivatives outside market hours. However, it is only permitted for limit orders. They will remain in queue and will go to the exchange when trading resumes the next day.