Commodity Options Explained With Examples

Published on Friday, August 24, 2018 by Chittorgarh.com Team | Modified on Sunday, August 9, 2020

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Commodity trading has a long history in India. SEBI has introduced Options Trading in the Commodities last year. Before that only trading in Commodity Futures was allowed. The introduction of Commodity Options presents an excellent instrument for investors to diversify and earn profits. Here is all that you need to know about Commodity Options Trading-

Commodity Options Definition, Meaning

What are Commodity Options?

Commodity Options are derivative contracts. However, unlike stock options that are derived from stocks, commodity options are derived from the commodity futures. Much like stock options, the contract is to buy the underlying at a specified time and a specified price.

There are buyers are sellers in commodity options. The buyer of the option has the right, but not the obligation, to honor the contract. If he sees the deal is profitable then he can exercise the contract or else choose to let it expire. The buyers pay a premium to buy a commodity options contract. The seller has to honor the contract when the buyer chooses to exercise it. The seller receives the premium when entering a contract.

Types of Commodity Options

Commodity Options are of two types: Call Options and Put Options.

A Call option gives the buyer of the contract the right to buy the underlying whereas a Put option gives the buyer the right to sell the underlying

Commodity Options can also be categorized into American and European based on exercise. American options can be exercised anytime during the contract cycle while European options can only be exercised at the expiry.

Commodity OptionsContract Specifications

  • Lot size - The lot size of a commodity options contract is similar to its futures lot size.
  • Exercise style - An American option can be exercised any time before the expiry of the option contract whereas a European option can be exercised only on the date of expiry.
  • Margins - Premium for buying and SPAN + Exposure margin for selling
  • Expiration Day - 3 days prior to its Futures expiration date
  • Strikes - Considering one 'At the money strike' (ATM), there would be 15 strikes above and 15 strikes below ATM, taking the total to 31 strikes.
  • At-The-Money (ATM) - The strikes closest to the settlement price is considered ATM
  • Close-To-Money (CTM) - Two strikes above and two strikes below ATM are considered CTM
  • Out-of-the-money (OTM) And In-the-money (ITM) - The definition remains the same as in Equity.

Difference Between Equity Options & Commodity Options

Commodity options are similar to stock or equity options. However, there are some key differences between the two which investors need to aware of like-

Equity vs Commodity Options

Characteristics

Equity Options

Commodity Options

Underlying

Equity, Nifty, Bank Nifty

Commodity Futures

Lot size

As decided by the exchange

Lot size of Future contracts

Exercise Style

Stock Options- American

Index Options- European

European

Premium Pricing Model

Black & Scholes

Black 76

Devolvement

Expires worthless if not exercised

Converted into Futures contract if not squared off

Moneyness

ITM, OTM and ATM

ITM, OTM, CTM and ATM

Expiry Date

Last Thursday of month

3 days ahead of the expiry of the Futures contract

So there are a lot of similarities between equity and commodity options while there are some differences as seen in the above table. Let's understand two critical differences between equity and commodity options- Devolvement and Moneyness.

  • Moneyness- Commodities options have a new terminology in moneyness called 'Close to Money' (CTM). Spots two strikes above and two strikes below the ATM is called CTM. The definitions of ITM, OTM, and ATM remains the same equity options.
  • Devolvement- On expiry Option contracts, that are not squared off, get devolved into their futures contract.
  1. Long Call and Short Put contracts get devolved into Long Futures contract
  2. Short Call and Long Put contracts get devolved into Short Futures contract

Equity vs Commodity Options

Option Position

Devolvement

Long Call

Long Futures

Short Call

Short Futures

Long Put

Short Futures

Short Put

Long Futures.

 On expiry day, here's how the devolvement of the options contracts takes place: -

 The Daily Settlement Price (DSP) of the Futures is taken as reference for Commodity options.

  1. Options having strike price closest to the DSP are considered an ATM. Two strikes above and below the ATM are considered as CTM.
  2. All CTM contracts are devolved only on 'explicit instruction' from the traders. In the absence of the 'explicit instruction', the contracts expire worthlessly.
  3. All ITM option contracts, except those that are in CTM, are devolved automatically, unless 'contrary instruction' is placed by traders.
  4. All OTM contracts, except those that are in CTM, expire worthlessly

How does the Commodity Options settlement work?

Say the DSP of a commodity option on the expiry date is 90. Now, assuming the strike interval of this commodity to 10 points, its moneyness will be-

ATM- 90

CTM- 70,80,90,100 and 110.

OTM- All strikes above 90 including 100 and 110.

ITM = All strikes below 90 including 70 and 80

Commodity Options settlement

Strike

Devolvement

ITM

Automatically devolved unless a 'contrary instruction' is given.

CTM

Devolved on 'explicit instruction'. If the 'explicit instruction' is not given then the contract expires worthless.

OTM

Expires worthless.

Profit/Loss Potential For Positions in Commodity Options

POSITION

PROFIT POTENTIAL

LOSS POTENTIAL

When you BUY a CALL option

Unlimited depends on the extent of price rise above strike price

Limited to the premium paid

When you SELL a CALL option

Limited to the premium received while selling the contract

Unlimited depends on the extent of price rise above the strike price

When you BUY a PUT option

Unlimited depends on the extent of price falling down to zero

Limited to the premium paid

When you SELL a PUT option

Limited to the premium received while selling the contract

Unlimited depends on the extent of price falling down to zero




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