Commodity Options Explained With Examples

Published on Friday, August 24, 2018 by Chittorgarh.com Team | Modified on Thursday, February 29, 2024

Commodity options are derivative contracts. However, unlike stock options, which are derived from stocks, commodity options are derived from commodity futures. Similar to stock options, the contract consists of buying the underlying asset at a certain time and a certain price.

Commodity Options Meaning, Definition

Commodity options are derived from commodity futures. Similar to regular options, the buyer of a commodities option has the right, but not the obligation, to fulfil the contract. If he believes that the contract is profitable, he can either exercise it or let it expire. A commodity option contract is purchased by buyers in exchange for a premium.

Commodity Options Trading in India

Commodity options trading has a long history in India. SEBI introduced options trading in commodities in 2017. Before that, only commodity futures trading was allowed. The introduction of commodity options is a great tool for investors to diversify and make profits. Here's everything you need to know about commodity options trading.

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

There are two primary commodity options: Call Options and Put Options.

Call option: This gives the investor the right to buy the primary commodity at a predetermined price or strike price on the expiration date of the contract. If the investor decides to exercise his right to buy, the contract is automatically converted into a futures contract.

Put option: his option gives the investor the right to sell the primary commodity at a predetermined price when the contract expires.

The expiry date is always the last Thursday of the month.

Commodity Options Contract 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.

Commodity Option Expiry

The expiry of options contracts is different for all commodities and depends on the commodity class.

• Precious metal futures expire on the 5th day of the expiry month; if the 5th day is a public holiday, the previous day is the expiry date. Commodity options have futures as their underlying; options on precious metals expire three business days before the futures expire.

• In the case of base metals, the last day of the contract month is the expiry date for futures contracts; the options expire three business days before the futures expire. Options contracts on energy complexes expire 2 days before the expiry date of the futures contracts.

If the expiry date falls on a public holiday, the expiry date for all contracts is brought forward to the previous business day.

Commodity options list

The types of commodities for options trading can be divided into three broad categories

1. Metals: Gold, silver, platinum, and copper are examples of metal commodities.
2. Agriculture: Corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar are examples of agricultural commodities.
3. Energy: Crude oil, heating oil, natural gas, and gasoline are examples of energy commodities.

Commodity Options trading time

The trading hours for commodities in India are from Monday to Friday. It takes place from 9 am to 11:30/11:55 pm. There is no trading on Saturdays and Sundays and on certain public holidays.

Commodity Options trading brokers

Investors can trade commodity contracts on the MCX and NCDEX exchanges. Various full-service commodity brokers in India offer commodity trading services. Unlike a discount broker, a full-service broker offers both online and offline trading through a network of branches and franchise offices. Here is a list of MCX commodity brokers in India.

Commodity Options strategies

Traders can use any strategy for commodity options trading that they can use for stock or index options. Some of them are:

• Strangles and straddles: One of the most common options strategies is to buy calls and puts simultaneously to profit from changes in market volatility.
• Covered short call: A short call option and a long position in the underlying asset. It not only improves the return but also protects a long position in the underlying asset in a stagnating financial market.
• Covered short put: In a covered short put strategy, a put option is sold and the premium is collected. At the same time, the trader holds a long position in the underlying commodity. A covered short-put position is a good hedging strategy. It not only minimizes risks but also improves the return.

Difference Between Equity Options & Commodity Options

Commodity options are similar to stock or equity options. However, there are some important differences between the two that investors should be aware of, such as

So there are many similarities between equity and commodity options, but also some differences, as the table above shows. Let's understand two main differences between equity and commodity options: Devolvement and Moneyness.

• Moneyness- In commodity options, there is a new terminology for moneyness called 'Close to Money' (CTM). Spots that are two strikes above and two strikes below the ATM are referred to as CTM. The definitions of ITM, OTM, and ATM remain the same for equity options.
• Devolvement- At expiry, options contracts that are not squared off are converted to the corresponding 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

 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