Trading In Commodity Options – All You Need To Know

The Future and option trading is a market altogether is a unique market in which different types of commodities, currencies and stocks are traded. Trading in options and futures is also referred to as derivative trading, which allows buyers and sellers to protect their investments against fluctuating prices. As such, it allows investors to hedge against price fluctuations. It was in October 2017, that SEBI approved option trading for the first time in India, with Gold being the first commodity to be traded on this market. But what exactly is option trading in commodities? Let’s find out.

A commodity trade option is essentially a contract which allows investors the right to purchase or sell an underlying commodity at a specific price (determined in advance) on the day when the contract expires. The right to buy is regarded as the call option, whereas the right to sell is referred to as the put option. The commodity trading space works a bit different as compared to equity trading, in that equity option trading is about the right to buy or sell shares of companies at pre-set prices.

Market regulators in India typically allow commodity options trading in the commodity futures market and not the spot market, since the spot/cash market in India is regulated by the state governments. The commodity derivatives market, on the other hand, is regulated by SEBI.

A call option is essentially the right given to the owner of the commodity to purchase an underlying commodity future at a fixed or strike price on the pre-determined date when the contract expires. The buyer, purchasing the commodity option is supposed to go long on the option. In case the buyer chooses to exercise the right to purchase the commodity; then the contract transfers into a futures contract on the expiration date. Call option buyers generally execute their rights only when they stand to gain intrinsic value or profit i.e. if the strike price is lower than the currently prevailing price of the commodity as per the futures contract.

While speaking of commodity options, you also need to understand what commodity put option is. A commodity put option allows the commodity owner the right to sell the underlying commodity future at a predetermined price, on a fixed date, upon the expiration of the contract. The contract is typically valid until the last Thursday of each month.

The owner has the right to sell or underwrite the put option on the commodity futures, and thus be exposed to pricing risks, especially if the buyer decides to exercise the right to buy the underlying contract. In such a situation, the owner is obligated to honour the deal and sell commodities, even if it means risking a loss. However, the seller earns a premium on such put commodity option trades since; the general consensus is that most options contracts are rendered worthless on the expiration date, when the strike prices are typically higher than the current prices.

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