Commodity Options Trading Guide India

Commodity Options

Options for commodities follow the same principles as futures. However, it is important to consider how you go about using them – this is the focus of this chapter.

– Black 76

It is essential to remember that these are options on Futures, instead of the spot market.

Take a look at a call option on Biocon, and the underlying is the spot price. The same goes for Nifty options which have their basis in the spot Nifty 50 index value. Not so with an option on Crude Oil – its underlying is not the spot price since we don’t have a spot market for commodities in India. But our futures market is very active and this is where commodity options are derived from.

When discussions involve crude oil options, it is important to bear in mind certain key points.

1.     The underlying for Crude oil option is Crude oil Futures.
2. The underlying for crude oil futures is the price of Crude Oil on NYMEX.

This can be seen as an offshoot of a derivative. When dealing with options, it is not essential to know the technical distinction between one based on spot and futures. The premium for the former is determined by Black & Scholes, while what’s known as Black 76 is used to evaluate the latter.

The differentiating factor between these two models is the treatment of the constant compounded risk-free rate. I’m not going to get into the specifics here, but do bear in mind that there are several Black & Scholes calculators available freely online – so don’t be too quick to enter your commodities variables into a conventional B&S calculator to obtain the premium estimate and Greeks. It simply won’t be accurate.

– Contract Specifications

We have yet to determine how the exchanges will set the framework for the options; however, a glance at the example framework leads me to believe that it won’t deviate significantly.

To commence with, Gold options may be introduced by exchanges, and a gradual but certain expansion to other commodities can be observed. It is this that should be focused upon.

Option Type – Call and Puts

Lot size – Since these are options on futures, the lot size will be similar to the futures lot size

Order Types – All order types would be permitted (IOC, SL, SLM, GTC, Regular, Limit)

Exercise style – Options are likely to be European in nature.

Margins – SPAN + Exposure margin applicable for option writing and full premium to be paid for option buying. A concept of devilment margin will come into play, I’ve discussed this towards the end.

Last trading day (for Gold) – 3 days before the last tender day

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.

This is where it gets a little tricky. Equity option traders are used to the following ‘Option Moneyness’ convention –

1.     At the Money (ATM) Options = This is when the spot is in and around the strike. So in a given series, only 1 strike is considered ATM.
2.     In the Money (ITM) = All call option strike below the ATM and call put option strikes above the ATM are considered ITM options.
3. Out of the Money (OTM) = All call option strike above the ATM and call put option strikes below the ATM are considered Out of the Money (OTM) options.

However, the commodities options will introduce us to a new terminology – ‘Close to Money’ (CTM) and this is how it will work –

1.     ATM – The strikes closest to the settlement price is considered ATM
2.     CTM – Two strikes above and two strikes below ATM are considered CTM
3. OTM and ITM – The definition remains the same as in Equity.

Settlement – For Futures’ M2M settlement on a daily basis, the exchange uses the commodities daily settlement price (DSP) as the reference. The DSP of the commodity on expiration day will be taken into account for options series too.

Let us grasp how the arrangement operates with this example – assuming the DSP of a certain commodity is 100 and the strike levels are ten points apart. Now, we can determine moneyness for each strike.

1.     ATM = 100
2.     CTM = 80, 90, 100, 110, and 120. Note, we have included two strikes above and below ATM
3.     OTM = All Call option above 100 and all Put options below 100 are considered OTM and therefore worthless
4. ITM = All Call options below 100 (including 80 and 90, which are CTM) are ITM, and all Put options above 100 (including 110 and 120, which are CTM) are ITM.

Long option holders specified as ‘CTM’ must provide an ‘explicit instruction’. This stage involves devolving the option into a futures contract at the predetermined strike. For example, issuing an explicit instruction when one has 80 call options would create a long futures position at 80. It appears this instruction requires entering via the trading terminal.

It’s essential to remember that, unless you explicitly assign your CTM option, it will be considered useless.

You should be aware that all ITM options – barring CTM – are automatically settled through devolvement into an equivalent futures position. If you’re holding such an option and you don’t want it to settle this way, then you must submit a ‘Contrary instruction’. If you fail to do so, the contract will revert to its default settlement method.

So, what are the reasons why one might not choose to use an ITM option?

It is possible that the ITM option you possess may not be worth exercising due to taxation and other fees. In this case, it is advisable to use the ‘Contrary Instruction’ option and not exercise your ITM choice.

– Devolvement into a Futures contract

When it comes to an ITM (or CTM) option, on expiry, the option will be converted into a Futures position. We know that a futures contract requires margin to be deposited with the broker, so what do we do in this instance? Initially I have to pay for the cost of the premium when investing in an option, and would not necessarily put aside additional funds for margins at that time.

To avoid this issue, there is the concept of ‘Devolvement Margin’. Let me explain what you need to know and expect –

1.     Options on commodities will end a few days prior to the initial tender date of the corresponding futures contract. This results in a small gap of days between expiration of the futures contract and the options contract.
2.     Prior to expiry, an exchange is likely to do a sensitivity analysis which produces a report that specifies the probable in-the-money and out-of-the money strikes.
3.     Exchanges will require ‘Devolvement Margin’ for all options, meaning you must have enough margin money in your account to carry the position forward. Half of this must be available the day prior to expiry and the rest is due on the final day of the option contract so that it can be converted into a futures contract.
4.     If you have a deep in-the-money option, the profits from this position can help cover some of the margins needed.
5.     The aforementioned point implies that the more profound the option, the lower margin is required. Conversely, CTM options will command a higher margin.
6.     If you possess a commodity option that is set to expire In-the-Money (ITM) and you wish to retain it leading up to maturity, then you must ensure you deposit margin funds in advance of the expiration date.
7. The margin, expiry dates, and tender dates will be different depending on the commodity.

Here is a quick note on how the options position will be devolved.