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.
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.
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.
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 –
However, the commodities options will introduce us to a new terminology – ‘Close to Money’ (CTM) and this is how it will work –
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.
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.
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 –
Here is a quick note on how the options position will be devolved.