The request for introduction of options in commodities, which was pending before the erstwhile regulator of the commodities market — the Forward Markets Commission — for over 10 years, finally saw the light of day, thanks to the sector’s new regulator, the Securities and Exchange Board of India (SEBI).
While introducing options in the commodities derivatives market on September 28, the regulator had said that it was a move to facilitate hedging by market participants and deepen the commodity derivatives market. However, to begin with, the regulator may permit such trading in only one or two commodities, agri and non-agri, to test the waters, say sources.
The two largest commodity exchanges — MCX and NCDEX — are currently trying to decide on the commodities on which options can be introduced, the contract specifications, the options style, the settlement procedure and trading cycle. The regulator, on its part, is studying the exchanges’ internal control systems, to see if their risk management system is robust.
Market participants also need to understand how options work differently from futures. The challenges with respect to creating awareness about the new product and bringing enough liquidity into the market, have to be addressed by the regulator and the exchanges jointly.
What are options?
Options are derivative contracts that give the buyer the right to buy (if it is a call option) or sell (put option) a specific asset (a commodity here) at a particular price (called ‘strike price’) in future. The consideration for exercising this right, paid upfront by the buyer, is called the ‘premium’. These contracts can be used for hedging by farmers, commodity processors and middlemen to hedge price risk by taking a view on a future price.
There are two parties to an option contract — a buyer and a seller (also called the writer). The buyer of an option is the one who, by paying the option premium, buys the right to exercise his option on the seller. The seller of a call/put option is the one who receives the option premium and is, thereby, obliged to sell/buy the asset if the buyer exercises his right.
So, clearly, the game is risky if you are a seller in an option contract — as your profit is limited to the premium amount while the loss is unlimited. But, for all hedgers — be it the farmers or commodity users who will be buying a put option or a call option — the risk is limited to the premium. If prices are not favourable to them, they can let the contract expire. Suppose, a farmer who is harvesting his crop wants to lock in the current price, fearing a crash in prices in the harvest season, he can buy a put option.
The regulator and the commodity derivative exchanges are still working on the finer details of the new product. Details of which commodities may see options being introduced, have not yet been confirmed, though the buzz is that commodities of high trading interest, including bullion and crude oil from the non-agri basket, and mustard seed, refined soy oil or guar, from the agri-side, may see option contracts being launched.
Currently, it is not even known if option contracts will track spot prices of the respective underlying or its futures price. With spot prices, the problem is, in most commodities, they are arrived at through a polling process conducted by the exchanges themselves, and the regulator has to review them.
Difference between futures and options
Though, both futures and options contracts are derivative instruments and they track the value of an underlying, there is a basic difference between the two. In futures, while both the buyer and the seller have the obligation to fulfil the contract, in options, while the buyer has the right, he has no obligation to fulfil it. Thus, for an options buyer, the loss is limited to the premium paid for the contract, while the profit is unlimited.
Say you are a maize farmer and buying a put option to sell 100 tonnes of maize at ₹1,400 per quintal, three months from now. If the price of maize goes down to ₹1,300 per quintal, you can exercise your right and make a profit of ₹100 per quintal, and this will offset the loss you may make while selling your produce in the physical market. However, if maize prices go up in the three months, you need not exercise your option.
The other advantage with an option is that the costs are relatively lower. In a futures contract, a trader will be required to pay an initial margin and also a mark-to-market margin, based on volatility in the market price. In options, the outgo is limited to the premium the trader pays on the contract initially.
Needs of a farmer
If the exchange wants to do the right thing by farmers, it has to seriously work on making the entire framework more user-friendly. It has to do away with a lot of procedural requirements and also see if it can offer a delivery-based settlement and set up more delivery centres across the country.
The exchanges and the regulator would also need to spend a fair bit of time in creating awareness. Not many farmers in the country are even aware of the futures market, which has been in existence for over a decade now. Also, to make the product a success, the regulator should consider allowing the entry of institutional players — including banks and mutual funds — as they can take risks and be the ‘writers’ in an option contract.