Education
What are options?
The value of an option is determined by the value of an underlying instrument. This type of derivative can get its value from a commodity, stock, currency, index, or any other form of security.
What is an option contract?
An option contract gives the investor the chance to buy an asset at a pre-agreed price or sell an asset at a pre-agreed price, with the decision to be made on a pre-agreed date. However, it is important to understand that this is an opportunity to buy/sell and not an obligation. The investor can choose to keep or leave the asset alone if they choose. There are two sides to an option contract, the buyer and the seller. The buyer is also referred to as the holder and the seller is often called the writer. Option contracts as we know them today have been around since 1973 when the Chicago Board Options Exchange first opened. Index options trading became available in India on the National Stock Exchange in 2001.
What does an option contract look like?
The first feature to learn about in an option contract is the strike price. This is the pre-agreed price that the holder can buy or sell the asset at if they choose to trigger their contract. This price remains fixed throughout the full period of the contract, and it does not have to match the market price. Market prices fluctuate, while the option contract price always remains the same.
The next thing to learn about is the contract size. This outlines how much of an asset the option contract refers to. Once again, the size is fixed from the contract start date and does not change. For example, if the contract is agreed for 100 shares, then the contract will always be for 100 shares. If the holder decides to trigger their contract, they have to purchase/sell the full 100 shares.
The option contract expiration date does what it says on the tin. Every single option contract comes with an expiration date, which is pre-agreed. This date stays the same throughout the duration of the contract. If the holder chooses not to trigger the contract before the expiration date, all terms of the contract expire.
The next feature to talk about is the intrinsic value. All money call options have this. The intrinsic value is the strike price minus the current price of the underlying security.
The settlement of an option is a process that only ever happens if the options contract is triggered. When the contract is first entered into, no assets are exchanged. It is up to the holder to decide whether to actually trigger the contract and therefore trigger that exchange. The settlement only happens in this case. If the contract runs down and expires, no settlement takes place.
No obligation is a useful term to remember as it is very important when it comes to options contracts. Remember, an investor has no obligation to do anything with an options contract. They can buy or sell at the pre-agreed price, but they can also choose to let the contract expire. From start to finish, it always remains an option, not an obligation.
Commodity Trade Option
In order to fully understand what a commodity option is, we must first explore options contracts. As the name suggests, an options contract is always an option rather than an obligation. The contract revolves around the holder’s option to buy or sell an asset at a pre-agreed price by a pre-agreed date, but the choice always remains in their hands. There are two main types of options contracts, European and American. American-style options contracts allow the holder to trigger the purchase/sale at any point before the expiration date. European-style options contracts allow the holder to make that decision on one pre-agreed date only. India currently only uses the European style of options contracts, and the expiration dates in question fall on the final Thursday of each month.
How do options work?
Options contracts come with unlimited potential and very limited risk for the holder. That is because the contract always remains an option, rather than an obligation. Therefore, the holder can always choose whether to trigger the purchase/sale if it works in their favor. On the day of the contract expiration, if the strike price is lower than the market price, the holder can trigger the purchase for a nice profit. However, if the strike price is higher than the market price, they can simply let the contract expire, thus limiting their losses. Even if the strike price is a lot lower than the market price, if the buyer triggers the contract, then the seller must follow through on the agreed terms. So, you might be thinking – why would a seller agree to such a contract in the first place? That’s because they charge a premium for writing the options contract in the first place. Whatever happens, the seller takes home that premium fee, even if the buyer does not trigger the contract. Therefore, the dream scenario for a seller is to claim a premium to write a contract that expires because the strike price ends up being higher than the market price. That way, they keep their assets and also earn a premium. The buyer is hoping to earn a profit by triggering the contract when the strike price is below the market price, even after they have already paid the premium fee.
What are commodity options?
A commodity option contract gives the holder the right to buy or sell underlying commodity futures at a pre-agreed price on a pre-agreed date. A right-to-buy commodity option contract is called a call option, while a right-to-sell commodity option contract is called a put option. Commodity trading is very different from equity trading where London Global Commodities shares are traded at pre-agreed prices. When it comes to the commodity futures market, regulators in India almost exclusively approve options trading, but not in the commodity spot market. This is because the SEBI regulates the commodity derivatives market but not the spot or cash market, which is under government regulation.
What is a call option on trading commodities?
There are two main types of commodity option contracts, involving the right to buy and the right to sell. A call option is the right to buy an underlying commodity futures. If the holder decides to trigger that option, the trade happens at a pre-agreed price and on a pre-agreed expiry date. When someone invests in an option, they are said to ‘go long’, so this is a good phrase to know. If the holder decides to trigger the option in the contract, then it devolves into a futures contract instead. Of course, the holder would only ever trigger the option if it presented some kind of profit – when the strike price is lower than the commodity futures prevailing price.
How does a commodity call option work?
It is often easiest to understand commodity call options when given a real-world example:
Let’s say that a trader expects a commodity to drop in value, but perhaps not as much as others are predicting. The one-month futures is currently trading at Rs.1000. Our trader opens a one-month commodity call option contract at a pre-agreed price of Rs.750. They have to pay the underwriter Rs.50 to take out that contract, no matter what happens. One month later, the trader has a decision to make. Do they trigger the option or not? Well, let’s say that the futures is now trading at Rs.900. The trader has an option to purchase at just Rs.750, so they go ahead and trigger the contract to devolve their option contract into a futures contract. That means they made a profit of Rs.100, because they paid Rs.750 plus a Rs.50 premium for something worth Rs.900. On the other hand, if the one-month mark rolled around and the trading price had dropped all the way down to Rs.500, our trader would simply let the contract expire. They would have lost their Rs.50 premium fee, but it would make no sense to purchase something at Rs.750 when it was now worth just Rs.500. Those are the two sides of the option contract coin.
What is a commodity put option?
There are two main types of commodity option contracts, involving the right to buy and the right to sell. A put option is the right to sell an underlying commodity futures. If the owner decides to trigger that option, the sale happens at a pre-agreed price and on a pre-agreed expiry date. If the holder decides to trigger the option in the contract, then the sale goes through. Of course, the holder would only ever trigger the option to sell if it presented some kind of profit – when the strike price is higher than the commodity futures prevailing price. The underwriter will be hoping that the put option contract expires worthlessly because the strike price is lower than the commodity futures prevailing price. In this case, they would simply collect their premium as a profit.
How does a put option on commodity trades work?
It is often easiest to understand commodity put options when given a real-world example:
Let’s say that a holder expects a commodity to rise in value, but perhaps not by as much as others are predicting. The one-month futures is currently trading at Rs.1000. Our holder opens a one-month commodity put option contract at a pre-agreed price of Rs.1500. They have to pay the underwriter Rs.50 to take out that contract, no matter what happens. One month later, the holder has a decision to make. Do they trigger the put option or not? Well, let’s say that the futures is now trading at Rs.1250. The holder has the option to sell at Rs.1500, so they go ahead and trigger the contract to push the sale through. That means they made a profit of Rs.200, because they sold something for Rs.1500 when it was worth Rs.1250 and paid a fee of Rs.50. On the other hand, if the one-month mark rolled around and the trading price had risen all the way down to Rs.1750, our holder would simply let the contract expire. They would have lost their Rs.50 premium fee, but it would make no sense to sell something at Rs.1500 when it was now worth Rs.1750. Those are the two sides of the put option contract coin.
What are the advantages of commodity option contracts?
Commodity put options are effective ways to take a short futures position without taking too much risk. After all, you can only ever lose the premium you pay. Everything else is potential profit or, at worst, zero loss. If the strike price is in your favor, you can buy or sell for a profit come the expiration date. If the strike price is not in your favor, then you can let the contract expire and the only loss you take is that original premium. When futures compulsory contracts come into play, the risk increases by a lot. Options are cheaper and less risky than futures because of the keyword ‘option’. There is never an obligation, and so you always know your maximum potential losses (the premium). Experts often refer to options contracts as insurance in volatile markets. If there is a big swing, you can make a nice profit without ever putting yourself at too much risk.