Introduction to Commodity Options

Introduction to Commodity Options

‘Options’, as the word suggests, refer to choices or alternatives. An option is a derivative contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying. For owning this right, the option holder pays a price (called ‘option premium’) to the seller of this right. The seller (writer) of option, on the other hand, bears the obligation to honour the contract should the buyer choose to exercise the option.

The option buyer will exercise their option only when the price of the underlying is favourable to them, otherwise they will let the option expire worthless.

Based on the right of the holder, options are of two types:

Call options: It gives buyer the right to buy the underlying
Put options: It gives buyer the right to sell the underlying
Based on exercise, options can primarily be of two types:

American: The buyer can choose to exercise the option at any time before the expiry of the option contract.
European: The buyer can choose to exercise the option only on the date of expiration of the contract.
As per current regulatory norms, only European style commodity options are available in India at present.

MCX offers options on commodity futures contracts traded on the exchange. These commodity options, on exercise, devolve into the underlying futures contracts. All such devolved futures positions open at the strike price of exercised options.

Commodity options are useful risk management tools, particularly for the small stakeholders, as the option buyer does not generally have to maintain margins. They are akin to price insurance for the hedgers which can be bought by paying only a one-time option premium.