A commodity option contract gives you the right to either buy or sell the asset associated with the contract. There’s no obligation to buy or sell, but if you want to do so, you must do it before the expiration date and at a fixed price agreed to when you signed the contract.
Commodity options are different to equity options, which involve similar mechanisms but only refer to buying and selling company shares rather than commodities.
In the case of India, options trading mostly takes place in the market for commodity futures (which involve buying or selling something in the future) rather than the commodity spot market, which is for buying or selling immediately. This is because state governments regulate cash and spot markets, while the Securities and Exchange Board of India (SEBI) regulates the derivatives market.
When you take out an options contract the call option is what gives you the right to buy the commodity. The contract is based on a specific price (the strike price) before the expiration date. Buying an option is known as “going long” in the trading world, but if the buyer doesn’t want to execute their right to buy, the contract will expire.
Usually, a buyer will execute their right to buy if the options contract has intrinsic value, meaning that the strike price is below the market price. This allows them to make a profit.
To get a better understanding of how commodity call options and their pricing works, it helps to refer to a real-life example.
If one a trader expects the price of gold to increase over the next month, they might decide to purchase a commodity options contract, which specifies they will have the choice to buy gold at a price of Rs.1500 per lot in a month’s time. They might pay a fee of Rs.70 to purchase this contract.
When the contract’s expiration date comes around, the trader will be able to see if their predictions were right, which determines their next move. For instance, it might turn out that the price of gold went from Rs.1400 to Rs.1700, which is comfortably higher than the agreed price of Rs.1500. Therefore, the trader can execute the contract, turning it into a futures contract and giving them a profit of Rs.200. In the options world, buying something at a price below the market price due to a contract is called being “In the Money” (ITM).
If the opposite happens and the price of gold goes from Rs.1400 to Rs.1200, the trader can simply decide not to execute the contract. Although they’ll lose the Rs.70 fee for purchasing the contract, the loss is more manageable than accepting a loss of Rs.200.
Unlike a commodity call option, a commodity put option focuses on selling rather than buying commodities. More specifically, a put option gives its owner the right to sell the asset associated with it at a fixed price on a specific date.
It’s also possible to sell or underwrite a put option contract, but this involves risk — if the buyer decides to execute the contract, the underwriter is obliged to make the sale, even if it’s not favorable for them to do so. However, the underwriter has the advantage of being able to make a profit from the fee buyers pay when purchasing an option contract. If buyers never execute their contracts, underwriters earn money from the fees paid whatever happens.
Again, let’s use an example to examine this concept in further detail. This time, if the trader expects the price of gold to increase, they’ll try to buy a put option at a price significantly above the current level, and hope the market price doesn’t quite reach the same level.
For example, a trader might purchase a contract that gives them the right to sell gold at a price of Rs.1500 per lot in a month, while the current price is just Rs.1300. In a month’s time, they might find that the price of gold has reached Rs.1400, which would make it profitable to execute the contract. This results in a profit of Rs.100, which is known as the intrinsic value — as long as the strike price is above the market price and the intrinsic value is a positive number, a trader is In The Money.
However, if things don’t go to plan — maybe the price of gold falls to Rs.1200 instead of climbing — the trader can decide not to sell. In this case, they’d only lose the cost of buying the contract.
The biggest advantage of using a commodity option contract is the opportunity to expose yourself to the potential for significant profits while minimizing the risk involved. Since there’s no obligation to execute an options contract if the market conditions aren’t favorable, you can not lose more than the upfront cost of buying the contract.
Yet if market conditions do turn out to be favorable (aka you can buy something at a value below its market price), you could earn big money.
Options are also more affordable than futures contracts, which require you to commit to buying an asset on a specific date. These involve a lot more risk and could see you paying a sizable premium on market prices if things don’t go the way you expect.
Many experts view options contracts as a way to hedge against pricing risks while also taking advantage of price volatility in the markets.