How introduction of options will impact commodity markets - Motilal Oswal
How introduction of options will impact commodity markets - Motilal Oswal

How introduction of options will impact commodity markets

In the last meeting of the SEBI, the Chairman, Mr. Ashok Tyagi, emphasised on the need to move rapidly on introducing options in the commodity markets. For over a decade, the only contract permitted in the commodity markets was the futures contract. Of course, futures on select agri-commodities and precious metals have been trading on the MCX and the NCDEX for over a decade now. MCX Gold and MCX Crude were some of the popular contracts on the commodity futures. However, the Act did not have a provision for the introduction of options in commodities. With Commodity Markets coming under the purview of SEBI last year and volatility of Commodity Prices moving up sharply, the need to introduce options on commodities has been strongly felt.
 
Why Options on Commodities?
There are a few basic reasons why options can add a lot of value in the Indian context..

Since options are a limited downside-risk product, they will help farmers and SMEs (who use agricultural products as inputs) to manage their risk more efficiently. This is unlike futures, where the downside risk can be unlimited if the price movement is unfavourable.

A farmer who wants an assured price for his product can just buy a put option (right to sell) at a particular strike price. This protects the farmer from any volatile price movements. Similarly, the SME that uses these agri-inputs can buy a call option on the commodity at a particular strike price. That not only hedges risk but also enables the SME to plan its finances better.

 

Options market pricing is based on the rapid flow of information. Typically the price of an agri commodity option will be based on factors like weather, cropping patterns, monsoons, output, demand conditions etc. The options market will bring about greater transparency by making quality inputs available to both the buyer and the seller of the option.

From an exchange perspective, this offers an additional product to expand the basket. The NSE saw a massive increase in volumes after the introduction of options on indices and stocks. Currently, the option volume on the NSE is nearly 4 times the volume of futures and spot.

 

From the perspective of commodity market traders and investors, it offers an additional opportunity to trade commodities with limited risk and margin worries. It also opens up the possibility of more sophisticated hybrid products combining futures and options on commodities, which can be valuable to proprietary traders.

Some Key challenges for options in commodities..

The massive growth in options on the NSE was largely on the back of institutional participation in the options segment. Currently, global FPIs are not allowed to participate in the commodity markets. For the commodity options to pick up in a big way, institutional participation will be the key.

Commodity futures are currently subject to Commodity Transaction Tax (CTT) on the same lines as STT is levied on equity futures and options. Equity options volumes picked up in the exchanges only after they shifted the STT on options to premium value rather than notional value. However, if the CTT is levied on notional value then the entire economics of the options business may become unviable. SEBI and the exchanges will have to look at exempting commodity options from the ambit of CTT or, at least, ensure that it is imposed only on the premium value.

Excise of options is not a very big issue with respect to equity options since the market is quite liquid and hence most strikes can be reversed easily on the exchange. However, commodity options being unique hedging products will require an alternate mechanism for liquidity. Also the option strikes will have to match with cropping patterns in case of agricultural commodities.

But the biggest challenge in commodity options will be; who will be the writer (seller) of these commodity options. For example, a farmer can buy a put options and an SME can buy a call option. The question is who will sell these options. That is where the role of an effective aggregator comes in. The aggregator can be an authorized institution or a bank. They will essentially have two roles. The first role will be to aggregate the produce of farmers to create marketable lots on the options exchange. Secondly, you need an option writer who will look at earning the options premium as a regular income.

Case Study: How Mexico used oil options to hedge price risk..
An interesting case study of using commodity options is how Mexico has been using oil options to hedge its oil price risk for over 25 years now. Mexico is the 6th largest oil producer in the world and oil accounts for nearly 1/3rd of government revenues. Back in 2008, just before the global financial crisis, Mexico had paid $1.5 billion as premium to hedge almost its entire oil producer when the price of Brent Crude was at $150/bbl. Mexico not only protected the downside risk, but also made a net profit of $3.5 billion on the trade after considering its hedging costs. Mexico has effectively used oil options as a part of its macroeconomic risk management strategy.
 
But global commodity options still have some way to go..
 

Data Source: FIA
 
The above chart clearly highlights that options volumes as percentage of overall commodity volume are yet to pick up. While commodity options are relatively more popular in the US markets, it still constitutes a very small part of the overall commodity volumes in other parts of the world. That is something that the Indian regulator and the exchanges may have to keep in mind while launching options on commodities and building expectations around the product.
 

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