Sellers crucial for success of commodity options
As the Securities and Exchange Board of India (Sebi) enters second year of regulating commodities market, exchanges are buoyed up by the in-principle approval for the launch of commodity options.
It is a significant move but more needs to be done. “The introduction of options trading is a necessary but not sufficient condition for healthy commodity markets,” said Jayant Manglik, president, Religare Securities.
This is largely an uncharted territory as forward trade, known as ‘Karbala’, was discontinued two decades back. Sebi has conveyed to exchanges and market participants that “two things are crucial for options. Educating users how to hedge and find enough options writers to keep the instrument liquid and to keep premium under check to control cost of using options for hedging,” said a source.
How to trade in options
An option is an instrument that gives a buyer the right to buy or sell a security at a predetermined price after paying a premium to the seller. The buyer has to bear all the risks related to price movement. For example, an importer who enters into a contract to buy a particular commodity takes price risk till the goods arrive. However, if he has bought options equal to the quantity of goods imported by paying a fixed premium, then the option price goes up even if the price of the commodity falls, helping the importer recover the losses. If price doesn’t fall, he loses money on premium paid for options but not on the import.
Similarly, if a farmer feels that by the time he sells the crop, prices may fall, he can buy options before harvesting. If product price falls, option price would go up. Buyers of options take limited risk to the extent of premiums they pay, like insurance premium.
In equities, institutions largely take risk on the other side. However, in case of commodities, institutions are not allowed to trade in options, leaving the field for traders and speculators. While call options provide the holder the right to buy an asset at a specified price for a certain period of time, put options give the holder the right to sell an asset at a specified price. The seller (or writer) of a put option is obligated to buy the stock at the specified price.
What should be done?
Manglik said, “Indices trading, weather & freight derivatives and other similar products are needed to attract new stakeholders like banks, FIIs, foreign trading companies and mutual funds. This will help the markets in meeting its twin objectives of efficient price discovery and risk mitigation. This is a very positive step by Sebi which will once again put Indian commodities markets on the growth path.”
Commodity exchanges are talking to market participants on who will be writing options, which commodities they plan to offer for options in the first stage, is their risk management and expertise for managing options vibrant enough to satisfy the regulator to permit them to launch options and so on. Exchanges, however, are ready with technology and infrastructure. Institutional players are considered better options writers and in equity derivatives, institutions led by foreign portfolio investors have a chunky share in writing options. Hedgers are buying options as an insurance premium and worldwide options writers make money.
What experts want
However, commodity derivatives are settled in delivery also. Hence, the mechanism to settle options on delivery needs to be worked out. Once that happens, hedgers can also write options and give delivery if risk turns out to be higher at the time of settlement. An expert in commodities and person involved with the process said, “In Indian context, it is advisable that Sebi allows choice of delivery in options settlement.”