Sharekhan Blog

What is Commodity Options?

  • Mar 11, 2024

Commodity training has basically been a part of financial history since ancient times. Empires and civilizations were mounted on successful commodity options trading between different parties.

Additionally, options trading in commodities are globally prominent among many major exchanges.

In 2017, the Indian commodity derivative market approved options trading in commodities after a lot of demand from trading members. It is recognized as one of the historic moments in trading. If you wish to learn more about commodity options, you are at the right place as we will take a deep dive to understand what is commodity options .

Commodities option

To have a better understanding of what a commodity option is, it is a must that you first take a moment to understand what an options contract is. Options are basically the rights to purchase or sell a security that is underlying at a price which is already fixed, also called strike price on a certain day. It is the day when the contract expires. There are two kinds of options, the European and American styles, based on when the rights to purchase or sell can be exercised.

In the American option, an individual may exercise their purchasing and selling just before expiration. With the European option, an individual may only exercise the right on that certain date when the option contract expires.

In India, only the European options are traded, and the options contract expires on the last Thursday of every month. It is the best commodity to trade in India. Since state governments in India supervise the commodity spot or cash market, while the SEBI solely oversees the commodity derivatives market, market regulators in India mostly permit options trading in the commodity futures market rather than the commodity spot market.

Fundamentals of commodity options

Commodity options trading is taken as a blessing in disguise by many individuals. These instruments provide you the freedom to buy and sell financial instruments. However, they do not obligate you to keep your end of the bargain when it expires. Although commodity options and stock options are comparable, there are three key differences between the two that set commodity options apart:

  • Commodities futures are the underlying of a commodities options transaction.
  • Commodity options expire three business days before the tender delivery period starts for the underlying commodities. The options for natural gas and crude oil expire two business days before the future expiry.
  • Commodity option settlement: In The Money, options contracts become futures contracts if the options are not squared off before the tender delivery period starts.

Brief instructions to get started with options trading

Here is an idea of how you do not have to wait for too long and get started with options trading:

  • First and foremost, you need to create a trading account with which you will be getting started with trading.
  • After that, you need to ensure that F&O trading is turned on in the trading account you created.
  • You are then required to list index options or stock options you would like to trade in.
  • After that, you need to get started with the index options that are furthermore liquid and less challenging to predict.
  • Following that, one thing you need to remember is that you must stick to almost 10- 20 highly liquid stocks.
  • You need to select the OTM options that are not too deep. Restrict yourself to OTM and ATM alternatives.

Call option on trading commodities

When a call option expires, the owner has the choice to purchase the underlying commodity futures at the strike price or at a set price. An option buyer who purchases it is considered to be "long" on the option. The options contract turns into a futures contract on the expiration date if the buyer decides to exercise his right to purchase.

When a call option has inherent value—that is, when the strike price is less than the going rate for the commodities futures contract—the buyer will only exercise his right to execute.

Wrapping Up

Purchasing put options in commodity options trading is an excellent method of reducing risk when taking a short position in the future. If the current values of the futures contracts are greater than the strike price, the option to not exercise the right to sell might be chosen. Since forced delivery is a part of the future, the stakes are significantly larger.

Team Sharekhan
by Team Sharekhan

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