“Commodity Treading & Future Option Maker”

1. N. R. Institute of Business Management (NRIBM-PGDM)
Assignment
On
“Commodity Treading & Future Option Maker”
Management Financial System
Submitted to,
Dr. Avni patel
Submitted by
Vatsal Patel P 1846
Term VI (Finance)
Batch -2018-20

2. Options trading in commodities is widespread globally with major exchanges like CME,
NYMEX, LME and ICE offering options on commodities ranging from gold to oil to industrial
metals. After a 13 year long gestation, Indian commodity markets launched options in Gold,
opening new avenues for trading and hedging. However it is important for traders/speculators
and investors to understand options trading in commodity markets as the expiry process is
different from that of equities and Forex.
Broadly, there are two types of commodity options, a call option and a put option, similar to
what we have in equities and Forex. There are two sides to every option trade, a buyer and a
seller. Each of these sides experiences the opposite outcome; if the option buyer is making
money the option seller is losing money in the identical increment, and vice versa.
Talking about gold options – A refiner/ Jeweler can sell out of the money options against their
inventory, if they are willing to accept considerable amounts of risk with the prospects of
limited reward, can write (or sell) options, collecting the premium. The premiums might be
small on an absolute basis – but your inventory can pay you returns and generate additional
income. On the other hand, an option buyer is exposed to limited risk and unlimited profit
potential, but faces inherent risk like with any form of speculation.
When to use Commodity Options?
A decision about buying or selling any option depends on your view of the market and your
desired objective. A trader may look at options differently compared to a commodity producer
looking to hedge his price risk. A hedger would be interested only in protecting his margins by
mitigating price risk while a speculator is interested in profiting out of market moves.
Advantage of options
 There is no mark to market margin calls for option buyers since they pay premium
upfront to the option seller.
 Cost is lesser than taking a futures contract, returns are relatively higher and maximum
loss is limited to the premium or price of option, unlike in futures where returns are
high and losses can be unlimited.
 Options are also more flexible and an option holder can participate fully in any price
movement
 Options represent a form of price insurance, the cost of which is the option premium
determined.

3. What’s different in commodity options?
Unlike equities, commodity options are on futures and not on spot. If you are trading Nifty
options, your underlying is Nifty SPOT and not Nifty Future, and that the same for any equity
stock option also, but in commodities, Gold options are on MCX Gold futures and not Gold
spot prices. The underlying for MCX Gold Futures is Gold price on the COMEX. So we are
actually trading a derivative of a derivative.
Strikes and Settlement
There will be a total of 31 strikes available for trading for every contract launched. Considering
one ‘At the money strike’ (ATM), there would be 15 strikes above and 15 strikes below ATM.
Expiry of option contract will happen three business days prior to the first business day of
Tender Period of the underlying futures contract, with Settlement of premium on T + 1 day
basis.
Exchange shall levy pre tender margin on the long buy positions entering the option tender
period, which starts 2 days prior to option expiry day, and the settlement will happen on Daily
settlement price (DDR) of underlying futures contract on the expiry day of options contract.
Exercise mechanism at options expiry
CE
Option
Strike
Price
Effect
ITM 29400
Shall be exercised automatically unless ‘contrary instruction’
given
ITM 29500
CTM 29600
Shall be exercised on ‘explicit instruction’ by the buyer
CTM 29700
DSP/ATM 29800
CTM 29900
CTM 30000

4. OTM 30100
Shall expire worthless
OTM 30200
Options to Future – the devolvement
ITM and CTM’s on expiry of the options can be converted / devolved into a Futures position.
Margins will have to be topped up into your account to convert your ITM’s and CTM’s into
futures called the Devolvement Margin. This will be in 2 tranches, one to be paid before the
option expiry day and other on the expiry day.
On expiry of options contract, all open position shall devolve into underlying futures position:
 long call position = Long Future
 long put position = Short Future
 short call position = Short Future
 short put position = Long Future
Is Physical delivery Optional?
Yes, physical delivery is optional. Commodities like gold are deliverable on the MCX, if you
choose to keep your position open when the tender period begins. But the option holder has a
choice to square off the position and book gains/losses if any.
To sum it up, launch of options in Indian commodity markets will increase participation and
enhance liquidity in the markets. Producers, traders and processors, exporters/importers get an
online platform for price risk management. It provides a platform for producers to hedge their
positions according to their view of the prices.
1. What are options?
It is a derivatives product like a futures contract, but different, in that risk is limited for a buyer,
while profit is unlimited. For the seller return is restricted to premium buyers pay to buy an
option that gives them the right to buy (call option) or right to sell (put). The seller has an
obligation to buy from the put buyer or to sell to the call buyer.

5. In India, options are European style, which can be exercised only upon maturity of the contract.
The American style options can be exercised any time over the life of a contract.
2. So is SEBI launching European style options?
Yes , but unlike in the equity market where options settle at the cash market rate of stocks or
indices, options in the commodity market will be settled at the futures price on expiry with an
option for hold ers to convert their positions to futures contracts.
This is because unlike in the equity segment, where Sebi regulates the cash market, in Agri
com modifies, Sebi regulates only futures and not the cash mark which is the preserve of
individual state governments. Sebi recently approved options trading in the commodity futures
market. The step is expected to offer a cheap er tool for farmers and speculators than futures
contracts.
3. Will options really make a difference to the market?
The extent of change might not be much if participation is not broad-based. Currently, Sebi
and RBI do not allow institutional participation by mutual funds or banks.Most participants are
retail-level traders. But the introduction will be a good tool for speculators, who provide depth
to the market by taking on the risk that hedgers seek to protect themselves against. It might
also facilitate farmer participation through aggregation.
4. How will options function in the commodity futures market?
Those options that end out of the -money at expiry will be squared off at a loss. Holders of
options ending in-the -money will have a choice to either square off at a profit or to convert
into a futures position. Most, it is believed, will prefer to square off rather than exercise to
convert to a futures position, which entails higher margining and risk requirements.
What is an “Option”?
An option is a contract between two parties to buy or sell a given amount of underlying assets
at pre-specified price on or before a given date.
Let us understand options contract with the help of an insurance example. Mr A insures his car
of Rs 5, 00,000 by paying a premium of Rs 10,000. If the event occurs that he has a car accident,

6. then he receives most of the value of his car, less the premium, assuming the car is destroyed.
If the event occurs that the car does not get destroyed, then he loses his premium.
If any accident occurs, Mr A receives payment equal Rs 5, 00,000 — Rs 10,000(premium paid)
= Rs 4, 90.000.
If the event of "no accident" occurs then Mr “A” only loses his premium of Rs 10,000.
Insurance Payoff is asymmetric where the upside and down side payoff are not the same just
like the Options Contract.
What are the different types of Options?
There are two types of Option – Call option and Put Option.
Call Option is an option which gives the right but not the obligation to buy the underlying at a
specific price on or before a specific date.
Put Option is an option which gives the right but not the obligation to sell the underlying at a
specific price on or before specific date.
Buyer of an option by paying option premium buys the right but not the obligation to exercise
his option on the seller/writer.
The writer of Call/Put option receives the option premium and thus it becomes obligatory for
them to sell/buy the underlying if the buyer wishes to exercise his option.
Features ofOption Trading: (what is premium? what is strike price? what
is expiration date?)
 Buying of option requires premium to be paid and selling of option requires margin to
be paid
 The price which option buyer pays to option seller to acquire the right is called an option
price or option premium
 The pre-specified price is called as strike price and the date at which strike price is
applicable is called expiry date
 The asset which is bought or sold is called underlying assets (here commodities)

7. Style of Options:
American Options can be exercised any time on or before the expiration date. (Binomial
option pricing methodology is mainly used to price American Option).
European Options can only be exercised on expiry date of contract. (Black and Sholes
methodology is used to price European Options).
All index option and even commodity options are European trade options in India and they
can’t be exercised in between but they can be sold anytime.
Option Value
Intrinsic Value of an option is the difference between the spot price and strike price of the
underlying i.e.
Intrinsic Value of Call option = Spot Price - Strike Price.
Intrinsic Value of Put option = Strike Price – Spot Price.
Time Value of an option is the difference between its premium and its intrinsic value i.e.
Premium – (Spot Price – Strike Price)
A Call ATM and OTM have only time value. Usually, the maximum time value exists when
option is ATM.
In-the-Money Option: An ITM option is an option that would lead to positive cash flow to
the holder, if it were exercised immediately. Call option is said to be in ITM when Spot price
> Strike price (i.e. higher) whereas Put options is said to be ITM when Spot price < Strike price
(i.e. lower/below)
At the money option: An ATM is an option that would lead to zero cash flow if it were
exercised immediately i.e. Spot price = Strike price.
Out-of-the Money: An OTM is an option that would lead to a negative cash flow if it were
exercised immediately. In case of Call option = Spot Price < Strike Price, then Put Option =
Spot Price > Strike Price.

8. Determinants of Option Price:
Spot Price of the Underlying Asset, Strike Price, Annualized Volatility, Time to Expiration and
Interest Rate are the determinants of Option Price.
Now that you have got to know about the basic of Option Trading, Let us go through a couple
of basic option strategies.
Options trading strategies can be customized as per the requirement of the participants and can
either be a simple “one legged” trades or exotic multi-legged complex strategies. However,
irrespective of its complexity and function all option strategies have one thing in common and
that is they’re based on only two fundamental option types: Calls and Puts.
1. The Long Call: In this strategy, you buy a call option or “go long”. This straightforward
strategy is a bet that the underlying commodity will rise above the strike price by the date of
expiry.
Example: Gold trades at INR 29000 per 10 grams, and a Call option at INR 29000 strike is
available for INR 290 with an expiry date in three months. The contract is for 1 kilogram,
which means this call option costs INR 29000 (Premium): INR 290 X 100. Here’s the payoff
profile of the long call contact:-

9. Gold Price at Expiry date in INR/10 gms Long call’s profit in INR
33000 400000
32000 300000
31000 200000
30000 100000
29290 (Breakeven) 0
29000 -29000
28000 -29000
27000 -29000
26000 -29000
Potential upside/downside: If the call option entry is well-timed, the upside on a long call is
theoretically infinite, until the expiry date, as long as gold moves higher. Even if gold moves
the wrong way (in the above, case downside), traders often can salvage some of the premium
by selling the call before expiry date. The maximum downside is a complete loss of the
premium paid — INR 29,000 in this example.
Why use it: : If you’re not concerned about losing the entire premium, a long call is a way to
bet on a commodities rising price and to earn much more profit than if you owned the
commodity directly. It can also be a way to limit the risk of owning the commodity directly.
For example, some traders might use a long call rather than owning a comparable amount of
gold stock (in this case 1 kilograms of gold) because it gives them upside while limiting their
downside to just the call’s cost (Premium which is INR 29,000) — versus the much higher
expense of owning the 1 kilograms gold stock and paying additional storage cost and security.
Advantage: Loss is limited only up to the premium paid while profit is unlimited.

10. 2. The Short Put: The short put is the opposite of the long put, with the commodity trader
selling a put, or “going short.” This strategy bets that the commodity will stay flat or rise
until the expiry date, with the put expiring worthless and the put seller walking away with
the whole premium. Like the long call, the short put can be a bet on a commodity price
rising, but with significant differences.
Example:Goldtradesat INR29000 per10 grams,anda PutoptionatINR29000 strike canbe sold
for INR290 withan expirydate inthree months.The contract is for 1 kilogram, whichmeansthis
put optionissoldforINR29000: INR290 X 100. The payoff profile of one short put is exactly the
opposite of the long put.
Gold Price at Expiry date in INR/10 gms Long Put’s profit in INR
33000 -29000
32000 -29000
31000 -29000
30000 -29000
29000 -29000
28710 (Breakeven) 0
28000 100000
27000 200000
26000 300000

11. Potential upside/downside: The long put is worth the most when the price of gold is INR 0, so
its maximal value is the strike price x 100 x the number of contracts. In this example, that’s
INR 29, 00,000. Even if gold price rises, traders can still sell the put and often save some of
the premium, as long as there’s some time to expiry date. The maximum downside is a complete
loss of the premium, or INR 29,000 here.
Why use it: A long put is a way to bet on a commodities price decline, if you can digest/bear
the potential loss of the whole premium. If the commodity price declines significantly, traders
will earn much more by owning puts than they would by short-selling the commodities in the
futures market. Some traders might use a long put to limit their potential losses, compared with
short-selling, where the risk is uncapped because theoretically a commodities price could
continue rising indefinitely and a commodity has no expiry date.
Advantage: Traders and Jewellers can use the long put to hedge their gold price risk.
3. The Short Put: The short put is the opposite of the long put, with the commodity trader
selling a put, or “going short.” This strategy bets that the commodity will stay flat or
rise until the expiry date, with the put expiring worthless and the put seller walking
away with the whole premium. Like the long call, the short put can be a bet on a
commodity price rising, but with significant differences.
Example: Gold trades at INR 29000 per 10 grams, and a Put option at INR 29000 strike can
be sold for INR 290 with an expiry date in three months. The contract is for 1 kilogram, which
means this put option is sold for INR 29000: INR 290 X 100. The payoff profile of one short
put is exactly the opposite of the long put.

12. Gold Price at Expiry date in INR/10 gms Short Put’s profit in INR
33000 29000
32000 29000
31000 29000
30000 29000
29000 29000
28710 (Breakeven) 0
28000 -100000
27000 -200000
26000 -300000
Potential upside/downside: Whereas a long call bets on a significant increase in gold price, a
short put is a more modest bet and pays off more modestly. While the long call can return
multiples of the original investment, the maximum return for a short put is the premium, or
INR 29000 in this case, which the seller receives upfront.
If the commodity price stays at or rises above the strike price, the seller takes the whole
premium. If the commodity sits below the strike price at expiry date, the put seller is forced to
buy the commodity at the strike, realizing a loss. The maximum downside occurs if the
commodity falls to INR 0. In that case, the short put would lose the strike price x 100 x the
number of contracts, or INR 29, 00,000.
Why use it: Commodity participants often use short puts to generate income, selling the
premium to other traders who are betting that the commodity price will fall. Like someone
selling insurance, put sellers aim to sell the premium and not get stuck having to pay out.
However, traders should sell puts sparingly, because they’re on the hook to buy the commodity
in this case gold if gold falls below the strike at expiry date. A falling commodity can quickly
eat up any of the premiums received from selling puts.

13. Commodity market participants can use a short put to bet on a commodity’s appreciation,
especially since the trade requires no immediate outlay. But the strategy’s upside is capped,
unlike a long call, and it retains more substantial downside if the commodity falls.
Advantage: Commodity participants can also use short puts to achieve a better buy price on a
too-expensive commodity, selling puts at a much lower strike price, where they’d like to buy
the commodity. For example, with gold at INR 29000, an investor could sell a put with INR
28000 strike price for INR 200, then for 1 kg gold contract:
If gold dips below the strike at expiry date, the put seller is assigned the stock, with the premium
offsetting the purchase price. The investor pays a net INR 80,000 for 1 kg gold, or the INR
28000 strike price minus the INR 20000 premium already received.
If gold price remains above the strike at expiry date, the put seller keeps the cash and can try
the strategy again.
Similarly, various multi legged strategies like the covered call and Married Put can be easily
executed through the call and put options.
4. The Covered Call: The covered call starts to get fancy because it has two parts. The
trader must first own the underlying commodity and then sell a call on the commodity.
In exchange for a premium payment, the trader gives away all appreciation above the
strike price. This strategy bets that the commodity will stay flat or go just slightly down
until expiry date, allowing the call seller to pocket the premium and keep the
commodity.
If the commodity sits below the strike price at expiry date, the call seller keeps the commodity
and can write a new covered call. If the commodity rises above the strike, the trader must
deliver the commodity to the call buyer, selling them at the strike price.
One critical point: For each 1 kilogram of gold, the gold trader/jeweler sells at most one call;
otherwise, the trader would be short “naked” calls, with exposure to potentially uncapped losses
if gold prices gains. Nevertheless, covered calls transform an unattractive options strategy —
naked calls — into a safer and still potentially effective one, and it’s a favorite among
commodity traders looking for income.

14. Example: Gold trades at INR 29000 per 10 grams and a Call option at INR 29000 strike is
available for INR 290 with expiry date in three months. In total, the call is sold for INR 29,000.
The trader buys or already owns 1 kilograms of gold
Gold Price at Expiry
date in INR/10 gms
Short Call’s
profit in INR
Profit from 1 kg Physical gold stock
in INR, bought at INR 29000/10
gms
Total Profit
in INR
33000 -400000 400000 29000
32000 -300000 300000 29000
31000 -200000 200000 29000
30000 -100000 100000 29000
29290 0 29000 29000
29000 29000 0 29000
28000 29000 -100000 -71000
27000 29000 -200000 -171000
26000 29000 -300000 -271000
Potential upside/downside: The maximum upside of the covered call is the premium, or INR
29,000, if gold remains at or just below the strike price at expiry date. As the gold price rises
above the strike price, the call option becomes more costly, offsetting most of the gains of
holding the physical stock and capping upside. Because upside is capped, call sellers might
lose a profit that they otherwise would have made by not setting up a covered call, but they
don’t lose any new capital. Meantime, the potential downside is a total loss of the gold’s value,
less the INR 29,000 premium, or INR 28, 71,000.
Why use it: The covered call is a favourite of traders looking to generate income with limited
risk while expecting the gold price to remain flat or slightly down until the option’s expiry date.
Advantage: Traders can also use a covered call to receive a better sell price for the gold, selling
calls at an attractive higher strike price, at which they’d be happy to sell the physical gold. For

15. example, with gold at INR 29000 per 10 grams, a trader could sell a call with INR 33000 strike
price for INR 200, then:
If the gold price rises above the strike at expiry date, the call seller must sell the gold at the
strike price, with the premium as a bonus. The trader receives a net INR 33, 00,000 per 1 kg
for the gold, or the INR 33000 strike price plus the INR 200 premium already received
If the gold price remains below the strike at expiry date, the call seller keeps the cash and can
try the strategy again
5. The Married Put: Like the covered call, the married put is a little more sophisticated
than a basic options trade. It combines a long put with owning the underlying stock,
“marrying” the two. For each 100 shares of stock, the investor buys one put. This
strategy allows an investor to continue owning a stock for potential appreciation while
hedging the position if the stock falls. It works similarly to buying insurance, with an
owner paying a premium for protection against a decline in the asset.
Example: Gold trades at INR 29000 per 10 grams and a Put option at INR 29000 strike is
available for INR 290 with expiry date in three months. In total, the put costs INR 29,000. The
trader already owns 1 kilograms of gold
Gold Price at Expiry
date in INR/10 gms
Long Put’s
profit in INR
Profit from 1 kg Physical gold stock
in INR, bought at INR 29000/10
gms
Total Profit
in INR
33000 -29000 400000 371000
32000 -29000 300000 271000
31000 -29000 200000 171000
30000 -29000 100000 71000
29000 -29000 0 -29000
28710 0 -29000 -29000
28000 100000 -100000 -29000

16. 27000 200000 -200000 -29000
26000 300000 -300000 -29000
Potential upside/downside: The upside depends on whether gold goes up or not. If the married
put allowed the trader to continue owning the gold that rose, the maximum gain is potentially
infinite, minus the premium of the long put. The put pays off if the gold price falls, generally
matching any declines and offsetting the loss on the gold minus the premium, capping
downside at INR 29000. The trader hedges losses and can continue holding the gold for
potential appreciation after expiry date.
Advantage: The above option strategy is a hedge. Traders use a married put if they’re looking
for continued appreciation in the price of gold or are trying to protect gains they’ve already
made while waiting for more.
If the commodity prices continue to fall/decline, this strategy will allow a physical player to
limit his losses only up to the premium and hence it acts as a hedge