Introduction
Futures and options on commodity derivatives is currently available on metals, energy and some agricultural products. The basics of futures and options contract and trading in case of commodities remains the same as it is with equity derivatives. Futures and options are explained in detail in previous chapter on equity derivatives. With basics remaining the same, in this chapter let us see about the various commodity contracts available for trading under commodity futures and options in India.
Exchanges that offer trading in commodities
Multi Commodity Exchange (MCX) offers derivatives trading in metals and energy products. While agri commodity derivative trading is offered by National Commodity Derivative Exchange (NCDEX). In October 2018 both NSE and BSE launched commodity trading in precious metals gold and silver and Brent crude oil. Whereas Indian Commodity Exchange (ICEX) offers trading in plantation products
Regulators
Commodities trading was regulated by Forward Market Commission (FMC) and later it was merged with Securities Exchange Board of India (SEBI) in the year 2015. And now the commodities trading is solely regulated by SEBI.
Participants
The primary participants in commodity derivatives are hedgers. Manufacturers and dealers in commodities and wholesale and retail traders use commodities derivatives to hedge against the volatility in prices of commodities.
As with any other financial instruments, speculators play major role in commodity derivatives too. And arbitrageurs trade the mismatch in price between spot and futures price or price difference between futures and options.
In Indian commodity derivative market, mutual funds, banks and FPIs are not allowed to trade.
Types of Commodities
Commodities ranging from metals and energy to agricultural products and plantations are traded in Indian commodity derivatives market. Below is the list of commodities traded on MCX the largest commodity derivatives exchange in India.
Options contracts are available for the following commodities in MCX.
Gold
Silver
Zinc
Copper
Crude Oil
Contract Specifications
Commodity contract specifications vary from commodity to commodity. As an example we will see snapshot of Gold taken from mcxindia.com to understand the important specifications that a trader needs to know. In commodities the price quoted will not be for one unit, rather it will be for more than one unit. The trading unit is the market lot size for the contract. So, with the difference in trading unit and the number of units for which it is quoted, let us see how to calculate profit or loss on our trade.
In the above snapshot you could see that the closing price of Gold is 35115 and it has increased by 79 from its previous close. So, this increase of 79 INR is for 10 grams. Therefore for the trading unit of 1 kg, the profit works out to 7900 INR. The formula to calculate this will be as follows:
Trading unit/ quote unit * price increase
1000/10 * 79
7900
If the increase was 1 rupee, then the profit will be 100 rupees. So, for every one rupee rise or fall, the profit or loss will be 100 rupees. The profit or loss can be calculated for all commodity contracts using the same formula.
Below is the ready reckoner for all commodity contracts available in MCX.
Margins
Initial Margins
Various types of margins are applicable in commodities derivatives market. MCX collects Initial margin comprised of SPAN and Extreme Loss Margin (ELM) upfront. For example, if the closing price of previous day is 35132, the contract value of one lot of gold will be Rs.3513200.
The formula to calculate contract value is as follows -
Closing price * Trading unit / quote unit
35132 * 1000/10
Rs.3513200
To calculate margin for this contract, let us use margin calculator available in tradeplus website. Screenshot of margin calculator in tradeplus website is given below.
From the above image you could see that the margin required for futures contract of gold is Rs.184443/-. This works out to 5.25% of total contract value of Rs.3513200. The margin so arrived comprises of 4% of SPAN and 1.25% of ELM.
In case of options, the seller of the option has to pay the initial margin and buyer of the option will pay only the premium.
Other Margins
Additional/ Special margin is collected in case of high volatility. Tender period margin and delivery period margins are levied on contracts nearing expiry.
Tender period margin is the incremental margin levied on all open positions during the tender period. This margin will be released once the delivery period margins are levied on the open positions.
Delivery period margins are levied on open positions that are marked for physical delivery during the tender period. This margin will get reduced once the trader pays the full value of the contract to take physical delivery of the commodity.
A margin called “Devolvement Margin” is applicable in case of options contract being devolved into futures contract. Meaning, the options contract can be converted into futures contract on expiry upon the traders instruction. More on devolvement will be discussed under heading “Settlement of commodity futures & options” in this chapter. So I encourage you to continue reading the full chapter. As of now, let us know that the margins assigned on the conversion is called “Devolvement Margin”.
Strike Price
Apart from ITM, ATM and OTM strikes, commodity options has one more strike called “Close to Money (CTM). If the strike is close to daily settlement price, it is said to be at the money (ATM). ITM and OTM means the same as it is in equity options. New term called “close to money” (CTM) refers to two strikes above and two strikes below ATM. If the daily settlement price is midway between 2 strike price, then 2 strike price above and below DSP will be the CTM. Remember that the underlying for commodity options are the futures contract of the corresponding commodity. And the daily settlement price of the futures contract will be the reference price for options contracts. Now let us understand the strikes of a commodity options with an example.
If daily settlement price for copper is 450
ATM (close to DSP) = 450
CTM (two strike price above & below ATM) = 445 & 440 / 455 & 460
AND
If daily settlement price for copper is 448 which is midway between two strike price
ATM (close to DSP) = 445/450
CTM (two strike price above & below DSP) = 445 & 440 / 450 & 455
Settlement of commodity futures & options
Multi Commodity Exchange Clearing Corporation Ltd (MCXCCL) is the clearing house to clear all commodity trades carried on MCX.
Commodity derivatives are settled in cash and by physical delivery. Physical delivery is compulsory in some agricultural products such as spices. In metals it is compulsory for all base metals and gold guinea and gold petal. However squaring off the position prior to expiry is allowed.
All commodity futures contract are settled at daily settlement price (DSP). The DSP for commodities futures will be the weighted average price of all trades done during last 30 minutes. In case of insufficient trades in last 30 minutes, last 10 trades or all trades in a day is considered. The daily settlement price (DSP) so arrived will be the reference value for the options series of the commodity derivatives.
Options settlement
The underlying for commodity options will be the futures contract of the respective commodity. And the settlement price will be the daily settlement price (DSP) of the futures contract of the commodity. All ITM and CTM contracts are settled automatically on the expiry and devolved into futures contract. The expiry of options contract will be few days prior to the expiry of futures contract.
Devolvement of options contract
Upon the expiry all ITM and CTM options contract are devolved into futures contract automatically. We have learned that the option buyer will pay only the premium and no margins are applicable to him. But, when he converts his open position to a futures contract, then he would have to pay the margin applicable for futures contract. The margins so assigned on the conversion is called “Devolvement Margin”. In the chapter on equity derivatives, we learned that all ITM contracts are profitable positions. The same is true with commodity options too. Hence, when ITM commodity options contract is assigned devolvement margin, the profit on the open position will be adjusted towards the margin payable by the trader.
Physical Delivery
You may wonder how to take delivery of crude oil or natural gas and store it at home. You need not take it to your house, but the commodities will be stored at warehouses accredited/approved as designated delivery centers. The buyer of the commodity who takes delivery will be given a receipt indicating the ownership of the stored commodity in the warehouse with details such as quantity and quality grade. This receipt is called “Warehouse Receipt”.
Delivery can be taken only in prescribed delivery lot fixed and in multiples thereof. The delivery lot varies from commodity to commodity. All outstanding odd lot positions should be squared off before the expiry of the contract.
Note:
Contract specifications for all commodities with details of settlement mode, delivery unit, warehouses etc are available in mcxindia.com under the menu “products”.
Key points to remember
- Basics of futures and options of commodities are same as equity derivatives
- MCXÂ offers derivative contracts on energy and metals and NCDEX offers contracts on agri products
- SEBIÂ is the regulator for commodity derivatives.
- Trading unit/ market lot and quote unit differs and it varies for each commodity
- Initial margin is comprised of SPAN and Extreme Loss Margin
- Devolvement margin is applicable in case of options contract devolved into futures contract
- Commodity futures is the underlying for commodity options.
- Commodity derivatives are settled by cash and physical delivery. However, it is compulsory for some commodity like gold.
- Close to the money (CTM) refers to two strike prices above and below the daily settlement price (DSP)
- The expiry of options contract will be prior to expiry of futures contracts.
- Traders willing to take delivery of the commodity can store it at designated warehouses and get a warehouse receipt as proof of his ownership.
- Physical delivery is allowed only in prescribed lot.
Round Up
Commodity derivatives market can be used to hedge against investment in gold and it also serves as a hedging instrument against price fluctuations of commodities such as agricultural commodities. To enable more and more small traders to participate in commodity derivative trading, MCX has introduced mini contracts with small trading units. This has increased the participation of speculators and commodity trading has become one of the actively traded segment in India.
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