How to Trade in Commodity Options?

Introduction

Commodity trading has been part of financial history since ancient times. Civilizations and empires were built- on successful commodity trading between different parties. Options trading in commodities is also globally prominent among major exchanges, for example, CME, NYMEX, ICE. They provide commodity options trading on a multitude of items that range from oil to precious metals.

Indian markets have completed 13 year gestation period and launched commodity options in Gold, which has led to expansion into new avenues for hedging and trading. However, commodity options trading is entirely different from Forex exchange or equities because the expiry period drastically differs. Thus, investors/buyers/speculators must understand how this type of trading works- to increase their profits.

In a nutshell, there are two primary commodity options-

a) Call option - This gives an individual the entitlement to buy the primary commodity at a predetermined fixed price or strike price on the expiration date of the contract. If the individual chooses to execute their right to buy, the contract will automatically transfer into a futures contract.

b) Put option - This gives an individual the power to sell the primary commodity at an already decided price when the contract expires. The expiration date is always the last Thursday of the month.
Naturally, there are two parties involved in the trade called buyers and sellers. Nonetheless, the parties experience the opposite results. For instance, in a model increment, the option buyer will make money and the option seller will lose money.

Types of options

Essentially, there are two central types of options in commodity market. They are- American and European style options. They are differentiated based on when the right to sell or buy can be implemented. For American options, it is before the expiration date. For European options, it is only on the date the contract expires.

How does options trading work?

In this type of trading, the buyer's risk is mitigated, and the profit potential is considerably high. It is because the buyer has the power to exercise their right of buying an intrinsic asset at the pre-decided or strike price on the day the contract expires if that price is lower than the present market price. Therefore, limiting the risk of losing any money. The seller has no other option but to execute the trade according to the previously decided terms if the buyer chooses to buy the asset at the strike price.

When is the right time to use commodity options?

The right time to trade in commodity options heavily depends on the market situation and personal goals. A trader’s perspective will differ from that of a commodity producer. The former will look at commodity options from a different perspective than the latter who- wants to hedge its price risk. A speculator gains profits by leveraging market moves while a hedger emphasizes protecting their margins limiting price risk.

Pros of commodity option trading

A) Options in commodity market provide more flexibility to the option holder as they can fully participate in any price movement.

B) It is more cost-efficient than a future contract, and the returns are considerably higher, and the loss is limited to the option’s price. In a future contract, the returns are significantly low, and losses can be extremely.

C) Option buyers don’t have to maintain mark-to-market margin calls since the premium is already paid for these contracts.

D) The trader receives protection from the fluctuation of risk prices of any commodity in the market.

E) Some professionals refer to options as a type of price insurance in the volatile derivatives commodity market. Traders can benefit from the volatility of price to hedge the pricing risks in both directions. 

F) During market fluctuations and distress like inflation, commodity options will provide a secure and diverse portfolio. It will also enable them to receive a huge amount of profits from every trade. 

G) The stakes are comparatively lower in commodity options trading than in future contracts. Thus, traders can buy put options to take a minimal position in future contracts.

How are commodity options different?

They are on futures and never on the spot. This is what makes it different from equities. For example, while trading in Nifty or equity stock, you are trading in Nifty/equity stock spot and not future. However, options in commodity market like Gold are on MCX Gold futures and not spot prices. Gold price on the COMEX is underlying for MCX Gold futures. Thus, in simple terms, you are trading a derivative of the derivative.

To sum up

Commodity options trading is not a complex process once you get the grip of it. You should conduct meticulous research on commodity options trading before getting into it. This guide should help you understand the basics of trading in commodity options and gain optimal profits from it.