How can options trading gain ground in commodities ?

The commodities futures market underwent changes in 2003 with many policy reversals. But option-based derivatives are yet to gain ground in commodities. Though the Forward Contract (Regulation) Bill, 2010, has provisions for option trading, its execution requires considerable attention from the regulator, commodity exchanges and market participants.

The government can replace the price support scheme with minimum guaranteed price (MGP). Policy makers are passive on the adoption of option-based trading despite the benefits.

Option can be over-the-counter and exchange-traded. Similar to the futures, option requires at least two parties to exercise the contract. Exchange-traded option can help to mitigate counter-party credit risk as the contract will be more standardised in nature. Farmers can avoid distress sales if they can opt for a longer put option, paying a put premium. Commodity processors, on the other hand, can hold a long call option, paying a call premium. Intermediaries between farmers and processors can act as option writers holding a short put and a short call position. They can be market agencies that procure from farmers and sell to consumers or civil supplies agencies such as FCI, STC, NAFED, HAFED and several private agencies. The payoff and profit structure are different. While farmers might delimit their potential loss, processors may have unlimited loss if the commodity price falls below the strike or exercise price of the contract. Farmers could wait for a better deal to exercise the contract. Thus, a minimum guaranteed price can be embedded in the long put option. On the other hand, processors can reduce their exposure through dynamic or “delta” hedging that implies that number of call option bought is relative to number of stocks sold. Based on financial aptitude, financial knowledge, and financial behaviour, agents can leverage their risks or increase their spread by formulating several option trading strategies. In addition, they can mix futures/forward and option contract (if offered in identical commodities) to protect them from unexpected losses, such as, “covered call” or “protective put”.

Option pricing (call and put) is important for an efficient commodities market. It depends on several variables known as Option Greek, which includes delta, gamma, vega, theta and rho. For example, one per cent increase/decrease or any absolute in underlying commodity price seeks to impact the relative change in option price or premium. Similarly, market volatility, time of the contract and rate of interest (asset borrowing and storage costs) seek to determine the magnitude of change in that option price.

If option market needs to be efficient, call-put parity should hold. Therefore, there should be a small deviation between market offered rate and an implied rate. Pricing exercise may be accomplished using binomial option pricing, Black-Scholes pricing, KMV-Merton pricing based on the model parsimony and robustness.

Introduction of option in commodities calls for a careful concern of the regulator and market agencies. It should be implemented in a phased-manner. Fundamental analysis of commodities is required on two fronts: pricing of commodities and variables influencing the option price.

Option need to be introduced in those commodities which are having liquid contracts and significant trade volumes in futures/forward and spot markets. However, speculative asset should be avoided. First, exchange-traded option may be introduced in non-MSP; and then in MSP-based commodities. Commodity exchanges need to work on the contract specification and spread for assessing liquidity. Option contract implementation is critical to encourage commercial users. The coming Budget may shed light on the fate of this derivative instrument, given the possibility of SEBI-FMC merger. Second, since the underlying asset is commodity, a comprehensive study needs to be undertaken with respect to economic fundamentals, price and non-price factors, stock-to-use ratio or carryover stock, crop management practices.

Farmer Producer Companies (FPCs) can work out the prospect of option market as they procure the produce from farmers’ interest groups at MSP or market offered rate and then, distribute to the Small Farmers’ Agribusiness Consortium (SFAC). Instead of procuring at MSP, SFAC through FPCs should offer minimum guarantee price to producer-members which might improve farmers’ marketing decisions and their risk-return metrics.

FPCs need to create or lease in storage space for holding farmers’ produce until they deliver in exchange platform. NCDEX may offer customised contract to FPCs and NABARD might act as clearing agent of commodity exchanges or could train or handhold FPCs for account opening and daily and final settlement.

Service providers need to be empanelled by exchanges to safeguard farmers from any unexpected margin call or mark-to-market loss. In other words, exchanges need to depute some third party to resolve any unwarranted default in the option market.

The writer is a Post-Doctoral Fellow of the Centre for Management in Agriculture, IIM-Ahmedabad. Views are personal.