Commodity Futures are options having as the underlying asset, a futures contract on commodities like gold, silver, crude oil, and a number of agriculture goods. There are even futures on financial instruments like treasure bonds and foreign currencies. To understand this better let’s look at an example: A gold futures contract gives the owner the right to buy or sell a specified quantity of gold for the price nominated in the contract at some future settlement date. In India, commodity futures are regulated by SEBI.
Commodity Trading
Commodity futures are swiftly traded by open outcry (method of communication between professionals on a trading floor). These futures are based on the changing market prices of the underlying commodity which can be due to economic or seasonal forces of supply and demand. Therefore, futures prices may change rapidly and without warning.
Commodity futures options enable the trader to effectively trade futures, but without the potentially unlimited risk normally associated with probable price movement in a futures contract. Why do you ask? Because commodity futures options give you the right but not the obligation to buy or sell a futures contract anytime up to an agreed expiration date. By contrast, a futures contract is simply an obligation to settle.
Commodity Futures Contracts
Commodity futures options contracts must specify exact things such as the commodity future being traded, whether the options are calls or puts, number of futures contracts being bought and sold, the expiration date as well as the exercise (or strike) price. In essence, they function just like stock options. But give the buyer the right but not the obligation to purchase or sell for a predetermined price within an agreed time frame.
Advantages of Commodity Futures
There are a number of advantages inherent to commodity futures options. The primary ones are:
Favorable margin requirements: You can take a position in a particular commodity by paying only a fraction of that value as margin. Moreover, the margins in the commodity futures market are lower than equity futures and options.
Diversification: Commodity prices are prone to supply-demand dynamics, weather conditions, geopolitical tensions and natural disasters. Accordingly, commodities are an independent asset class and can prove to be an effective means of diversification in one’s investment portfolio.
Implementation of strategies and fairer pricing: Governed by international price movements, commodity markets are less prone to rigging or price manipulation.
Commodities in India
Commodities can be categorized into major groups like agriculture produce, metals, meats, financials, currency or resource markets. In India, they can be further broken into these categories:
| Commodity sectors | Constituents |
| Agriculture | Grains: Rice, Basmati rice, wheat, maize, jeera.
Oil and oilseeds: Castor seeds, soy seeds, castor oil, refined soy oil, soymeal, crude palm oil, groundnut oil, mustard seed, cottonseed, etc. Spices: Pepper, red chilli, jeera, turmeric and cardamom. Pulses: Chana, urad, yellow peas, tur dal. |
| Metals and materials | Base metals: Aluminum, copper, nickel, zinc, tin.
Bulk commodities: Iron ore, coking coal, bauxite, steel. Others: Soda ash, chemicals, rare earth metals. |
| Precious metals and materials | Gold, silver, platinum and palladium. |
| Energy | Crude oil, natural gas, Brent crude, thermal coal, alternate energy. |
| Services | Oil services, mining services and others. |
Commodity Futures Increasing Popularity
Commodity futures options are becoming more popular among stock options traders. In the past few years, the market has witnessed a lot of stock option traders convert to commodity options because commodities have gained significant traction. The concepts, strategies and stock markets know-how can be easily transferred to options on futures.
Why You Should Opt for Commodities Futures
1. They give traders that variety of having over 30 different markets from which to choose. These markets are always in a variety of chart patterns and volatility, which allows the trader to scan for the most effective option trading strategies.
2. They include more favorable margin requirements for the short sold options and also the ability to receive interest on both investment capital and premium received. For example, you receive Rs. 50,000 from selling options on treasury bond futures contracts. You now have an extra Rs. 50,000 in your trading account, in addition to the trading capital you used to margin this trade. You can then invest the trading capital plus your additional Rs. 50,000 and obtain interest on the whole amount.
3. Traders can buy and sell without the upsetting concern of counterparty risk. Counterparty risk is the risk associated with the other party to a financial contract not meeting its obligations. When trading through the stock exchange or the commodity exchange the clearing corporation assures each trade executed on the exchange. Effectively, the exchange becomes the counterparty for each trade. This makes the entire process of trading, clearing and settlement relatively risk-free.
4. Commodity markets instill a more standardized approach to commodity trading. The process involves a full-fledged exchange mechanism in the form of standardized contracts; expiry time tables; full proof risk management mechanisms lime SPAN, comprehensive security and surveillance systems, and a host of other benefits. All these inherent qualities of the commodity markets eases the risk associated with trading in commodities that guarantees the trades will be executed and honored.
Risks Associated with Commodity Futures
Trading commodity futures potentially involves considerable risk of loss and might not be appropriate for all investors. Investors should carefully think about whether trading is suitable in light of circumstances, expertise, and financial resources.
SPAN Methodology to Calculate Futures
The commodity markets utilize the SPAN system which stands for Standardized Portfolio Analysis of risk. SPAN is a risk-based portfolio approach for computing margin requirements in an account for futures and options on futures. Their methodology rather than calculating the margins for a new position added to an account, as a standalone option, SPAN works out the effect of the new position on the whole account. Put simply, it recalculates the portfolio as a whole.
Conclusion
To trade in commodity futures options, the first thing you need is to find a commodities broker. Angel One is an established commodities broker with membership to NCDEX and MCX and years of experience to guide you in commodity futures services. The company has an extensive network of 11,000 sub-brokers across the country and a slew of awards for client appreciation and premium trading services. Visit their website to know more.
