By Kunal Sharma
The Multi Commodity Exchange of India Ltd (MCX), India’s largest commodities bourse by turnover, plans to introduce options trading by January 2017 to boost revenue, after the markets regulator permitted the trading of the derivatives at the end of last month. The Securities and Exchange Board of India (SEBI) permitted the trading of options contracts on 28 September, 2016 with the aim of increasing liquidity and attracting more investors to the commodities market.
The options contracts are expected to facilitate hedging by market participants and help deepen the commodity derivatives market. Only futures contracts based on individual commodities are traded on commodity bourses now. At present, the National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange of India (MCX) are the two main nationwide commodity exchanges. NCDEX, which is dominated by larger rival MCX, has around 10.61% of average monthly turnover.
Currently, SEBI has not clarified how many commodities will be permitted and whether both agricultural and non-agri commodities options will be allowed. There is also no clarity on the types of options that will be preferred. SEBI will spell out the details of the type of options and the products on which they can be launched in due course.
“For farmers, it will be a game changer,” said Samir Shah, MD, NCDEX. “It would help them to sell their produce in the derivatives market and thereby get the benefit of price protection in case the price falls below their cost of production and also derive the benefit of any rise in the price. Options are also a much better hedging instrument as compared to futures for hedgers.”
Saying that the exchange was awaiting detailed guidelines from SEBI, he added, “The Exchange is prepared for the launch of options and has also invested in next generation trading technology, gearing towards providing unrivalled levels of performance.”
WHAT DO OPTIONS BRING TO THE TABLE?
Firstly, the initial outlay is much lower in options. While the initial outlay and volatility margins that an investor pays could vary between 4 and 14 per cent of the contract value (translating to an outgo of ?5,000 to ?20,000 per contract), the premiums on options are much lower, sometimes a quarter of the initial margins paid on futures contracts.
Secondly, traders and investors have to shell out mark-to-market difference to the exchanges every day in future contracts, according to CP Krishnan, Director of Geofin Comtrade. This causes a huge hindrance to genuine hedgers as they have to keep making good the difference between the closing market price and the opening value of the contract to the exchanges. Hedgers can now use option contracts where there is no further outgo after the initial payment for the option premium.
Thirdly, losses in options are limited to the premium paid whereas a trader who uses futures faces unlimited losses. Amateur investors and traders can lose all their capital in futures contracts while this is less likely with options.
WHAT ARE THE ROAD BLOCKS?
The primary reason why many investors/traders/hedgers stay away from commodity exchanges is the frequent suspensions and banning of contracts. The regulator needs to ensure that this practice stops, for it erodes the confidence of the users. Finally, a review of the commodity transaction tax will also help. It was this tax that stifles volumes on commodity exchange.
FUTURES, WHAT?
Futures provide the holder of the contract with both an obligation and a right. Say, a speculator goes long on rice contracts (that is to say he’s bullish on rice). Now, should the price of rice go up, the speculator stands to gain, but if the price goes down, he’ll have to pay, and vice versa. However, what if he’s not a speculator, but wants to hedge his risk against a sharp rise in the price of rice which might be a raw material in the final product he manufactures. In this case, he is supposed to take actual physical delivery after 3 months. So, to make an equivalent amount amount of profit on the rise of rice as the loss he would make if the price of his raw material should go up he would have to purchase an equivalent amount of future contracts right now. So, if the spot prices of rice are Rs. 10 per kg now, and after three months they are at Rs. 13 per kg, his effective cost would be Rs. 10 per kg because he would have gone long on the rice contracts when the price was Rs. 10. So, in effect, he would have locked in the price of Rs. 10 but taken delivery when the price was Rs. 13. This could go the other way round as well where he could lose Rs. 3 per kg on the future contracts but gain the same by paying lower on actual delivery. Thus, the price is effectively locked at Rs. 10. Hence, futures involve mark-to-market settlement and therefore require more funds.
SO WHAT GOOD WOULD OPTIONS DO?
Options will give the holder the right to buy or sell the rice at a pre determined price (A RIGHT but NOT an OBLIGATION to pay) and options entail only a one time payment of a premium. So, should the price move against the speculator, he can choose not to exercise the option but here he stands to lose the entire premium paid by him but also stands to gain the entire amount of the price difference between the strike price and the expiration price of the contract.
So, with reference to the previous example, if the rice producer hedges, using options, and the price of rice go up, he will exercise the option to buy the rice at the pre determined price of Rs. 10. However, if the price of rice goes down, it will not be an equally balanced situation like futures, where he gains on one hand and loses on the other. Here, in this case, he shall simply not execute the contract but in the process lose the entire premium paid. So he will gain Rs. 3 per kg on actual delivery and lose only the amount of premium on the options instead of the entire Rs. 3 per kg.
Thus, in effect, when hedging with futures, the profit made by the producer may purely be of operating efficiency, so to speak, but while hedging with the newly introduced options, one can also take advantage of the favourable price action in raw materials.
AREN’T OPTIONS JUST PERFECT THEN?
No, options are a very risky kind of financial instrument with a decaying time value of the premium and to even get close to an accurate method (with shortcomings of its own nonetheless) of determining the fair value of premium to be paid for an option, it would require two gentlemen by the names of Fischer Black and Myron Scholes who would need to have PhDs in applied mathematics and a Nobel Prize in economics.
Naturally then, there would exist vast parts of these options that would go uncomprehended by the farmers and the small scale manufacturers looking to hedge their risks. They will not be able to rely on the brokers and dealers who would execute these trades on their behalf due to conflict of interests and would get duped out of their money if they do so.
The confusion between futures and options, margin calls and premiums, and the risk of over reliance on and addiction to such instruments are some of the apparent drawbacks of this proposed scheme. Clearly, passing some sort of an examination, and testing the basic knowledge and understanding people have about these complex financial instruments, seems only logical. The success of this plan, thus, relies heavily on the quality of execution by the good men over at SEBI which, if substandard, could cost the farmers their life savings and in some cases even their lives.