Commodity Options - Basic Terminology

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  • 30 Jan 2023

In India, the trading of commodity options has a genuinely long history. Securities and Exchange Board of India launched commodity options trading in 2017. Previously, only Future Trading was permitted. The advent of Commodity Options Trading provides a fantastic tool for upcoming investors to diversify their portfolios and benefit from the same. This article will provide details about Commodity Options Trading.

Commodity options are a type of Derivative Contract. Comparable with stock options, the contract calls for the purchase of the securities at a specific time and price. Commodity options have both buyers and sellers. The commodity option buyer can fulfil the contract, but isn’t liable. If he/she believes that the contract is lucrative for them, they can execute the contract at any given period or let it lapse.

A premium amount needs to be paid by the buyer when purchasing a contract. When they choose to execute the contract, the commodity option seller needs to honour it. The seller gets the premium amount paid by the buyer after the commodity option contract is executed.

Commodity Options can be divided into two types: Put and Call Options.

  • Put Option The Put Option provides the commodity option holder to sell a contract.

  • Call Option The Call Option provides the commodity option holder to purchase a contract.

  • Size of a Lot: The quantity exchanged in a Commodity Options Contract is referred to as the size of a lot.
  • Style of Exercise: The Commodity Options Contract specifies the option style, which governs when, how, and under what conditions the Commodity Options holder can exercise the contract.

There are three types of exercise styles:

  • European: The commodity options contract can be exercised only on the expiration date.
  • American:The commodity options contract can be exercised at any given period before the expiration date.
  • Bermudan:The commodity options contract can be exercised on some specified dates.
  • Day of Expiration: Three days before the expiration date of the Futures contract
  • Strikes: Given one 'ATM strike,' there will be 15 above strikes and 15 below strikes, for a total of 31 strikes.
  • ATM (At The Money): ATM or At the Money refers to the strikes nearest to the contract settlement price.
  • CTM (Close to Money): CTM or Close to Money is defined as two above and below strikes near the ATM.
  • OTM (Out of the Money): The term OTM refers to a commodity option contract with purely extrinsic value. The delta for these commodity options will be less than 50.0.
  • ITM (In the Money): The term ITM refers to a commodity option that has inherent value.

Note: Your market perception and intended outcome influence the choice to purchase or sell any commodity option. A trader may see commodity options differently from a producer seeking to hedge price risks. A hedger is concerned with safeguarding his margins by limiting price risk, whereas an investor is concerned with benefiting from market movements.

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