COMMENTARY
agricultural futures that signalled the
Options and the
Commodity Market
Kushankur Dey, Debasish Maitra
The necessity of options in
commodity markets in India
has been discussed for a long
time. It aids in improving
market liquidity, information
transmission, and acts as a risk
transfer mechanism. However,
given the nature of farm and
non-farm commodity markets,
financial investors may be
attracted more towards non-farm
commodity options. This would
eventually lead to illiquidity in
farm commodities. The regulator
and exchanges should therefore
work in unison to launch options
in a prudent manner, especially in
farm commodities, to benefit the
concerned stakeholders, including
producer groups and processors.
The authors have benefited from the working
paper “Options: A Critical Missing Link in
India’s Commodity Market,” Multi Commodity
Exchange of India, 2014.
Kushankur Dey (kushankur@ximb.ac.in)
teaches at the Xavier School of Rural
Management, Xavier University, Bhubaneswar.
Debasish Maitra (debasishm@iimidr.ac.in)
teaches at the Indian Institute of Management
Indore.
Economic & Political Weekly EPW OCTOBER 14, 2017
T
he Ministry of Finance allowed
options trading in commodities in
2015–16. The Securities and Ex-
change Board of India (SEBI), the new
regulator of commodity derivative mar-
kets, has recently approved, in principle,
options trading in commodities. The
approval came after a few rounds of dis-
cussion between the Commodity Deriva-
tives Advisory Committee (CDAC) and
the regulator (Sahgal 2016). Now, with
this risk management instrument, will
the breadth and depth of commodity de-
rivative market increase and would this
factor in the efficiency of price risk
transfer mechanism?
To address this, serious work in product
development and market regulation with
reference to amendments to the relevant
by-laws and rules needs to be accom-
plished in a stipulated period. How the
regulator, SEBI, and exchanges would
go about this can generate considerable
attention and debate in academic and
policy circles. The regulator has released
the framework related to settlement and
delivery in June 2017. Drawing a critical
perspective from the mechanics of options
market, we aim to discuss some of them
in this article.
Rationale
The need for options has been felt on
some occasions (Sen 2005). Options
trading impacts information transmission
and aids in improving market liquidity
and complementing existing product
such as futures (Camerer 1982; Chan
and Lien 2002; Dey 2015).
It is noteworthy to mention that China
followed a “rectification” approach by
“right-sizing” the number of commodity
exchanges in the early 2000s (three from
more than 40 exchanges that existed in
the 1990s), and allowed options trading
in commodities in 2012. This happened
when Dalian Commodity Exchange in-
troduced a mock trading of options in
vol lIi no 41
introduction of options trading. In India,
a similar intent was expressed by the
Parliamentary Standing Committee of the
Ministry of Consumer Affairs, Food and
Public Distribution in late 2011 (MCX 2014).
A few developing countries like Brazil,
Argentina, and South Africa experi-
enced the functioning of options market
in commodities after the United States
(US) first introduced options contract
on the Chicago Board of Trade in agri-
cultural products in 1982. In Brazil,
BM&FBOVESPA launched gold options
trading in 1986 followed by options in
coffee and live cattle in the early 1990s.
Argentina through Mercado a Término
de Buenos Aires and Rosario Futures
Exchange introduced options in wheat
and corn in the 1990s, while South Africa
allowed options in a phased manner, for
example, floated in wheat in 1997, fol-
lowed by yellow maize in 1998, sunflower
seeds in 1999, and so on (MCX 2014).
However, the “tulip mania” that occurred
in the Netherlands in the 17th century
had put a stigma on options trading.
Options Microstructure
An option gives a right to the buyer (op-
tion holder), while the seller (option
writer) has an obligation to exercise the
contract on or before the time of expiry or
maturity of the contract. An option, un-
like a futures contract, delimits the risks
but provides unlimited gain or loss to the
buyer or options holder. For an options
seller or writer, maximum profit is limited
to the premium the seller receives from
the buyer; potential losses are also lim-
ited. In the case of long call option (a
right to buy), there is a possibility of un-
limited gain to the option holder, and in
the case of short call option, unlimited
losses to the writer. In the case of put
option (a right to sell), the potential gain
or loss can be delimited with the strike
price movement. The option pays a
premium while the seller receives that
premium by writing the contract. In con-
trast, a futures contract can expose the
buyer or seller to unlimited gain and
unlimited loss but in a linear fashion.
Options give more flexibility than other
derivative products in terms of position
closing—offsetting, exercising, expiration,
29
COMMENTARY
and the nature of product. Pure insurance
product is associated with a secondary
market and free from any counter-
party risk.
Options can outweigh a futures contract
from the tax imposition viewpoint as
well. For example, a commodity transac-
tion tax (CTT) at 0.01% is levied on the
futures contracts of non-agricultural com-
modities. After its imposition in 2013–14,
the trading volume has declined by 45%
due to an increase of 300% trading costs
for the proprietary traders or exchange
members (Chopra 2015). However, the
outlay due to the imposition of CTT on
options can be negligible that may not
factor in as a liquidity barrier.
To make the options market liquid
and effective to hedging, microstructure
plays an important role. In other words,
a liquid microstructure aids in reliable
price discovery, broad-based price dis-
semination and effective hedging against
price (basis) risks. Microstructure refers
to a process by which an investor’s desire
and expectation gets translated into fi-
nancial transaction. To create a robust
microstructure, certain issues related to
option mechanics need to be addressed.
First, options pricing relating to the
(call and put) premium estimation in
commodities comes to the fore. What
methodology is to be used to derive this?
Will it follow the standard Black–Scholes–
Merton model that has been heavily
adopted in financial asset pricing? Would
this be appropriate for options pricing in
commodities?
Second, position limit, margining sys-
tem, and trading cycle should call for
serious engagement through arithmetic
exercises and decisions within the pur-
view of the regulation that may not be
like that of futures or over-the-counter
derivative products. Mark-to-market rela-
ted to daily settlement, however, may
not be pertinent to options trading un-
like that of futures contract. Regulator
and exchanges need to work out how the
exercise or strike price will be deter-
mined and in what manner the spot prices
will be polled. Is the newly promoted
electronic National Agriculture Market
ready to facilitate spot price pooling?
What criteria commodity bourses follow
to fix the opening strike price for options
30
contract? Which commodity classes are
to be chosen for different options styles:
European, American, and Bermudan?
It is interesting to note that CDAC in
June 2016 expressed that the European
style would be approved for options
contract culminating in physical delivery.
The former style options can be exercised
upon the maturity or settled in cash at
the time of expiry that is followed in the
index-stock options traded in India, for
example, in National Stock Exchange of
India (NSE). American-style options can
be exercised on or before the maturity
that is followed in the single-stock
options. These are in vogue in developed
markets, for example, in Chicago Mer-
cantile Exchange, US.
Bermudan options, a synthetic option
having the characteristics of American
and European, can be exercised on or
before the expiry. CDAC has opined that
commodity options will be based on
futures contract as unlike in the equity
market that lacks a cash segment
(Sahgal 2016). There is a high possibility
that the final settlement of options con-
tract would follow the final settlement
price of the futures contract that is mostly
based on either the simple average of
pooled spot price at the delivery centre
called due date rate. In the case of daily
settlement, weighted average futures
price is taken as closing futures price.
The regulator has resolved the issues of
settlement through amendments to the
Securities Contracts (Regulation) (Stock
Exchanges and Clearing Corporations)
Regulations, 2012 and Securities Con-
tracts (Regulation) Act, 1956.
CDAC and market experts are in favour
of the pilot-like launch of options
permitting in one or two each in the ag-
ricultural (for example, mustard seed,
refined soy oil, guar) and the non-agri-
cultural (for example, gold, silver, zinc,
copper, and crude oil) segment. For the
non-farm segment, the average daily
turnover should be around `1,000 crore
whereas in farm segment, the turnover
is to be pegged at `200 crore (Sahgal
2016). Top five commodities in daily
turnover in the concerned exchange are
subject to the inclusion for options
trading. It is understood that all the
commodities suggested meet the criteria
OCTOBER 14, 2017
for inclusion in options trading. Multi
Commodity Exchange of India (MCX) and
National Commodity and Derivatives
Exchange (NCDEX) would facilitate options
trading in non-farm and farm segments,
respectively.
We need to bear in mind that com-
modity exchanges are yet to experience
a liquid- and broad-based futures market,
while stock exchanges have illustrious
capacity and acquired expertise in the
new product development. A critical
view is important while suggesting the
eligibility criteria (product and partici-
pants) for introducing options in com-
modities. For instance, India has no
crude oil spot market, and often, crude
contracts are cash-settled that vitiates
the mechanism for efficient spot and
futures price discovery and adequate
risk management. Similarly, a handful
of commodities are actively traded on the
national commodity exchanges, especially
in the farm segment, and speculators
appear to have played “spoilsport” in the
agricultural futures market (Sahadevan
2014). Further, commercial users/pro-
ducer groups who might prefer to devise
a protective strategy to ward off their
anticipated price risks should be cautious
before they make a sizeable position
(call/put) in option trade.
The estimation of sensitivity of options
price to the spot price, storage costs, in-
terest rates (lending and borrowing),
and spot price movement, among others,
entails an underlying robust option mar-
ket microstructure. Unlike stocks, com-
modities, especially, agricultural are not
available in “paper” form. These are not
standardised and their spot markets are
yet to be organised and efficient in price
discovery. Furthermore, storage costs
are variable, subject to agents’ incentive
to holding the commodities in a period
of scarcity; charges are not uniform, and
service providers or assayers are diverse
in character and service profile.
Executing Options Trade
Many interactive sessions need to be
conducted with the market participants
to get a comprehensive view of commo-
dity derivative markets. These would
include trading volume, liquidity, share
of different class of commodities in
vol lIi no 41 EPW Economic & Political Weekly

the trade, the magnitude of partici-
pation in futures contracts and feasibi-
lity of the new product launch or possi-
bility of coexistence of the new and
existing product.
As the stock market is not akin to
commodity market, one need not be
biased when designing options contract
specifications and surveillance measures.
Nonetheless, illustrations on this can
be extracted from the national stock
exchanges that have experienced the
promise and pitfalls of options trading
on the bourses.
Participants, including commercial users
(processors, exporters, importers, grow-
ers), can be empowered to share their
views on the feasibility of options in
commodities. Users or farmer organisa-
tions hold that cooperative and farmer
companies’ participation can make the
options trading more nuanced and en-
hance the scope for options on futures
with multiple delivery grades (Lien and
Wong 2002). However, as farmer partici-
pation in futures remains a utopian
proposition so far, without adequate in-
stitutional support, their participation
even in options would remain infeasible.
In other words, whether options in farm
segment would be a “game changer” for
farmers remains a questionable claim.
In contrast, options can benefit small
and medium enterprises, and the national
government. For example, Malawi gov-
ernment utilised options contract for
mitigating the country’s food crisis. The
government, in 2005, entered a contract
with the Standard Bank of South Africa
through erstwhile South African Futures
Exchange to procure about 60,000
tonnes of white maize at a cost of around
$18 million (UNCTAD 2009). Similarly, the
coffee cooperative, FEDECOOP in Costa
Rica, helped plantation growers hedge
their risks through millers by entering
put options to manage producers’ down-
side risks (Varangis et al 2002). Many oil
exporting countries such as Mexico,
Angola, Oman, and Nigeria use options
to mitigate the skewed price movement
in international oil markets (for details,
see MCX 2014).
Food Corporation of India (FCI) and
state procurement agencies can use call
options to hedge their risks against price
Economic & Political Weekly EPW OCTOBER 14, 2017
uncertainty of procured stocks from
farmers under the price support scheme.
FCI can also utilise call options to guard
against price fluctuations of agro-com-
modities such as wheat and maize.
Farmer organisations can use put options
in delimiting their potential loss by
paying options premium. If the market
price goes below the minimum support
price (MSP), they can sell their commodi-
ties to public procurement agencies at
the MSP. In that case, loss from options
trading will be equivalent to the option
premium paid alone.
Trading firms are actively engaged in
commodity buying and selling. In this
activity, they take a stock of their expo-
sure or aim to mitigate downside risks.
Options contract can thus appeal to
them as there is flexibility embedded in
exercising options and insurance against
abnormal losses. However, they should
not corner off the market to meet up
their risk appetite. Similarly, domestic
institutions like mutual funds participa-
tion in options may be allowed in the
non-farm segment.
Exchange views can be put on priority
as they facilitate trading in association
with associated market infrastructure
institutions engaged in settlement and
delivery. The regulator can draw some
operational guidelines and adopt best
practices from transnational exchanges
that are successfully running the ex-
change operation in options segment,
and have demonstrated the potential
benefit of options in price risk manage-
ment (Dana et al 2006). Some of them
include the Chicago Mercantile Exchange
Group in the US (energy and agricul-
ture), London Metal Exchange in United
Kingdom (metals), Chicago Board of Trade
in the US (agriculture), South African
Futures Exchange in South Africa (agri-
culture), Taiwan Futures Exchange in
Taiwan, and Tokyo Commodity Exchange
in Japan (metals), among others.
Optimism with Caution
In 2011–12, commodity exchanges wit-
nessed a boom, trading volume reached
about `181 lakh crore with an annualised
growth rate of 54%. However, following
this splendid performance in the trade,
the trading volume has decreased sharply
vol lIi no 41
COMMENTARY
and exchange-traded derivative market
might have lost its sheen. The reasons
for this can be many, but the imposition
of CTT in non-agricultural segment, spot
exchange crisis, and management issues
of the national-level exchange are seen
to have downgraded the market senti-
ment in general (Lingareddy 2015).
In 2014–15, the traded volume of futures
contracts further declined to `61.7 lakh
crore and in 2015–16, this improved
marginally and stood at `67 lakh crore.
Agricultural commodity product-wise
share has also declined significantly, for
example, castor seed and chana futures
have been suspended over the past year
“due to rampant speculation and corner-
ing of stocks by speculators to boost
prices artificially” (Iyengar 2016). The
aggregate turnover of agricultural com-
modities across the three exchanges—
National Multi Commodity Exchange,
NCDEX and MCX—stood at `77,696 crore
while that of non-agricultural commodi-
ties was `5.73 lakh crore as reported in
June 2016 (Laskar 2016).
It is interesting to note that options
trade accounts for 75% of NSE’s total
derivative turnover of `404 lakh crore in
2016–17. Average daily turnover of equity
derivatives on the NSE has been `3.31
lakh crore against just `25,000 crore–
`30,000 crore for the three national ex-
changes in commodities considered.
While institutional investors have been
allowed in the financial derivative mar-
ket, commodity derivative market has
not witnessed that sort of participation
so far. SEBI may allow domestic institu-
tions like mutual funds in commodity
options to push up the market liquidity
(Sahgal 2016). Thus, the scope of institu-
tional participation may remain limited
to the non-agricultural segment. In other
words, options in the selected agricul-
tural commodities need to attract agro-
based firms and farmer companies if the
market turns out to be liquid.
Futures traded volume on the com-
modity exchanges indicates that the
non-farm segment outperforms the farm
segment in terms of lot or contract size
that results in enhanced liquidity in the
former segment (SEBI 2016). The provi-
sion of cash settlement and more diverse
nature of participation in non-agricultural
31
COMMENTARY
segment have led to the volume unlike
that of in the agricultural segment
(Lingareddy 2015). Therefore, options
in non-agro products may be attractive
to the financial investor, while agro
products may not generate that much of
interest to either the exchange member
or client.
So, is this an opportune time to launch
options in both non-agro and agro com-
modities? Are market participants, espe-
cially members and investors, ready to
support this move? Have the regulator,
demutualised exchanges, and clearing
houses enough bandwidth, knowledge,
and capacity to oversee this new prod-
uct development? If not, mature stock
exchanges may facilitate options trading
in selective commodities. They have
been illustrious in facilitating the trade
as evident from the above discussion.
However, any wrong move or counter-
productive decision on the type of product
and options style being permitted can
have serious repercussions on the com-
modity market in general: if actual users
Module on Health Statistics
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32
are sidelined or not encouraged to hedge
their risks, options market may be left to
the whims and fancies of speculators who,
through sophisticated trading modali-
ties, could make the market more vola-
tile and less useful to the ones who need
it. The regulator’s purpose may not be
achieved then. Whether options in com-
modities would make the market more
nuanced needs a clinical diagnosis of the
commodity market rather than a popu-
list move to bring about any reform in
the commodity market.
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Features
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annual data from
1980 onwards.
Structured in six
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• Demography
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• Infrastructure
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vol lIi no 41 EPW Economic & Political Weekly