With the Union Cabinet clearing a Bill to amend the Forward Contracts (Regulation) Act, introduction of options and index futures could be a reality. This will, however, take some time as after parliamentary passage, the regulator will have to prepare the rules and regulations.
Options will help farmers hedge. They will also help the corporate and agri commodities segment grow. The derivatives market reduces the risk involved.
At present, only futures trading has been allowed. But hedging there is costlier and involves paying a daily mark to market (revaluing assets at market prices) margin. Options can make hedging cheaper, as the risk here is confined to the premium paid for buying the option. It also helps reduce risk and cost by deploying several strategies.
“An options facility is useful, as apart from reducing the cost of hedging, it reduces the risk. Several companies are waiting for these instruments to hedge their risks in commodities,” said Gnanasekar Thiagarajan, director at Commtrendz Research, which advises several companies. An exchange official explained on condition of anonymity that, “We have already started working on how options will work and are studying what are the global practices and will soon start taking market feedback to find out the suitability of these products for India.”
How it works
There are two options: A call option (you buy this if you are bullish or see prices moving up) and a put option (if you expect prices to come down or are bearish). The buyer of the option has the right to exercise it. His risk is confined to the premium paid. The seller of the options has to bear all the risk and is known as the option writer. His risk is not limited but he gets a premium when he sells the option. At the settlement time, he has to pay a premium, even if it is higher. Banks, brokers and physical market traders who have the capacity to give or take deliveries can become option writers.
For example, if a farmer wants to hedge today, he will have to pay daily mark to market margins, which he will not be comfortable with. A cotton farmer may fear that prices will fall when the crop comes to the market and hence sell cotton in the futures market today, the contract maturing when he expects the crop. However, when options are allowed, he can simple buy a put option maturing in the month when he expects the crop to be harvested.
So, if prices are higher when the crop comes, he can let the put option expire and forget the premium he has paid. If prices are low when he harvests, the premium on his put option would have increased. This means he will get a lower price for his produce but increased premium on the put option.
Similarly, a textile mill would like to buy cotton cheaper and hence would buy a call option. So, if prices fall when the crop comes, it will buy at a cheaper rate from the market and forget the premium paid; if prices are high, it will pay a higher price for cotton but will get a higher premium, as the call premium goes up when prices rise. Who will sell or write options? There will be market makers, investment bankers who will write options. Generally, traders or market makers sell or write options, as these are for hedging and generally squared off.
Globally, the settlement date for options in commodities is a few days before the futures settlement. Before the settlement date, one has to square off the position or it is transferred to a futures and option holder.
The regulator is working on how options will be introduced. Says Forward Markets Commission Chairman B C Khatua: “It is expected that introduction of options will facilitate participation of farmers on the futures platform, which has been the endeavour of FMC and the government all these years. It would enable the market to reach a higher level of sophistication and impart greater efficiency in both price discovery and risk management processes.”
