NISM Series XVI – Commodity Derivatives: Chapter 3 – Commodity Options Explained (Short Notes)
This is Part 3 of 7 in our complete NISM Series XVI Commodity Derivatives short notes series. In this chapter, we cover commodity options in detail — types of options, key terminologies, option pricing models, option greeks, payoff profiles, options on commodity futures, options on goods, and key trading strategies. Everything is written in simple, exam-ready language.
Start from the beginning? Read Part 1: Introduction to Commodity Markets or Part 2: Commodity Futures.
1. What Is an Options Contract?
An options contract gives the buyer the right — but not the obligation — to buy or sell a specified quantity of a commodity at a predetermined price (strike price), on or before a specified future date.
This "right without obligation" is what distinguishes options from futures, where both parties have obligations.
Two Types of Options:
| Option Type | Right Given to Buyer | Obligation of Seller |
|---|---|---|
| Call Option | Right to buy a specified quantity at the strike price on/before expiry | Obligation to sell to the buyer if the buyer exercises the option |
| Put Option | Right to sell a specified quantity at the strike price on/before expiry | Obligation to buy from the buyer if the buyer exercises the option |
Options contracts can be exchange-traded (standardized) or OTC (customized).
2. Key Positions in an Options Contract
| Party | Position | Right / Obligation |
|---|---|---|
| Call Buyer (Long Call) | Long | Right to buy |
| Call Seller (Short Call) | Short | Obligation to sell to call buyer |
| Put Buyer (Long Put) | Long | Right to sell |
| Put Seller (Short Put) | Short | Obligation to buy from put buyer |
3. Important Option Terminologies
- Option Premium: The price paid by the option buyer to the option seller for the right granted by the option.
- Writer of an Option: The option seller who receives the premium and assumes the obligation to perform if the buyer exercises the option.
- American Option: Can be exercised at any time on or before the expiry date.
- European Option: Can only be exercised on the expiry date. Important: As per current SEBI regulations, only European-style commodity options are available on Indian derivatives exchanges.
- Lot Size: The number of units of the underlying asset in a single options contract.
- Expiration Day: The last trading day of the options contract — the day on which the contract ceases to exist.
- Spot Price: The current price of the underlying commodity in the spot market.
- Strike Price (Exercise Price): The price at which the option holder can buy (call) or sell (put) the underlying commodity by exercising the option.
- Open Interest: The total number of outstanding (open) options contracts for a particular underlying asset at any given time.
4. Moneyness of an Option
Moneyness indicates whether an option would generate a profit if exercised immediately.
| Status | Call Option | Put Option |
|---|---|---|
| In-the-Money (ITM) | Market price > Strike price | Market price < Strike price |
| At-the-Money (ATM) | Market price = Strike price | Market price = Strike price |
| Out-of-the-Money (OTM) | Market price < Strike price | Market price > Strike price |
| Close-to-the-Money (CTM) | ATM option plus a few nearby ITM and OTM options that are close to ATM (used in SEBI circulars for exercise mechanism) | |
5. Intrinsic Value and Time Value of an Option
Option Premium = Intrinsic Value + Time Value
- Intrinsic Value: The amount by which an option is in-the-money (ITM). It is the profit an option buyer would realize if they exercised the option immediately, without adjusting for the premium paid.
- For a Call option: Intrinsic Value = Spot Price – Strike Price (if positive; otherwise zero)
- For a Put option: Intrinsic Value = Strike Price – Spot Price (if positive; otherwise zero)
- ATM and OTM options have zero intrinsic value.
- Time Value: The additional premium above intrinsic value that reflects the possibility the option may become more profitable before expiry. As long as the option has not expired, there will always be some time value. ATM and OTM options have only time value.
6. Risk-Reward Profile of Options
| Position | Maximum Risk | Maximum Reward |
|---|---|---|
| Long Call (Buy Call) | Limited to premium paid | Unlimited (as commodity price can rise indefinitely) |
| Short Call (Sell Call) | Unlimited | Limited to premium received |
| Long Put (Buy Put) | Limited to premium paid | Strike price minus premium paid (commodity price can fall to zero) |
| Short Put (Sell Put) | Strike price minus premium received | Limited to premium received |
7. Determinants of Option Premium
Five key factors determine the premium (price) of an option:
- Price of the Underlying Asset: When the underlying commodity price rises, call option value increases and put option value decreases. When price falls, the opposite occurs.
- Strike Price: A higher strike price reduces the call option's intrinsic value (lower premium) but increases the put option's intrinsic value (higher premium).
- Volatility: Higher volatility increases the premium of both call and put options equally, as there is a greater chance the option will move in-the-money during its life.
- Time to Expiration: More time remaining means more uncertainty, and therefore higher premiums for both calls and puts. As expiry approaches, time value decays (known as time decay or theta).
- Interest Rates: Higher interest rates increase the value of call options and decrease the value of put options.
8. Option Pricing Models A. The Binomial Pricing Model
- Developed by William Sharpe in 1978.
- Considered the most flexible, intuitive, and widely used model for option pricing.
- Represents price evolution of the underlying as a binomial tree — at each time step, the price can either move up or down by fixed rates with given probabilities.
- Works by iterating through all possible price paths from today to expiry.
B. The Black-Scholes Model
- Published in 1973 by Fisher Black and Myron Scholes.
- One of the most popular, relatively simple, and fast models for calculating option prices.
- Does not rely on iterative calculation (unlike the binomial model).
- Uses five key inputs: underlying price, strike price, volatility, time to expiration, and risk-free interest rate.
- A variant called the Black-76 model is specifically used for pricing options contracts where the underlying is a futures contract (common in commodity markets).
9. Option Greeks
Option Greeks measure how sensitive an option's price is to various risk factors:
| Greek | Symbol | What It Measures |
|---|---|---|
| Delta | δ or Δ | Sensitivity of option price to a small change in the underlying asset's price |
| Gamma | γ | Rate of change of Delta with respect to a change in the underlying asset's price (second-order sensitivity) |
| Theta | θ | Sensitivity of option price to the passage of time (time decay) — generally negative for option buyers |
| Vega | ν | Sensitivity of option price to changes in market volatility of the underlying |
| Rho | ρ | Change in option price for a given percentage change in the risk-free interest rate |
10. Put-Call Parity Theorem
The Put-Call Parity theorem defines the relationship between call premium, put premium, spot price, and strike price for European options. If this relationship does not hold, arbitrage opportunities arise.
Formula:
C – P = S – K / (1 + r × t)
Where:
C = Call Premium
P = Put Premium
S = Spot Price (Current Underlying Price)
K = Strike Price
r = Risk-free interest rate
t = Time to expiry
11. Options on Commodity Futures (India-Specific)
In India, commodity options devolve into commodity futures contracts — not into direct ownership of the commodity. This means:
- The underlying of a commodity options contract is a commodity futures contract of a specified month.
- On exercise, the option position converts into a futures position.
Settlement Method on Exercise:
| Option Position | Converts To |
|---|---|
| Long Call | Long position in the underlying futures contract |
| Long Put | Short position in the underlying futures contract |
| Short Call | Short position in the underlying futures contract |
| Short Put | Long position in the underlying futures contract |
Exercise Mechanism:
- All ITM options (except those belonging to the CTM series) are exercised automatically at expiry, unless the long position holder gives a contrary instruction.
- All OTM options (except CTM series) expire worthless.
- CTM (Close-to-the-Money) options have a special exercise process as per SEBI circulars.
12. Options on Goods
Options on Goods differ from Options on Futures — they devolve directly into physical delivery of the commodity rather than into a futures contract.
- A Call Option on Goods buyer, on exercise, receives direct delivery of the commodity.
- A Put Option on Goods buyer, on exercise, must make direct delivery of the commodity.
Advantage of Options on Goods:
Since the underlying is the actual commodity and not a futures contract (which can be subject to speculative price distortions), Options on Goods may better reflect true physical market prices.
Ways to Close an Options Position:
- Offset: Taking an opposite position in the same contract (most common method)
- Exercise: Exercising the option to take or give delivery
- Expiration: Allowing the option to expire (for OTM options)
13. Key Option Trading Strategies A. Covered Short Call
A position created by combining a long position in the underlying commodity with a short call option. This strategy attempts to enhance returns in a stagnant or mildly bullish market while partially hedging the long position. Different from a naked short call, where the investor does not own the commodity.
B. Covered Short Put
Created by selling a put option while holding sufficient funds to buy the commodity if required. Enhances returns on idle funds while partially hedging a short underlying position. Different from a naked short put.
C. Spread Trading with Options
| Spread Type | Strategy | Objective |
|---|---|---|
| Vertical Spread | Buy and sell options with the same expiry but different strike prices | Profit from directional price movement in the underlying commodity |
| Horizontal Spread (Calendar Spread) | Buy and sell options with the same strike price but different expiry months | Profit from expected changes in volatility |
| Diagonal Spread | Buy and sell options with different strike prices AND different expiry months | Profit from both market direction and volatility changes |
D. Straddle and Strangle
These strategies involve simultaneously buying calls and puts to profit from volatility changes regardless of price direction.
- Long Straddle: Buy a call and a put with the same strike price and same expiry date. Profitable when large price moves occur (either direction), regardless of direction.
- Long Strangle: Buy a call and a put with the same expiry date but different strike prices (OTM call and OTM put). Lower cost than a straddle; requires a larger price move to be profitable.
Quick Revision – Key Exam Points
- In India, only European-style commodity options are available on exchanges (exercisable only at expiry).
- Commodity options in India devolve into commodity futures, not direct commodity ownership.
- The Black-76 model (a variant of Black-Scholes) is used for pricing options on futures contracts.
- Binomial model was developed by William Sharpe (1978); Black-Scholes was published by Fisher Black and Myron Scholes (1973).
- ATM and OTM options have zero intrinsic value — only time value.
- The writer (seller) of an option receives the premium and bears the obligation; the buyer pays the premium and holds the right.
Practice Questions (NISM XVI Pattern)
- What type of options are currently available on Indian commodity derivatives exchanges?
Answer: European-style commodity options only - A long call option has a strike price of ₹4,800. The current spot price is ₹5,100. Is this option ITM or OTM?
Answer: In-the-Money (ITM) — spot price > strike price for a call - Which option pricing model uses a binomial tree to represent price evolution?
Answer: The Binomial Pricing Model (developed by William Sharpe, 1978) - What variant of Black-Scholes is used for pricing commodity options in India?
Answer: The Black-76 model - What does "theta" measure in options pricing?
Answer: The sensitivity of the option price to the passage of time (time decay) - If a long call position on a commodity option is exercised in India, what position does the holder receive?
Answer: A long position in the underlying commodity futures contract - What is the difference between a long straddle and a long strangle?
Answer: In a straddle, both call and put have the same strike price. In a strangle, they have different strike prices (typically OTM for both).
Continue Your NISM Series XVI Preparation
- ⬅️ Part 2: Commodity Futures – Cost of Carry, Convergence, Basis
- ➡️ Part 4: Commodity Indices – AGRIDEX, iCOMDEX, Index Futures
- ➡️ Part 5: Hedging, Speculation, Arbitrage & Spread Trading
- ➡️ Part 6: Trading Mechanisms
- ➡️ Part 7: Clearing, Settlement, Accounting & Regulation
🎯 Test your options knowledge now! Take a free NISM Series XVI Mock Test on PassNISM to check your readiness.