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Gold Options: Meeting a Critical Market Need

Mrugank Paranjape[1]

 

Almost about one and half decade after the inception of national-level online commodity futures trading in India, the much awaited commodity Options trading are finally set to enter the marketplace. SEBI, through its circular dated June 13, 2017, issued detailed guidelines for the launch of Options trading in commodities. The regulator has announced that on a pilot basis each exchange shall be allowed to launch Options on futures of only one commodity that meets certain prescribed criteria. MCX, the market leader in commodity futures tradingin India, has already begun mock trading in gold Options with gold (1 kg) futures contract as its underlying.

 

The use of commodity contracts with Option features is not a modern development. In ancient times, transactions contracts with embedded Option features were important to commerce with evidential references dating back to the Greek civilization. While present day Options trading in commodity futures contract started on gold futures and sugar futures on exchanges in U.S. in 1982; over the years, trading in commodity Options has spread both across sectors and geographies. Today, exchanges from developing nations of Africa and South America offer Options trading in commodities. Interestingly, in India, before the four-decade long hiatus on commodity derivatives market of 1960s to early-2000s, the use of Options on almost all commodity derivatives for different periods was widespread all over the country. In fact, Options on cotton futures in Mumbai (then Bombay) were traded unto even one year out.

 

Options to complement futures

 

For the past few years, gold prices have consistently displayed significant levels of volatility (see figure 1). In FY 2016-17, the annualized price volatility in gold was over 13 per cent. In other words, at the micro level, a firm in gold business with an annual turnover of Rs. 1,000 crores was exposed to a price risk of about Rs. 130 crores in 2016-17, significant enough to not only wipe out the entire margins but also as a source of huge risk to its very survival in an increasingly globalized and competitive business environment.Thus, the business risk arising from volatility in gold prices clearly necessitates risk management in this metal. Gold futures at MCX, being offered to market participants since November 2003, have been providing stakeholders a cost effective instrument for price risk management.  The success of the MCX gold futures contract can be gauged by the fact that today a very large number of transactions in gold jewellery and bars/coins in India are benchmarked to MCX gold futures prices, quoted as a premium/ discount to MCX gold prices. In other words, MCX gold futures prices have emerged as a strong reference for all stakeholders. 

 

Gold Options, if and when introduced, would complement existing gold futures contract in providing risk management solutions to several categories of stakeholders, especially those who are risk averse, who hitherto would abstain from using traditional derivative products. The structural design of Option contract are particularly suited to small stakeholders such as small jewelers and goldsmiths carrying gold price risks, who do not have the financial wherewithal to hedge using other derivatives. For instance, there are no margin calls for option purchasers. Instead the purchaser has to pay a one-time fee/premium upfront to the option seller also known as writer. Thus, the option purchasers know exactly how much they have to pay, making it easier for them to fund their payment in advance. This facility contrasts with other derivatives whose transactions involve margin calls where the amount to be paid is never fixed, as it varies according to movements in the market prices of the underlying. Another feature of Options, which make them attractive to hedgers, is its flexibility. While options enable the hedger to hedge against adverse price movement by locking in at a price, option also offer the flexibility to take advantage of any favourable price movement. The maximum loss for an option buyer is just the premium, which is well-known at the time of entering the contract.

 

Gold Options – An investment avenue

An account of flexibility and relatively low cost of participation, gold Options contract would make for an attractive investment avenue for all classes of investors. Currently, many investors are seeking diversification away from other segments of the securities market. By expanding into gold Options, these investors can not only gain access to an investment that is uncorrelated to other traditional asset classes such as equity and debt, but also cater to Indian’s penchant for investment in gold. Besides, it has been empirically proven that over a long period, the risk-weighted returns (RAR) from investment in the gold derivatives market are better than those in other comparable asset classes, which makes gold Options an investment option to all classes of investors. Sharpe ratio, which is often used to characterize how well the return of an asset compensates the investor for the risk taken, is higher in the portfolio with gold Options as against portfolio without the presence of gold.

 

Such an attraction of gold Options can surely help all classes of investors – retail or institutional - to engage in low-risk trades with Options. As a result, we may witness a lot more trading interest in the gold derivatives market, which can bring in high levels (and quality) of liquidity along with the associated benefits that come in from high liquidity. For instance, owing to the trading preferences of diverse participant groups, as well as smaller transaction costs, gold Options can assume a leading role for information transmission between derivatives’ and underlying markets, contributing to market efficiency. This is corroborated by a study by Chan and Lein (2002)[2]. The study says that while market maintains some distinct characteristics in the period after the launch of Options, a common theme was found after their introduction, namely, the instantaneous feedback between spot and futures markets improved drastically.

 

Besides, one can expect a host of other benefits, such as lowering of impact cost, improved market stability, lowering of volatility, reduction in risk of market cornering, improved price discovery etc. ushered upon market participants as and when Options on gold are introduced. It has been established by research studies that increases in market liquidity improve economic welfare as they reduce systemic risk. In addition, a highly liquid market promotes market transparency by obstructing market manipulation and engendering a greater degree of informational efficiency. By encouraging the build-up of liquidity, therefore, gold Options can contribute to efficiency in gold markets and make hedging further less costly. Notably, Camerer (1982)[3] inferred that an organized exchange traded commodity Options market could be expected to attract many more participants than private firm market.

 

Further like gold futures, investing in gold through gold Options would not need physical holding or idling of gold. In turn, it would not necessitate gold imports in the country and, therefore, would not have any adverse impact on India’s Current Account. On the contrary, since gold Options trading would not necessarily require physical holding of gold, it would actually contribute to dampening of gold imports by weaning away investment interest from physical to paper gold.

 

Multiple access to gold

Currently, MCX gold futures contract being a compulsory physical delivery contract,offers market participants cash-carry opportunities in addition to trading opportunities. The strength of physical delivery as a mode of settlement of the futures contract can be gauged by the fact that about 100 tonnes of gold have been delivered through MCX gold futures since its inception on MCX, thereby signifying its high level of acceptance among the physical market participants. Now, with a potential gold Options contract to devolve in underlying futures contract at expiry of the Options contract, as indicated by SEBI guidelines, participants can have an additional avenue to trade in gold physical markets through the Options contracts. In other words, market participants can have three legs of trading access to gold:futures, Options and physical gold.

 

Flexibility through gold Options

The introduction of Gold Options in addition to the already available and vibrant gold Futures contract could yield a high degree of flexibility and innovation in trading and hedging strategies. Apart from traditional Options strategies such as straddle, strangle, etc. which can be applied by market participants to attain the expected pay-offs, they can also combine futures and options to create new strategies suiting their requirement on account varying payoffs of futures and options.

 

Indeed, a combination of gold Futures and gold Options would offer gold stakeholders a wide variety of strategies from the perspective of both hedging as well as investment, thereby catering to the requirements of all classes of stakeholders – hedgers and investors alike –in a highly efficient manner.

 

Disclaimer: Views are personal and not the views of the publisher.