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Tuesday, 31 January 2017

Commodity Options in Indian Market Scenario

Currently in Indian market, the futures trade has been functioning successfully for the last 14 years. It has been increasingly supported by the participation of traders and merchants and few of the large and medium farmers. Involvement of small and marginal farmers, who comprises of about 78 per cent of the farming community, is still not so acclimatized with the futures trading. Still a lot of effort is needed in this direction. With every passage of time the commodity futures trade have evolved with increased strength and transparency.
The introduction of commodity options trade as a new instrument is likely to enhance the participation base as it requires lesser exposure capital thereby reducing the enormity of loss. In simple terms, in a futures contract, both participants in the contract are obliged to buy (or sell) the underlying asset at the specified price on settlement day. As a result, both buyers and sellers of futures contracts face the same amount of risk. On the other hand, the option contract buyer has the right but not the obligation to buy (or sell) the underlying asset. Hence the term "option" and this option come at a price in the form of a premium (more specifically, the time value of the premium). With this "option", the option buyer's risk is limited to the premium paid but his potential profit is unlimited. Sellers of options take on an additional volatility risk in exchange for the premium. However, their potential profit is then capped while their potential losses have no limit. Hence, this premium can be high if the underlying asset is perceived to be very volatile. The other major difference is that Options can be exercised at any time before they expire while a futures contract only allows the trading of the underlying asset on the date specified in the contract. In futures, the performance of the contract is done only at the future specified date, but in the case of options, the performance of the contract can be done at any time before the expiry of the agreed date. Apart from the commission paid, futures do not require advance payment, but options require the payment of premium. In futures, a person can earn/incur an unlimited amount of profit or loss, whereas in options the profits are unlimited, but the losses are up to a certain level.
The very motive of starting the Commodity futures was to facilitate efficient price risk management and price discovery in a fair, transparent and orderly manner. The futures market was to help Indian farmers to hedge their produce against potential risks arising out of price movements in spot markets so that they can get guaranteed price for their produce in the future. But, in spite of 14 years of futures trading through Commodity Exchanges, majority of the farming community is till away from participating on the platform either due to lack of awareness or due to complexity of the trading process. Currently, the futures markets continue to be dominated by speculators and non-commercial players who frequently indulge in price rigging and other market abusive practices with impunity.
I feel that the desired penetration level has not been achieved owing to lack of liquidity and existence of fear factor in the minds of small and marginal farmers who are still depended on the whole sellers and local aggregators. According to market estimates, not even 2000 farmers in India are directly trading on commodity futures exchanges. Even the participation of farmers marketing cooperative bodies (such as NAFED, HAFED and Farmers Producers Group) is very limited due to lack of adequate knowledge of the functioning of futures market. Such bodies can act as aggregators and hedge positions in futures exchanges on the behalf of their farmers. Thus with such level of penetration in the market, we can apprehend that futures have failed to achieve their avowed objectives of price discovery and price risk management especially for small and marginal farmers (owning less than 2 hectares of land).     
In the Indian Scenario where an average Indian farmer lacks a basic understanding of what is involved in futures trading. The options trading are even more difficult to comprehend as it adds yet another layer of complexity on what is already a very complex trading instrument. In the same vein, small enterprises lack the resources and capacities to trade actively in derivatives contracts for hedging purposes. Even experienced traders struggle to understand the risks involved in trading both futures and options contracts. Moreover the bulk of trading in the Indian commodity futures market is carried out by speculators and non-commercial traders who attempt to profit from buying and selling futures contracts by anticipating future price movements but have no intention of actually owning the physical commodity, while the participation of hedgers is almost negligible. Time to time the commodity exchanges are conducting short duration training workshops for small stakeholders but such workshops are inadequate to impart information and insights on the complexities of derivatives trading.
Having said all about the complexity of the futures and options trade, the introduction of Option in the Commodities trade is still a very welcome step, but the quantum of challenges to implement it is enormous. The major challenges could be enlisted as:
·         Lack of awareness about the options
·         Majority of actual participants (Farmers, Producer’s Organization, Government entities & banks) are still not clear on the process of how it could be applied on the agricultural products.
·          Liquidity is still lacking in most of the agricultural products being traded on exchanges
·          Fragmented nature of spot market
·         Over-politicization of state agricultural produces marketing committees (APMCs) and state agricultural produces marketing boards (APMBs)
·         inadequate warehouses, storage and grading facilities
·         poor condition of roads and other infrastructure in the rural India
If these challenges are met, option trading in Commodity market for India is bound to make remarkable changes in the Indian Agriculture System. 

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