Foundation — Rights, obligations and the shape of an option pay-off

Commodity options — the foundation

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1. The one idea everything else follows from

"Options contracts can be either STANDARDIZED (EXCHANGE-TRADED OPTIONS) or CUSTOMIZED (OTC OPTIONS). There are TWO TYPES: CALL OPTIONS AND PUT OPTIONS."

1.1 The premium

⚠️ "In an options transaction, THE PURCHASER PAYS THE SELLER (THE WRITER OF THE OPTION) AN AMOUNT FOR THE RIGHT TO BUY (in case of call options) OR FOR THE RIGHT TO SELL (in case of put options). This amount is known as the 'OPTION PREMIUM'."

1.2 The four positions

Read the seller's column carefully. A call seller must sell if exercised. A put seller must buy if exercised. The seller's action is always the mirror of the buyer's right.

1.3 The buyer's three choices

⚠️ "An option buyer has the following choices:"

1. ⚠️ "EXERCISE the option on the expiration date"
2. ⚠️ "SELL the option in the Exchange BEFORE the expiration date"
3. ⚠️ "LET THE OPTION EXPIRE without being exercised on the expiration date"

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2. The vocabulary

2.1 American versus European

⚠️ AMERICAN: "A style of settlement in which the options buyer HAS THE OPTION TO EXERCISE HIS RIGHT to call for delivery or take the delivery ON OR BEFORE THE EXPIRY of the options contract. The owner CAN EXERCISE HIS RIGHT AT ANY TIME ON OR BEFORE THE EXPIRY DATE."

⚠️ EUROPEAN: "The owner CAN EXERCISE HIS RIGHT ONLY ON THE EXPIRY DATE/DAY of the contract."

And what they turn into on exercise:

• ⚠️ "Within commodity 'options on futures', on exercise, a few commodity options DEVOLVE INTO THE UNDERLYING FUTURES CONTRACTS" — "all such devolved futures positions are considered to be devolved AT THE STRIKE PRICE OF EXERCISED OPTIONS, on the expiry date of options, during the END OF THE DAY PROCESSING"
• ⚠️ "In the case of 'OPTIONS ON GOODS', they result in DIRECT DELIVERY OF THE UNDERLYING COMMODITY ITSELF" — "the options devolve into DIRECT DELIVERY OBLIGATIONS where the delivery positions are created and considered to be DELIVERABLE AT THE STRIKE PRICE of exercised options on the expiry date"

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3. Moneyness

⚠️ ITM: "This option would give the holder A POSITIVE CASH FLOW IF IT WERE EXERCISED IMMEDIATELY."

⚠️ ATM: "Would lead to ZERO CASH FLOW if it were exercised immediately. Therefore, FOR BOTH CALL AND PUT ATM OPTIONS, STRIKE PRICE IS EQUAL TO SPOT PRICE."

⚠️ OTM: "One with STRIKE PRICE WORSE THAN THE SPOT PRICE for the holder. This option would give the holder A NEGATIVE CASH FLOW if it were exercised immediately."

3.1 Close to the money — a commodity-only concept

Hold on to that restriction — it is one of the most reliably examined distinctions in this chapter.

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4. Intrinsic value and time value

⚠️ "For an option, INTRINSIC VALUE refers to THE AMOUNT BY WHICH THE OPTION IS IN THE MONEY, i.e. the amount an option buyer will realize, BEFORE ADJUSTING FOR THE PREMIUM PAID, if he exercises the option instantly."

"With minimum value possible as zero BECAUSE NO ONE WOULD LIKE TO EXERCISE HIS RIGHT UNDER NO ADVANTAGE CONDITION."

⚠️ TIME VALUE: "It is the DIFFERENCE BETWEEN PREMIUM AND INTRINSIC VALUE, if any, of an option. ATM AND OTM OPTIONS WILL HAVE ONLY TIME VALUE because the intrinsic value of such options is zero."

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5. Long and short on options

⚠️ LONG: "Buyer of an option is said to be 'LONG ON OPTION'."

• ⚠️ "You have THE RIGHT TO EXERCISE that option"
• ⚠️ "Your POTENTIAL LOSS IS LIMITED TO THE PREMIUM AMOUNT you paid"
• ⚠️ "PROFIT WOULD DEPEND ON THE LEVEL OF UNDERLYING ASSET PRICE at the time of exercise/expiry"

⚠️ SHORT: "Seller or the writer of an option is said to be 'SHORT ON OPTION'."

• ⚠️ "You have AN OBLIGATION TO THE BUYER as you have received the option premium"
• ⚠️ "Your MAXIMUM PROFIT is THE PREMIUM RECEIVED"
• ⚠️ "YOUR POTENTIAL LOSS CAN BE VERY HIGH"

5.1 The risk and reward table

Note why the put rows are capped where the call rows are not: a price can rise without limit, but it cannot fall below zero. So a long put's best case is the strike falling to nothing — strike price less premium.

5.2 Why option pay-offs are non-linear

⚠️ "This is UNLIKE RETURNS FROM A FUTURES CONTRACT or returns from a position in the spot market, WHICH ARE LINEAR AND ARE THE SAME FOR BOTH BUYER AND SELLER."

The workbook spells out the contrast: in a futures contract, "the return would increase by say Rs 10 for every Rs 8 increase in spot price and would ALSO DECREASE BY Rs 10 for every Rs 8 decrease." But "in a long call option, the returns are NEGATIVE AND REMAIN CONSTANT irrespective of the amount of decrease in spot price, while returns KEEP INCREASING with increasing spot price."

⚠️ "Similarly, for a LONG PUT option, the returns are NEGATIVE AND REMAIN CONSTANT irrespective of the amount of INCREASE in spot price, while returns KEEP INCREASING WITH DECREASING SPOT PRICE."

⚠️ The break-even for a long call: "STRIKE PRICE + PREMIUM."

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6. The gold worked example

"Style: EUROPEAN · Contract: GOLD · Strike price: Rs 48,000 per 10 grams · Premium paid: Rs 500 per 10 grams · Expiry: 5th October · Settlement price on expiry: Rs 50,000 per 10 grams"

6.1 The zinc scenario tables

"Commodity: ZINC · Strike Price: Rs 180 · Call Premium: Rs 10 · Put Premium: Rs 8 · Expiry: One month"

CALLS — "on expiration, if the market price is HIGHER than the strike price, the call option WILL be exercised":

Look at the last two rows. Whether the price falls to 160 or to 140, the call buyer's loss stays at Rs 10 — the premium. That flat line is the whole value of buying an option rather than a future.

PUTS — "if the market price is LOWER than the strike price, the put option WILL be exercised":

Check the arithmetic on the 160 row: 180 − 160 = 20 intrinsic, less Rs 8 premium = Rs 12 net. And at 140: 180 − 140 = 40, less 8 = Rs 32.

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7. The MSP as a put option

"Maize: Rs 1,850 per quintal (previous year it was Rs 1,760 per quintal). Wheat: Rs 1,925 per quintal. These are the GUARANTEED PROCUREMENT PRICES by the Government."

The maize illustration: ⚠️ "If MSP = Rs 1,850 per quintal and market price = Rs 1,350 per quintal, farmers get price protection (PUT OPTION BUY POSITION) at Rs 1,850. Farmers will SELL TO GOVERNMENT AT Rs 1,850 INSTEAD OF SELLING IN THE MARKET AT Rs 1,350. The government, LIKE A PUT OPTION SELLER, HAS TO TAKE DELIVERY at Rs 1,850. BY CHANCE, IF ACTUAL MARKET PRICE GOES ABOVE MSP (say Rs 2,000), THEN THE FARMER MAY NOT EXERCISE this option but MAY SELL IN THE MARKET DIRECTLY."

The wheat illustration: ⚠️ "If MSP = Rs 1,925 and market price = Rs 1,825, this gives a benefit to farmers to sell to the government SO LONG AS THE MARKET PRICE REMAINS BELOW MSP. GOVERNMENT IS OBLIGED TO PURCHASE AT Rs 1,925 SO LONG AS THE FARMERS KEEP SELLING TO IT."

This is the clearest illustration in the whole workbook of what "right without obligation" means in ordinary Indian life. The farmer keeps the upside — sells at Rs 2,000 in the market if prices rise — while being protected at Rs 1,850 if they fall. And the Government carries the obligation without collecting a premium for it, which is precisely why MSP costs the exchequer money.