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Commodity Options

An options contract in which the underlying is the right to enter a commodity futures contract — a second-order derivative that a Category III AIF may trade up to 10% of its funds in one commodity.

In plain language

A Commodity Option does not give you the commodity itself, and it does not even give you a commodity futures contract outright. It gives you the right to enter one.

That makes it a second-order derivative: its underlying asset is a Commodity Futures contract, which is itself a derivative on the actual commodity. Like any option, the buyer has the right — but not the obligation — to exercise, while a Commodity Future obliges both sides to complete the trade.

A Category III AIF that expects commodity prices to move can use a Commodity Option to take that view with limited downside, since it can simply let the option lapse if the price does not move as expected.

How it works

Commodity Options trade on recognised stock exchanges, alongside Commodity Futures, in underlyings such as Precious Metals, Base Metals, Energy Products and Agricultural Products.

A Category III AIF can take a Long Position (expecting the price to rise) or a Short Position (expecting it to fall) through Commodity Options, the same as it can through Commodity Futures, Stock Futures, Stock Options and Index Options.

The concentration limit. A Category III AIF can trade Commodity Futures and Commodity Options up to a prescribed limit of 10% of its investable funds in one underlying commodity.

The leverage limit. Where derivative positions, including Commodity Options, add up to leverage, the fund's maximum leverage is capped at 2 times its NAV, computed as total exposure (long plus short positions, after permitted offsetting) divided by NAV. Prior investor consent is needed before the fund takes leverage, and disclosures must be made to investors and SEBI periodically.

A worked example

Kaveri Commodities Fund, a Category III AIF with Rs 150 crore of investable funds, expects gold prices to rise over the next quarter.

Rather than buying gold futures outright, it buys Commodity Options on gold futures, capping its maximum loss at the premium paid if gold prices fall instead.

Its total position in gold-linked Commodity Futures and Commodity Options is limited to:

10% x Rs 150 crore = Rs 15 crore

If the fund also holds crude oil positions, a separate 10% limit — another Rs 15 crore — applies to crude oil as a different underlying commodity. The two limits do not share a common pool.

Why NISM asks about it

Chapter 8, section 8.2.2 (Positions in Commodity Derivatives and Equity Derivatives Markets), defines Commodity Options as a second-order derivative on Commodity Futures and sets the 10% single-commodity limit and the 2-times-NAV leverage cap. One of the chapter's sample questions is a direct True/False on the 10% limit. Expect the second-order-derivative framing to be tested directly.

Common exam traps

  • Commodity Options are a derivative on Commodity Futures, not on the commodity itself — that is what makes them "second-order".
  • The 10% limit is per underlying commodity, not a single blanket limit across all commodities held by the fund.
  • The 2-times-NAV leverage cap applies across all derivative exposure, not to Commodity Options alone — Commodity Options are one contributor to that total.
  • Do not confuse a Commodity Option with an Index Option or Stock Option — all three exist side by side in the workbook's list, distinguished only by their underlying.

Check yourself

  1. 1.A Category III AIF is permitted to trade in commodity derivatives contracts up to what limit in one underlying commodity?

    1. a)5 per cent of its investable funds
    2. b)10 per cent of its investable funds
    3. c)20 per cent of its investable funds
    4. d)25 per cent of its investable funds
    Show the answer

    Answer: (b) 10 per cent of its investable funds

    This is the workbook's own sample question, stated as True. A Category III AIF is permitted to trade in Equity Derivatives contracts and Commodity Derivatives contracts, such as Commodity Futures and Commodity Options, up to a prescribed limit of 10 per cent of its investable funds in one underlying commodity. Option (c) is the Large Value Fund concentration limit for an investee company and option (d) the overseas investment cap — both real figures used as distractors.

  2. 2.A Category III AIF buys a commodity option on a recognised stock exchange. What is the underlying of this contract?

    1. a)The physical commodity, delivered to the fund on exercise
    2. b)A commodity price index published by the exchange
    3. c)The right to enter into a commodity futures contract with the same underlying commodity as the option
    4. d)The spot price of the commodity, settled in cash on the expiry day
    Show the answer

    Answer: (c) The right to enter into a commodity futures contract with the same underlying commodity as the option

    The workbook describes commodity options as ‘a second-order derivative contract with commodity futures as its underlying asset’, and lists ‘Commodity Options’, wherein the underlying is the right to enter into a Commodity Futures contract, having the same underlying commodity asset as the Option contract.

    • Physical delivery is associated with commodity futures, where the fund has ‘the obligation to buy or sell the contract, for final physical settlement’. An option gives a right, not an obligation.
    • An index is the underlying for index futures and options on equity indices.
    • Cash settlement on the spot price is not how the workbook describes commodity options.

    Note the related limit: a Category III AIF may trade commodity derivatives up to 10 percent of its investable funds in one underlying commodity.

Where this is taught

Free preparation for NISM Series XIX-B

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