Informist, Tuesday, Sep 12, 2023
By Rajesh Gajra
MUMBAI – When the National Stock Exchange last week announced the launch of new crude oil and natural gas options contracts in October, it was seen as following the footsteps of its much larger rival in commodity derivatives, Multi Commodity Exchange of India. The move highlighted the growing importance of energy derivatives contracts for commodity exchanges in terms of volume generation, but it was more in keeping with the growing investor preference for options over futures.
The options contracts planned by NSE will have existing futures contracts on crude oil and natural gas as the underlying.
MCX launched crude oil futures options on its commodity derivatives platform in May 2018, and followed it up with the launch of natural gas options in January 2022. These two options contracts now attract much higher trading volume than the futures contracts on which they are based.
NSE's market share in commodity derivatives is less than 0.5%. MCX is the predominant player in this market with a share of around 96%, while National Commodity & Derivatives Exchange has a market share about 4%. According to MCX's investor presentation, the exchange had 96.3% market share in commodity futures in the June quarter. In comparison, NCDEX had a market share of 3.5% and NSE 0.2%.
Over the last three years, the share of derivatives turnover of crude oil and natural gas, also referred to as energy, in the total turnover of MCX has risen sharply. In Apr-Jun, 73.2% of the average daily turnover of MCX came from energy derivatives, sharply up from 22.7% for the whole of 2020-21 (Apr-Mar).
FUTURES TO OPTIONS
As seen in the equity market in the last couple of years, commodity investors, particularly traders that account bulk of the daily volume, have preferred trading in options over futures, particularly in the energy derivatives contracts.
This dramatic shift took place on MCX in 2021-22, when the average daily turnover in crude oil options, at 66.16 bln rupees, overtook the turnover of 44.81 bln rupees in crude oil futures. In 2022-23, the gap widened, with the former at 258.88 bln rupees and the latter at 35.45 bln rupees.
In the current financial year, the June quarter has seen average daily turnover in crude oil options rise sharply yet again to 475.18 bln rupees, while that in crude oil futures declined to 26.67 bln rupees.
When MCX launched options contract on natural gas futures in January 2022, the same trend was observed. In 2022-23, the options average daily turnover was 59.86 bln rupees, higher than 51.3 bln rupees in futures. In the June quarter of the current financial year, the gap has increased. Average daily turnover in natural gas options was 73.05 bln rupees in Apr-Jun compared to 35.22 bln rupees in natural gas futures.
Addressing an analyst's concern on cannibalisation of futures turnover by options during a post-earnings investor call in July, MCX's Managing Director and Chief Executive Officer P.S. Reddy disagreed and said that the trend was partly due to futures traders hedging their exposure through the options contracts.
Moreover, retail investors are interested in the options contracts due to lower margins, Reddy said. "In futures for example, crude oil futures, it (margins) will almost be 30-40%." Reddy also partly attributed the attraction for options trading to regulatory changes that led to peak margin regime around two years ago.
When undertaking bets on prices of crude oil, natural gas, and other commodities, traders have to put up less money if they buy or sell options as compared to buying or selling futures.
Abhilash Koikkara, head-forex and commodities, Nuvama Wealth, said a key reason driving traders' preferences in energy derivatives is the high initial margin requirement of around 40% in crude oil futures and around 23% in natural gas futures. "So, paying option premium is a cheaper option to trade and hedge," he said.
According to Ravindra Rao, vice president and head-commodity research, Kotak Securities, the transition from futures to options gained momentum when 100% margin requirement was imposed on MCX's crude oil contracts around 2020-21 "when the NYMEX counterpart went into negative territory."
"Futures typically involve leverage, where traders pay only a fraction of the contract's value as margin to initiate trades. However, the introduction of the 100% margin requirement negated this advantage," said Rao. Since option contracts were already available and traders only needed to pay the premium to participate, it strongly appealed to them, resulting in a significant shift in trading volume to options, Rao added.
The liquidity is strong in energy derivatives also due to the fact that crude oil and natural gas prices are internationally linked, according to Koikkara. High daily volatility in crude oil and natural gas prices also attracts intraday traders, making the contracts highly liquid, he said.
However, the commodity options contracts are unlike equity options. Their underlying is the futures contract, and not the commodity. This is in contrast to equity derivatives market where the stock options contract has shares as underlying, and not the corresponding stock futures contract.
According to Ashwin Ramani, derivatives analyst at SAMCO Securities, futures markets, typically commodity futures, have a larger number of participants compared to spot markets. "This increased participation leads to a broader range of opinions, information, and trading strategies, which contributes to a more robust and efficient price discovery process," said Ramani.
NSE launched futures trading in crude oil and natural gas very recently, in Feb-Mar. But the total turnover of commodity contracts itself is very low, with the average daily being just 654 mln rupees in the current financial year till Monday. The exchange is betting on crude oil and natural gas options contracts to boost the volume. End
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