Get Ready for Commodity Options!

Asad Dossani

At long last, SEBI has issued regulatory guidelines for commodity options trading. Initially, each exchange is allowed to launch contracts on one underlying asset. This is fantastic news for everyone involved - from the producers looking to hedge to the traders looking to profit. It represents the maturing of the Indian financial markets. In the weeks ahead, we'll learn more about the available contracts. And how you can start trading them.

Why trade options?

Two reasons: limited risk and potentially unlimited profits. Suppose you buy an option. Your profit increases if the price moves in your favour. But your losses are limited to the premium you paid. If you expect prices to go up, you buy a call option. If you expect prices to do down, you buy a put option. For more advanced traders, option selling is a great way to profit from a quiet market.

Now, perhaps you've already traded stock options. That's great. But there is a big difference between commodity and stock options. With stock options, the underlying asset is the stock itself. Your profit or loss depends on where the stock price ends up. With commodity options, the underlying asset is a futures contract, not the commodity itself. These are sometimes called options on futures.

Why options on futures? For an option market to work properly, the underlying asset should be easy to trade. For example, it is easy for traders to buy or sell a stock. But it isn't possible for you or me to trade physical barrels of crude oil. Instead, we trade crude oil futures. And so, commodity options are options on futures.

The commodity option market will become huge. In the US, commodity options are very popular. India's market will follow that trend. But before you start trading, you need to be prepared. You need to know what you're doing before risking your hard-earned capital.

To that end, here's my newest initiative: an online learning course on derivatives trading! In this course, you'll learn the ins and outs of derivatives trading. Especially options trading. And once commodity options hit the market, you'll be ready to profit.

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Market Notes

Put-Call Ratio: A True Contrarian Indicator to Beat the Crowd

In an earlier market note, we showed how a breadth indicator called the advance-decline (AD) ratio helps quadruple returns by giving a simple signal. The AD ratio signal is just one of several market indicators that help us to sense the overall health of the market.

Today, we will show you another important indicator. This time it's a sentiment indicator - the put-call ratio (PCR).

PCR is widely used by derivatives analysts to gauge the overall sentiment or mood of the market. We calculate PCR by dividing the open interest of put options by the open interest of call options.

Put options are used to bet on decline. Call options are used to bet on advance. An increase in traded put options - that is, a higher PCR - signals the majority of the traders are speculating the market will go down.

So a higher PCR means that the majority of the market participants are bearish or expect a sell-off.

Now there are two types of market participants in any market: the crowd and contrarians.

Those in the crowd tend to be ruled by their emotions and biases and therefore act irrationally. The crowd tends to read the market incorrectly, especially during market extremes. They tend to be optimistic during market tops and pessimistic during market bottoms.

The crowd makes up the majority of market participants.

On the other hand, contrarians tend to act in a way that is, you guessed it, contrary to the crowd. That is, they tend to be optimistic during market bottoms and pessimistic during market tops.

It's important to remember most sentiment indicators track the crowd. And since they are usually wrong during market extremes, we who aim to be contrarian have a clue about what not to do.

So the PCR is a contrarian indicator. It signals bullishness when the crowd is bearish and vice-versa.

A high PCR tells us that the general public, the majority of the market, the crowd players are bearish. Because this ratio is a contrarian indicator, a high PCR is generally favourable for the markets. Similarly, a low PCR suggest that markets are unfavourable.

Let's have a look at how the PCR as a contrarian indicator has performed on the Nifty 50 Index in the recent past.

Nifty Index and Its PCR
Ashok Leyland Encounters Strong Resistance 

Note that the green horizontal line in the bottom panel of the chart is at a PCR of one.

The PCR trades between 0.85 and 1.15 most of the time. A reading above 1.10 and below 0.90 are the extremes and usually act as a contrarian indicator.

When the Nifty's PCR goes above 1.10, put trades are increasing and calls are declining. This indicates the crowd is bearish. But as a contrarian, this rising reading means the markets becoming more favourable.

After the index bottomed in December 2016, the PCR inched up to trade above 1.10 in January 2017. And since that bottom, the Nifty Index traded in a strong uptrend with its PCR trading at higher levels too, hardly going below one.

Currently, the Nifty's PCR is trading at 1.13. This means put open interest is higher than call open interest. And this is favourable for the markets.

But this is based on recent market data. How has the PCR as a contrarian indicator performed historically? We have done extensive analysis of market performance when PCR levels were high and when PCR levels were low.

More on this next time. Stay tuned...

From The Market Wizards...

"Remember, your goal is to trade well, not to trade often." - Alexander Elder

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1 Responses to "Get Ready for Commodity Options!"
RAJKUMAR S D
17 Jun, 2017
Sir, Excellent and effective writing in simple words. But please advise whether we have to trade like herd mentality or contrarian trader in present non stop bullish trend for nifty and bank nifty. Noises from all corners are coming that correction is due so it becomes difficult to trade as contrarian as per your article. Please suggest. RAJKUMAR S D 9323486534 Like 
We request your view! Post a comment on "Get Ready for Commodity Options!". Click here!