Navia’s Policy & Process on the MCX – Option settlement & Devolvement
MCX has introduced Gold Option contract from 17th October 2017 onwards, and 28th November 2017 was the first expiry of the Option Contract. This document illustrates the option settlement process on the expiry day and the required margins prior to the expiry of the contract, if the contracts are not closed by the client.
Commodity Options price are based on the price of Commodity Futures
An important aspect to note with commodity options is that these are options on Futures and not really the spot market. If you look at Nifty options, the underlying is the spot Nifty 50 index value. However, if you were to look at an option on Crude Oil, the underlying here is not the spot price of Crude Oil. This is quite intuitive as we do not have a spot market for Crude Oil or for that matter any commodities in India. However, we do have a vibrant futures market. Hence the commodity options are based on the commodity futures market.
If one were to talk about the crude oil options, then you need to remember the following –
- The underlying for Crude oil option is Crude oil Futures
- The underlying for crude oil futures is the price of Crude Oil on NYMEX
So in a sense, this can be considered a derivative on a derivative.
Option terminology that you need to understand
At the Money (ATM) Options = The strikes closest to the settlement price is considered ATM
Close to Money (CTM) = Two strikes above and two strikes below ATM are considered CTM
In the Money (ITM) = All call option strike below the ATM and all put option strikes above the ATM are considered ITM options
Out of the Money (OTM) = All call option strike above the ATM and all put option strikes below the ATM are considered Out of the Money (OTM) options
Devolvement into Futures contract
The term Devolvement means conversion of an ITM/CTM option contract to future contract. Assume you have an ITM (including CTM) option, and upon expiry the option will be converted (or devolved) into a Futures position. Now, we all know that a futures position requires margins to be parked with the broker. How do we account for this? I mean, when I go long on option, I just have to pay for the premium right? Naturally, at the time of buying the option, I would not park additional margin anticipating that the option ‘might’ get devolved into a futures position.
To circumvent this, the concept of ‘Devolvement Margin’ was introduced.
Commodity options will expire few days before the first tender date of the futures contract. This means, there will be few days gap between the expiry of the futures contract and the options contract
- Few days before the options can expire, exchanges will conduct a ‘What if scenario’ and generates a ‘Sensitivity Report’ to identify strikes which are likely to be ITM and CTM
- For all such ITM and CTM options, exchanges will start assigning ‘Devolvement Margin’, this means you will have to fund your account with enough margin money to carry forward the option position. 25% of underlying futures margin will be charged on the beginning of T-2 days and 50% of underlying futures margin will be charged at the beginning of T-1 day where ‘T’ refers to the expiry day of the Options contract. At the end of the T day (after expiry) – the options will get converted to futures contract (if not closed) and 100% of the futures margins would apply. For example, The Expiry of the Gold option contract is on 28 November 2017 and the futures contract expires on 5 December 2017. Half of the margin needs to be added to the account on 27 November and the remaining on 28 November 2017.
- If you holding a deep ITM option, then the profits arising out of this position will be considered to offset a portion of the margins required
- How much margin, expiry dates, tender date etc will vary based on the commodity
5.On expiry of options contract, the open position shall devolve into underlying futures position as follows:-
- Long call position shall devolve into long position in the underlying futures contract
- long put position shall devolve into short position in the underlying futures contract
- Short call position shall devolve into short position in the underlying futures contract
- Short put position shall devolve into long position in the underlying futures contract
6. All the OTM contracts will be closed automatically with zero price.
7. All options contract belonging to ‘CTM’ option series shall be devolved only on ‘explicit instruction’ for devolvement by the long position holders of such contracts failing which they will expire worthless.
8.All In the money (ITM) option contracts, except those belonging to ‘CTM’ option series, shall be devolved automatically, unless ‘contrary instruction’ has been given by long position holders of such contracts for not doing so.
9.CTT will be charged on the devolved contracts and the clients should have the sufficient margin on the next day to avoid exchange penalties.
10. Devolved contracts of the current month will be closed as per the future contract expiry.
11.There will not be any margin charged to the OTM contracts on the day prior to the expiry of the contracts on the expiry day.
Margin calculation with Premium
On the first day margin will get charged, based on the premium if the option contract is in profit, so in this case the margin requirements will be as follows,
- Option Contract profit- Premium - margin applicable on the 1st day,
- If the Option is loss , premium will not be considered and 25% of the margin is applicable on the 1st day,
What is the effect of the devolvement margin in the accounting process?
Presently this margin is not part of the span file and it is provided by the exchange at the end of the trading day. So the back office will debit this margin in the back end and this devolvement margin is not reflected in the trading system.
- Devolvement margin is not part of the span file
- Devolvement margin is not uploaded in the front end.
Navia’s risk management Policy on Devolvement.
Navia shall follow the following process and shall square off the entire ITM and CTM contracts before devolving to the future contract. The Process is given below.
- Sensitivity Report provided by exchange prior 4 days from the expiry day.
- Blocking the expiry option contract 2 working days prior from the expiry in NON-Square off Mode (Block fresh open position)
- Informing to the clients on best effort basis about the levy of devolvement margins and the shortfall in margins, if any after the levy.
- Square off the all ITM, CTM & ATM option open position after auto square off execution at the option expiry day.
- All the OTM contracts expire worthless and it will be zero.