Commodity derivative options to spur farmer participation

The Securities and Exchange Board of India’s (Sebi) decision to allow options trading in commodity derivatives comes as a shot in the arm for farmers, who can now look to a wider portfolio of derivatives to hedge risks in their produce better. Although detailed guidelines are yet to be out, market participants say even the cost of trading in commodity options (both farm and non-farm items) will likely be only a fraction of that for trading in futures.

This will potentially catapult the scale of farmers’ participation in the country’s commodity derivatives market like never before. Currently, NCDEX, the largest farm commodity exchange in the country, has around 1,63,000 farmers (who are members of various farmer producer organisations) registered for trading through brokerages. Of them, only 33,000 farmers have actually traded in various commodities. This dismal participation of farmers in India, where around half of the workforce is still in agriculture, has to change, and allowing more products, including options, could be a key driver of it, said the market participants.

Mrugank Paranjape, managing director and chief executive of MCX, told FE that options would also lead to overall enhancement of liquidity in the market, thus strengthening the price discovery process and reducing the trading costs. “Since options carry limited downside risk, it will be an excellent tool for SMEs and farmers to hedge their commodity price exposures. Farmers, especially, would reap the benefits of a price insurance by utilising options in case the price falls below their cost of production, thus enabling them to realise a valuable price for their produce,” he said.

Calling the Sebi decision a step in the right direction, Ashok Gulati, chair professor at ICRIER, said boosting the participation of farmers in the commodity derivatives market, however, is going to be a long haul, given the small-farmer economy that India is. Derivative products have to be designed suitably to cater for them and their awareness level has to be raised, among others. “The good thing is that a beginning has been made now,” he added.

Samir Shah, managing director and chief executive of NCDEX, said: “Options along with futures will play a very important role in the overall development of the commodity markets. The biggest beneficiary though will be the farmers, for whom options will be a game changer.” Shah said the Sebi move would help farmers sell their produce in the derivatives market and thereby get the benefit of price protection in case the price falls below their cost of production and also derive the benefit of any rise in the price.

However, for it to be a reality at the earliest, analysts call for incentivising farmers’ participation in a transparent and regulated market structure, relaxing entry barriers for them (in the form of membership criteria, stringent KYC norms, margin requirements), allowing maximum number of cash crops for trading and improving competitiveness of small and marginal farmers through aggregation. The mandatory net worth of Rs 50 lakh for a trading member (broker) is also a barrier to farmer producer organisations becoming trading members to help bring in more farmers, they said.

Options are of two kinds: Call or put. A call option gives the holder the right but not the obligation to purchase a futures contract at a specific price on or before a certain date. A put option gives the holder the right but not the obligation to sell the futures contract at a specific price on or before a certain date. While call options are commonly used to safeguard against rising prices, put options are usually exercised for protection falling prices.

For instance, a farmer who is growing maize can buy a put option to sell 10 tonnes of the commodity at, say, `1,500 per quintal five months from now. If the maize price goes down to `1,300 per quintal, he can exercise his option, making a profit of `200 per quintal. This will offset the notional loss he would incur if he sells the produce in the physical market. And if the price of maize goes up to `1,600, he may choose not to exercise his option. Options give the holder the right to buy or sell the underlying asset at expiration while a futures contract holder is obligated to buy or sell the underlying asset on a future date. The buyer of a commodity option pays a premium to the seller of the option for the right.