SEBI (Securities and Exchange Board of India), distraught by a huge upsurge in equity derivatives volume, particularly in the index derivatives, has implemented certain measures to curb the level of activity.

Mandatory upfront collection of option premium from buyers, removal of calendar spread benefit on the expiry day, intraday monitoring of position limits, increase of contract value, restriction of weekly expiry to only one index per exchange and increase in margin requirement on expiry day are the steps implemented by the market regulator through a circular in October.

While these actions come into effect on various dates, by February, all of these will be in place. Arguably, this will create a tighter environment for participants to operate in the equity F&O (futures and options) segment.

To a certain degree, this could encourage traders to gravitate towards commodity F&O market. Those who consider making such a move to diversify their trading portfolio, should be aware of the differences between equity and commodity derivatives. Here we discuss the separating factors, products available and the rules of the game.

Fundamentally different

While there are certain things of common interest for equity and commodity investors, such as global economy, political conditions, business environment etc, both have certain unique aspects too.

Owning a stock means owning a fraction of a business. Stocks derive its value from how well the company performs. Outside of the broader economic conditions of the country in which the company operates profitability, balance sheet health, management quality etc. will carry a lot of weight during analysis.

Commodities, on the other hand, are physical goods where the supply-demand dynamics lie at the core. So, here, investors resort to more of a macro approach.

In general, commodities are more volatile, also making it riskier than stocks as they are subject to everchanging macroeconomic conditions and factors of production and consumption. To put things into perspective, the annualised volatility (based on daily returns over the past 10 years) of Nifty 500 index is 16 per cent, whereas for crude oil, it is 37 per cent. Gold, though, is relatively stable with 14 per cent volatility.

In effect, stocks and commodities, being different asset classes, have their own influencing factors.

Driving factors

Commodities can be broadly classified into four categories: Precious metals, base metals, energy and agricultural commodities. In this article, we will discuss the first three as the derivatives segment in agri commodities is not as active as the rest.

Precious metals: Production and consumption numbers are indeed important for precious metals such as gold and silver. But there are certain factors that tend to have a quicker, significant impact on its prices.

While the dollar movement can influence price of almost all commodities, it can be more pronounced for precious metals. The monetary policy actions by the US Federal Reserve and the geopolitical developments, too, play a crucial role. 

In recent years, the central bank’s accumulation of gold, the beginning of the rate cut cycle by the Fed and conflicts like the Russia-Ukraine war and Israel-Hamas war has been putting upward pressure on the prices.

The impact of the above factors is evident from how gold and silver have performed since October 2022. The absolute return of gold and silver between October 2022 and November 2024 is 62 per cent and 64 per cent, respectively, significantly outperforming other commodities and even equities. For instance, the performance of Nifty 50, S&P 500, aluminium and copper stood at 37 per cent, 57 per cent, 19 per cent and 23 per cent respectively.

Gold, in particular, is seen as a safe haven by investors and so, whenever there are concerns over global growth, geopolitical uncertainties etc, the demand for gold goes up.

To know about the developments in gold and silver, one can follow the World Gold Council and The Silver Institute respectively. These institutes put out several reports in various frequencies, including production and consumption data.

Base metals: Aluminium, copper, lead, nickel and zinc are the commonly traded ones. Also referred to as industrial metals, the fate of these commodities largely hinges on China, the largest consumer and producer of base metals with over 50 per cent market share in both production and consumption. Therefore, an expanding Chinese economy is positive for these metals and vice versa.

One should keep a watch on metal-specific developments too. For instance, in 2023, when most of the metals were reeling under pressure, copper outperformed the rest by returning a marginal gain of 2 per cent. The reason was a huge demand in China for applications in renewable energy (installation of 300 gigawatts – 60 per cent of the total global addition in that year – of green capacity took place that year) and EVs (electric vehicles), which use more copper than a normal vehicle. Copper plays a key role in green technologies due to its physical and chemical properties. Likewise, the auto sector is a major consumer of aluminium and so, broadly tracking this industry can help form a view on the metal.

There are other factors that can disrupt the supply-demand equation. Take, for instance, social unrest in the South American countries Peru and Chile, largest producers of copper and zinc with considerable mining capacity, towards 2022-end. Social issues lead to a supply-side strain, leading to a spike in price.

Authorities for base metals include International Aluminium Institute, International Copper Study Group, International Lead and Zinc Study Group. They publish data related to supply and demand, latest developments with respect to change in production/mining capacity etc.

Energy commodities: Because of its significance, crude oil and natural gas are often in the news, making them the most volatile among the lot. The annualised volatility of crude oil and natural gas is 37 per cent and 55 per cent, respectively.

Tracking inventory statistics, high frequency data, is imperative. If the stockpiles of crude oil and natural gas increase more than expected, it could mean lower demand, weighing on the prices and vice versa.

For natural gas, the use case in electric power generation for heating, especially from Europe in the winter, is a significant contributor to the demand. So, if the winter is colder than usual, the need for natural gas can go higher, an upward risk for price. Not to mention the impact of the Russia-Ukraine war. Following the Russian invasion in 2022, the price of natural gas surged as Russia is the second-largest producer and the biggest supplier of natural gas to the European countries. However, plagued by oversupply and warmer winters in Europe in recent years, the price started to collapse in the last quarter of calendar year 2022.

For crude oil, the Organization of Petroleum Exporting Countries Plus (OPEC+) production policy is crucial as this grouping produces about half of the global oil. When they announced a delay in reversal of production cuts in early 2024, the price rallied. However, as production has been outpacing demand, the crude oil price has been under pressure since April this year. Oversupply has kept the prices lower despite so many tensions in West Asia, a significant region when it comes to oil.

For any news and data related to energy commodities, the US Energy Information Administration’s Short Term Energy Outlook (STEO), released every month, is a solid source.

For commodity traders, keeping track of the developments, as mentioned above, aids in better decision-making. 

Equity Vs Commodity derivatives

Almost all brokerage houses that offer equity derivatives provide access to commodity derivatives. Both segments can be operated from the same trading account.

Commodity market runs longer (between 9 a.m. and 11:30/11:55 p.m.) when compared to the equity segment (between 9:15 a.m. and 3:30 p.m.). However, 223 stocks are available in F&O, whereas the list is much smaller in commodities. Below are other notable differences.

Spot market: As the name ‘derivatives’ suggests, these contracts derive its value from an asset which is called the underlying. For equity derivatives, equity indices or individual stocks can be the underlying. One stark difference between equity and commodity derivatives is, in India, the spot (cash) market for equities is vibrant, whereas the same for commodities is not active and traders cannot participate in it.

In fact, India is a price taker in commodities, another reason why tracking performance of commodities in the international market is critical. Therefore, the exchange rate of rupee against the dollar is a noteworthy factor while conducting forecasts.

For example, copper, in terms of dollars, has lost 7.5 per cent since September-end. Consequent to the rupee deprecation of about 2.2 per cent against the dollar in this period, in rupee terms, copper is down only 3.6 per cent.

Options: Another point of difference is something related to options. Unlike in equities, where the stock is the underlying, for commodity options it is the futures contract of that commodity. So, when stock options which are in-the-money (ITM) are exercised, you will have to either deliver or buy the underlying stock depending on whether you hold a long/short position on calls and puts. Whereas ITM commodity options devolve (convert) into future contracts.

When a long call (put) option expires ITM, it will devolve into futures long (short).

When a short call (put) option expires ITM, it will devolve into futures short (long).

Example: Suppose you are holding a gold 77,000-call option and the price of its underlying — gold future expires at ₹80,000. As the underlying price is greater than strike price of the call option, this is said to have expired ITM. This trade will be settled with a long position on gold futures, which will have a purchase price as ₹77,000 (strike price of the option). Once you have this position in your trading account, you can opt to exit or continue to hold based on your outlook.

Traders can avoid exercising options by giving a ‘contrary instruction’ before expiry, essentially denoting not to go ahead with exercising. On such events, the trades will be settled in cash.

With respect to futures, precious metals and base metals are compulsory delivery contracts, similar to equities. But energy commodities and commodity index derivatives are cash settled.

But note that the margin requirement will go up as we near the expiry date. For example, margin obligation for gold (aluminium) futures will start increasing five (three) days before expiry. This is referred to as the delivery period during which margin requirements might even increase to 25 per cent of contract value.

Contract value: Some level of standardisation is followed in maintaining the contract value of equity futures. After the new SEBI rules are implemented, the value will be maintained between ₹15 lakh and ₹20 lakh. Earlier, it was ₹5-10 lakh. This will be checked twice a year. In case the value tops ₹20 lakh, the lot size will be trimmed; if it falls below ₹15 lakh, the lot size will be increased so as to bring the contract value back to the ₹15-20 lakh range. But such modifications will not happen in commodities. This is why we can see a wide range of contract values, leading to huge margin obligations in some cases.

In general, the upfront margin requirement will be the sum of initial margin and Extreme Loss Margin (ELM). For all gold futures, they are 6 per cent and 1 per cent respectively, taking the upfront margin to 7 per cent.

So, for example, the current contract value of gold futures (trading unit: 1 kg) is over ₹77 lakh, but that of gold petal futures (trading unit: 1 gm) is ₹7,700. So, the margin for trading in the former is ₹5.4 lakh, whereas for the latter is ₹540.

During certain scenarios where the price of a commodity witnesses unusually-high volatility, exchanges can stipulate additional margin on top of the existing upfront margin. There have been instances where margin requirements shot up to 50 per cent. In addition to this, traders should maintain a MTM (mark-to-market) margin to adjust for any possible unrealised losses.

Daily price limits: Price limits or price bands are the boundaries set for a day of trading to check excessive speculation.

In equities, both index and stock futures have a range of 10 per cent of the base price. Once these levels are reached, trading will be paused for 15 minutes, called cooling period, before trading resumes.

Coming to commodities, broadly, there are two initial limits – 3 per cent for a low-volatility commodity like gold and 4 per cent for a high-volatility commodity like natural gas. Once these levels are reached, the next step in both cases will be the expansion of the limit to 6 per cent. There will be a cooling period of 15 minutes when the 6 per cent range is reached. Post this, the limits will be widened to 9 per cent.

In case price movement in international markets is more than the maximum daily price limit of 9 per cent, the same may be further relaxed in steps of 3 per cent.

Risks: As mentioned earlier, commodities are riskier than stocks. So, traders who participate in commodity derivatives should maintain more vigil. While this does not mean trading in equity derivatives is not risky, happenings like price dropping below zero have not taken place in stocks.

In 2020, crude oil prices briefly dropped below $0 a barrel, triggered by supply glut and a drop in demand. Another incident is the nickel short squeeze in early 2022 as a result of the Russia-Ukraine war. Short sellers quickly liquidated their positions, leading to price surging over 100 per cent in less than three months.