Saturday, January 7, 2012

Protect your capital with commodity options

A direct exposure to commodities as an asset class in a typical portfolio of a retail investor is very limited, though there is some indirect exposure in the form of commodity-driven stocks. The limited direct exposure may be due to the lack of familiarity and inherent risks in commodity markets or even the higher exposure threshold in some cases or poor access to some of the physical markets. 

Commodities offer many advantages to a portfolio, including diversification and hedging the risk of rising inflation. There are only a handful of common factors that drive commodities and other asset classes like stocks or bonds, thus making portfolio diversification more effective. 

The recent Union Cabinet decision to allow exchange-traded commodity options has come as a boon for retail investors who are keen to take direct exposure to commodities but are wary of the downside risks associated with it. The proposed changes to the Forward Contracts Act will need parliamentary approval before they are enforced to become law. If the law comes into force, risk-averse investors will be able to design their own commodity-related capital protection plans with the help of options. 

Let’s take the example of a retail investor who wants to take an exposure of Rs 100 to any of the commodities, say, gold, with an investment horizon of one year. With that Rs 100, the investor should buy an instrument which pays interest only on maturity such as a government treasury bill (gilts) which is free of default-risk. 

The return of capital is assured. The last 364-day gilt cut-off was at 6.40%. The investor would have to pay around Rs 93.6 to buy this bill, which leaves Rs 6.40 from his initial capital of Rs 100 with him. Now with the Rs 6.40 left with him, all the investor has to do is to buy the farthest month ‘at the money call option’ contracts on the gold listed on exchanges. 

The farthest month contracts commodity options contracts are likely to be traded for three months ahead. Before the expiry of the options contract, he will have to sell his current position and buy a fresh call option contract, again three months ahead. So the investor has to do this process of ‘rolling over’ of his contracts for four times a year. The rollover may be at the same or lower or higher price. The investor will, on a net annual basis, either gain or lose a bit, depending on prevailing circumstances. This is known as the ‘net roll over cost’. 

At end of the year, the investor will certainly get Rs 100 from the maturity of the risk-free gilt, thus completely protecting his capital, irrespective of the direction that gold prices took that year. His call options position will capture not all, but much of the upside if any, in the underlying gold prices. 

The transaction as well as the net roll over costs will take away some of the upside in the gold prices. But the investor should take this loss of upside as the cost of protecting or insuring his capital. For instance, if this strategy offers, say 80%, participation in the rise of gold prices in that year with complete capital protection, it will make a lot of sense, especially when the starting price is higher. 

The extent of participation may go higher or lower if a savvy investor uses an active options strategy or takes a little more credit risk by buying a zero coupon corporate bond. The liquidity of the underlying options remains a key to the success of this capital protection strategy. 

Source: Economic Times

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