A new instrument to hedge risk in gold investments 

*This is a sponsored feature by MCX.

Investing in any commodity involves its fair share of risk, but gold in particular is tricky because of its constant demand and price fluctuations. With a little planning though, you can have your share on the returns of the gold and can limit one’s price risk on your exposure to gold.

The Multi Commodity Exchange of India Ltd., or MCX, recently introduced gold options contracts, an ideal way to limit your liability while protecting your investment.

For the uninitiated, options are just that - a financial instrument that gives a buyer the choice to buy a commodity at a later date. Options give the buyer the right - but not the obligation - to buy an underlying asset at a fixed price by a specified future date.

So, why would anyone buy an option instead of just buying the actual commodity? Well, price movements mean waiting to buy commodities can leave you exposed to a higher price and potential loss. Options allow investors to secure the underlying derivative at a future price that is locked in, known as a contract.

For example, a jeweler may want to procure gold from a wholesaler. Between the time she orders it and pays the invoice, the price may go up, causing her to lose money. Similarly, when the jeweler takes possession of the gold, it takes time for it to be processed and sold to customers, meaning the price may drop and affect her eventual profit margin.

That’s where options come in. There are two types of options: in a call option, the buyer has the right, but not the obligation, to purchase the commodity within a fixed time frame at a specified price, called the strike price. A put option gives the buyer the right to sell the commodity at a fixed price at a specified future date to offset any losses due to volatility.

There’s a catch to being able to guarantee a future price on a commodity - buyers pay a fee, called a premium, to secure the contract.

That means, if you hold a call option and gold prices go up, you are guaranteed the agreed upon lower buying price. If gold prices decline, you’re not obligated to buy from the seller who gave you the contract. You can forego the contract and buy your gold on the open market at a cheaper rate. Keep in mind that the cost of this option is the premium paid.

Conversely, if you buy a gold put option and price goes down upon expiry of the contract, you pocket the difference. You earn a profit, which is the difference between the new price of the commodity and the strike price, minus the premium.*

A new instrument to hedge risk in gold investments 

Here’s an illustration of how gold price fluctuations play out with call and put options.

Vandana wants to buy 1 oz. of 24 carat gold for her son’s wedding next month. She agrees to a strike price of Rs 86,500/oz. and buys a gold call option at said price for a premium of Rs 850 to protect herself in case gold prices increase in the next 30 days.

When it’s time for the contract to expire, the price of gold has actually dropped to Rs 83,500/oz. Vandana decides to take advantage of this saving by allowing the contract to expire (and losing the Rs 850 premium), and buying gold in the open market. She saves Rs 2,150 (the difference between the strike price and the market price of gold, with the premium subtracted).

Juhi is a wholesaler who bought 1 oz. of gold at Rs 85,000. She buys a gold put option at a strike price of Rs 85,000 for a premium of Rs 800, in case gold prices slide. When her contract expires, gold has fallen to Rs 82,000/oz., but Juhi’s strike price of Rs 85,000 ensures a profit of Rs 3,000/oz. Subtract the Rs 800 premium, and she nets Rs 2,200.

Note that a commodity option contract becomes a futures contract upon expiry. Unlike options contracts, where the buyer has a right, but not an obligation, to purchase the commodity, a futures contract requires both the buyer and seller to fulfill the contract on a certain date.

Because gold prices are volatile, it’s important to understand how much risk you’re comfortable taking. But now, thanks to the introduction of gold options contracts, the precious metal can be a novel investment with both practical and financial value.