What is Devolvement for Commodity Options?

Devolvement in commodity options in India refers to the automatic conversion of an ITM (in-the-money) commodity option into a futures contract at expiry. Let us examine it in more detail below.

What is devolvement in commodity options?

Devolvement in commodity options is essentially the process by which an ITM (in-the-money) commodity option is automatically converted into a futures contract at expiration. This happens only when the option is not exercised or sold beforehand.

Why does this happen? It is because the option becomes profitable and is thus automatically converted to fulfil the terms of the contract. However, the trader has to maintain the margin for the futures position in this case. OTM (out-of-the-money) options expire absolutely worthless. Only ITM long positions devolve automatically. ITM short options are assigned, not devolved.

Devolvement applies only to MCX commodity futures options, not equity options. It is important for traders and investors to have an understanding of devolvement in commodity options on MCX. 

How Devolvement in Commodity Trading Works

Here’s how devolvement works in commodity trading: 

• ITM options: Whenever any commodity option concludes at expiration in-the-money, then it converts automatically into a futures contract for the same underlying commodity. In this case, a long call option devolves into the long futures position, while a long put option devolves into a short futures position. Please note that devolvement occurs at the strike price, but the futures position is opened at the Daily Settlement Price (DSP) as per MCX guidelines.
• OTM options: These contracts are not converted and expire completely worthless. 
• Contrary instruction: In case any trader wishes to avoid the devolvement of options into futures contracts, he/she will have to provide this contrary instruction before the expiry. This prevents any such conversion. MCX refers to it as DNE (Do Not Exercise) for long ITM positions. There is no “contrary instruction” for short options. Also, short ITM options result in assignment.
• Risk & Margin Requirements: You have to maintain the necessary margin for the corresponding futures contract. Margin requirements escalate as expiry approaches. This has to be done 2 days before expiry to ensure you meet the additional devolvement margin requirements for options contracts to complete the conversion. Failure to meet the margin requirements may lead to the exchange liquidating your position. 

Example for Devolvement in Commodity Options

Suppose you have a gold futures contract that is expiring on 24th February, 2026, and the gold options contract is expiring on the 15th of February, 2026. If you have any open ITM options positions for gold on the 15th of February, they will be converted into futures after that date. This procedure is known as devolvement. 

Let’s take another example - 

Let’s say you purchase a call option on gold futures from the MCX (Multi-Commodity Exchange. Suppose you purchase one lot of the Gold Call Option with a strike price of ₹80,000 per 10 grams, with an expiry on December 20, 2025. You also pay a premium for this particular right. On the date of expiry, in case the DSP (daily settlement price) of the underlying Gold January Futures (many commodity options link to the futures for the next month) contract stands at ₹81,500 per 10 grams. Hence, since the settlement price is above the strike price, your option is in-the-money (ITM). 

If you did not square it off before the cut-off date or give any contrary instruction, the option contract will be automatically devolved. Your long call option will become a long position for the underlying Gold January Futures contract at this particular strike price.

CTT Charges on Devolvement

The CTT on devolvement in India stands for the Commodity Transaction Tax. It applies to the subsequent futures position whenever any commodity option devolves at expiration. It is calculated at a rate of 0.01% on the settlement price of the devolved futures contract. In this case, the tax is paid by the seller. 

The formula for the CTT is thus the following:

Settlement Price x Number of Lots x Lot Size x 0.01%

Margin Requirements for Devolvement

The margin requirements for devolvement are as follows: 

• 2 days before expiry: 25% of the futures margin
• 1 day before expiry: 50% of the futures margin 
• On the day of the expiry: 100% of the futures margin

Short Position Settlement

The short position settlement depends on whether you exercise the option. If you choose the DNE (Do Not Exercise), then the ITM short position will not be devolved into the futures position. It will, instead, be cash-settled.

What is DNE for Commodity Options?

The Do Not Exercise (DNE) option is applicable when you hold your ITM long position but do not have 100% of the futures margin required for devolvement. The broker will usually close the long position before the expiry. If illiquidity or another reason prevents the broker from closing the long option position, it may be marked as DNE. This prevents the option from devolving into futures. A DNE window is provided by the exchange till 15 minutes after the market closes on the day of the option expiry. 

Settlement Method of Commodity Options Contracts

The commodity options settlement process involves two primary methods, namely physical delivery or cash settlement. It all depends on the specifications as outlined by the exchange.

A majority of commodity options are cash-settled, meaning that the underlying commodity is not exchanged; instead, the positions are settled based on the difference between the market price at expiration and the contract's strike price. It is a more convenient method that does not require logistics or the associated costs/complexities of handling physical commodities. 

In the case of physical delivery, the actual exchange of the commodity happens upon the expiration of the contract. Sellers have to deliver the specific quality and quantity of the commodity to the exchange-designated warehouse for buyers to take possession of it. The whole process is supervised by the clearing agent/broker and involves multiple aspects, such as transportation, warehousing, and quality control. There are also penalties for the failure to deliver or take delivery on time. 

Devolvement of Options Positions into Futures Positions

As you can see, devolvement thus refers to the automatic conversion of in-the-money options into corresponding futures positions on the date of expiry. This is common for several commodity options and a few equity options as well.

In this case, the option converts into a long or short futures position at the strike price of the option in question.

As the holder, you will then be obligated to the future contract terms. Some examples include a long call position, a long put position, a short put position, or a short call position. 

Understanding the Margin Requirements for Options Positions Settlement Mechanism

The margin requirements are the following: 

• 4 days before expiry: 25% of the futures margin
• 2 days before expiry: 50% of the futures margin
• 1 day before expiry: 100% of the futures margin
• Day of expiry: 100% of the futures margin