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A commodity option is a contract in which a person, known as an option writer, sells an investor the right to buy or sell a commodity at a guaranteed price for a fixed period of time. Options are traded on a wide array of commodities, including grains, meats, and currencies. Oil, metals and financial instruments are also common commodities for commodity options investing.
Some people confuse commodity futures and commodity options. There are actually two major differences. A commodity option creates a right to buy the commodity. In contrast, a commodity futures contract creates a legal obligation to buy the commodity. The other important distinction is a that futures contract must be honored by a specific date. An option may be exercised at any point during a limited time period.
There are four essential elements to a commodity option. The first property is the underlying commodity. This is the type of commodity the option gives the investor the right to buy or sell. The second element that is critical to creating a commodity option is the strike price or exercise price. This is the guaranteed price at which the investor can exercise the option to buy or sell the commodity.
The third characteristic of a commodity option is the expiration date. This is the last possible date that the buyer has the right to exercise his or her right to buy or sell the commodity option. The investor cannot buy or sell the underlying commodity at the promised price after this date. The last element of a commodity option is the premium. The premium constitutes the price the investor pays to buy the option. Conversely, the option writer receives the premium for taking the risk in writing the option.
There are basically, two types of commodity options: call and put options. An investor buys a call option because he or she expects the price of the underlying commodity to go up by a certain amount within a limited period of time. A buyer who anticipates a movement down in a commodity’s price typically buys a put option. Put options gives the purchaser the right to sell a certain commodity at a specific price during a limited period of time. Many investor will buy calls and puts options together as part of a an investment strategy, such as a spread.
An investor who purchases an option does so because he or she feels the price of the underlying commodity will make a substantial move in a particular direction during a specified time period. Investors typically buy options because they are less expensive than the actual commodity. Options not only allow investors to reduce cost, but also lower the level of risk. Investors, who are right about the direction of price movement, and the size of the movement, may reap a substantial profit from their investment.
In contrast, an option writer believes the price of the underlying commodity will not move very much. Or, price movement will be in the opposite direction. An option writer who is wrong about price volatility may suffer a huge loss. However, some of the loss may be offset with the money an option seller receives for taking the risk of writing a commodity option.
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