Commodity options trading

Commodity options trading encompasses all the transactions that occur between producers searching to get the opportunity to sell or buy a commodity at a certain price.

This form of trade offers producers a chance to protect their goods from the risk of price changes. The past ten years have been “haunted” by this phenomenon, which made the prices for the products grown or stored to be so uncertain that what seemed profitable when planted or placed on feed turned out to be unprofitable due to price decreases.

Another circumstance that contributed to the emergence of commodity options trading resided in the uncertainty of the final production price. If a producer used a forward pricing alternative (like a cash contract or hedging in the future markets) to control price risks, he would expose himself to an additional risk of uncertain final production, which was incurred because of over or under forward pricing of expected production.

In other words, commodity options trading is a way to  “insure” prices against declines while taking advantage of price increases. There are two types of commodity options – one to insure products that are being sold against price declines, and another to insure products that are purchased against price increases.

 

Purchasers that are involved in this market have the “opportunity” and not the “obligation” to exercise their agreement. For instance, if a farmer wanted to buy the right to sell corn for $3.00 per bushel, he would find this opportunity within the commodity options market. After paying  the market determined premium, the respective producer could then collect on the option if the prices for corn per bushel were below $3.00 when the product would actually be sold. In case the prices exceed $3.00 oer bushel, the corn could be sold for the higher bid, which would make the cost of the premium to be absorbed.

Commodity options trading has very similar mechanics to options trading in the sense that the commodity option derives its value from an underlying commodity, which is  a futures contract for the respective derivative. For instance, a November soybean option is based on a November delivery soybean futures contract.

To put it differently, the options are on futures and not on the physical commodity. One such option has a strike price specified and an expiration date as well. It comes in two forms- either a call or a put option.

In conclusion, commodity option market is just a subbranch of the option market

Previous post:

Next post: