Commodity Options, Commodities Option
Commodity options are agreements between buyers and sellers that give buyers the right (but not the obligation) to buy or sell a certain amount of commodity at a specified price on a specified future date. Any commodity, such as grain or crude oil, can be used as the underlying asset for a commodity options contract.
A buyer of the commodities option has the right to buy or sell the underlying option before the contract expires. However, the right to exercise the option of either buying or selling does not put the buyer under an obligation to exercise this option. At the same time, the seller is bound to buy or sell the underlying. To exercise this flexible option, a buyer pays a premium to the seller of the option.
Commodity options are of two types: call options and put options. In a call option, the buyer of the option has the right to buy the underlying commodity at a prescribed price on a date that is specified for the future. Meanwhile, a put option provides the right to sell the underlying commodity at a prescribed price at the prescribed future date. The price that is fixed to buy or sell on a specific date in the future is known as the strike price.
How are Commodity Options Traded?
Commodity options are traded in an organized options exchange. These exchanges are responsible for standardizing the contracts by specifying the terms that need to be incorporated in the contracts. These include the quantity, price and future date expiration of the underlying commodity. The exchanges serve as facilitators of commodity options trading and ensure that the trade is fair and transparent.
Benefits of Commodity Options
Commodity options are used widely by individual investors, hedgers, and aggressive investors. They are effective tools in hedging against risks due to crop failures and anticipated losses that occur because of uncertainties in other market segments.
Risks of Commodity Options
Commodity options may promise huge returns on a small margin. However, such high returns are not always certain. Note that small fluctuations in the price of the underlying commodity may induce broad movements in the prices and hence result in great losses.
Find out more about Options on Commodities Investment.