by Amanda Harvey
Commodity options trading is the buying and selling of option contracts whose underlying asset is a commodity such as an energy-based, metal, agricultural or livestock product. The option contract entitles the holder to buy a certain amount of the underlying commodity at a pre-determined price (known as the strike price) on or before the expiration of the contract. The buyer of the option is not obligated to purchase the commodity, but the seller of the option must supply the commodity at the agreed price if the buyer decides to exercise their contract. As with other types of options, a premium, calculated as a percentage of the price of the underlying asset, is paid to buy these options.
When trading commodity options, the simplest types of options are a call option and a put option. A call option increases in value when the price of the underlying commodity rises, and conversely, a put option gains value along with a drop in the commodity price.
Profiting from Commodity Options Trading
A trader involved in commodity options trading may attain a profit in more than one way. Firstly, if they are trading a call option, they may purchase an amount of a commodity for less than the market price if their prediction is correct and the price rises above the strike price of their option contract. They can then immediately re-sell the commodity at the market price, thereby generating an increase on their investment.
Another method of profiting from trading commodity options is to re-sell the option contract. A call option will generally have risen in value along with the rise in market price of the underlying commodity, and the reverse is true for a put option which typically gains value with a drop in the commodity price. This strategy for trading commodity options allows the trader to realize a return on their initial investment of the option premium, without having to outlay a substantially higher amount of capital to actually purchase the commodity.
Commodity Options for Hedging
An investor who holds futures in a commodity may purchase commodity options as a means of hedging against the possibility that the price will move against their futures position. This option contract acts as a form of insurance, and can help to mitigate a potential loss. Most commonly, put options are bought to offset the losses that would be sustained by commodity futures if the price of the commodity drops.
Choosing Which Commodity Options to Trade
Volatility is a very important component in options value, and if the price of a commodity is stagnant, the option will not make money. Therefore, it is important to trade options on commodities that are likely to experience significant movement in price. Analysis can be used to identify commodity options that are poised to break out of a trading range.
It is also suggested that a trader buy options that are fairly valued or undervalued, and have sufficient time remaining before expiry that they have a good chance of generating a profit. Another tip is to choose a strike price that is not too far away from the current commodity price; especially if the time until expiry is limited.
Where Commodity Options Trading Takes Place
The Chicago Board Options Exchange (CBOE) is the world’s largest and busiest options trading venue, and a large percentage of commodity options trading takes place through the CBOE. There are other exchanges also offering commodity options, and trading is often conducted through a brokerage.
Whether a trader wishes to make a profit purely from the increase in value of the options contract, to actually trade the underlying commodities, or to hedge a position in those commodities, commodity options trading offers a viable market to be explored.