Tuesday, February 17, 2015

What is commodity options

Commodity options are options based on commodity. Commodity option is a right but not an obligation to trade a commodity at a specific price. Commodity options are used by agricultural producers, commodity purchaser, investor, and speculator. Each of them has their own goal for using commodity option. Agricultural producers and commodity purchaser buy option for hedging. Investor and speculator use this option to make profit.

Agricultural producers or farmer uses commodity options to reduce their risk of loss because of commodity price change. A farmer who planted wheat buy options so they can sell their wheat at a specific price. At the time he planted the wheat it was $ 300 per bushel and he hope that the price stays at $ 300 per bushel in order to make profit. If for some reason the price drops to $ 250 per bushel the farmer won't be making any profit. To reduce his risk the he bought put option so in the future he can sell at $ 300 per bushel.
You now know that you can buy a right to sell commodities at a certain price. This right is called put option. If there is a right to sell, then there is a right to buy. The right to buy is called call option. Commodity purchaser who wants to protect their self from the wheat price increase will buy call option. There are many companies which buy wheat. One of them is flour producer. Flour is made from wheat, so to produce flour they need to buy wheat. If flour producers want to keep buying wheat at $ 300 per bushel, they will buy call option. If wheat rises to $ 320 they will need to spend more money to buy wheat and this will reduce their profit.
Commodity option is similar to stock options. It also has premiums, strike price and expiration date. The concept is similar with stock options. Strike price is the price at which the underlying commodity can be bought or sold. Premium is the price of the right. Expiration date is the last date which the option is still valid.

After the option passes the expiration date and were not executed, it means that it expire worthlessly. Here's an example. The farmer bought a put option at strike price $ 300 for $ 50. $ 50 is the premium. When the option expired the wheat price is at $ 305. So the farmer does not execute his right because he can sell it at higher price than strike price. The farmer will gain by selling his wheat at $ 305 but loss his $ 50 money from the options premium.

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