Commodity options allow investors to buy or sell a commodity at a guaranteed price for a specified period. There are two types: call and put options. Options are less expensive than the actual commodity and can reduce risk. Options writers take on risk and can suffer losses if they are wrong about price volatility.
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 specified period of time. Options are traded on a wide range 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 big differences. An option on a commodity creates the right to purchase the commodity. Conversely, a commodity futures contract creates a legal obligation to buy the commodity. The other important distinction is that the futures contract must be honored by a specific date. An option can be exercised at any time during a limited period of time.
There are four essential elements to a commodity option. The first property is the underlying commodity. This is the type of commodity that the option gives the investor the right to buy or sell. The second building block of 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 latest possible date on which the buyer has the right to exercise his right to buy or sell the commodity option. The investor may not 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 is the price the investor pays to buy the option. Conversely, the seller of the option receives the premium for assuming 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 expects the price of the underlying commodity to rise by a certain amount within a limited period of time. A buyer who expects a downward movement in the price of a commodity typically purchases a put option. Put options give the buyer the right to sell a certain commodity at a specific price for a limited period of time. Many investors will buy calls and combine options as part of an investment strategy, such as a spread.
An investor who buys an option does so because he believes that the price of the underlying commodity will move substantially in a particular direction during a specific period of time. Investors typically buy options because they are less expensive than the actual commodity. Options not only allow investors to reduce costs, but also to lower the level of risk. Investors, who are right about the direction of the price movement and the size of the movement, can make a substantial profit from their investment.
Conversely, an options writer believes that the price of the underlying commodity won’t move much. Or, the price movement will be in the opposite direction. An options writer who is wrong about price volatility can suffer a huge loss. However, part of the loss can be offset by the money an option seller receives for taking the risk of writing out an option on a commodity.
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