Commodity options allow investors to buy or sell a commodity at a guaranteed price for a fixed period of time. There are two types of options: call and put. Options are less expensive than the actual product and can reduce risk, but options writers can suffer huge losses.
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 fixed period of time. Options are traded on a wide range of commodities, including grains, meats, and coins. Oil, metals, and financial instruments are also common products for commodity options investing.
Some people confuse commodity futures and commodity options. There are actually two main differences. A product option creates a right to purchase the product. In contrast, a commodity futures contract creates a legal obligation to purchase the commodity. The other important distinction is that the futures contract must be fulfilled on a specific date. An option can be exercised at any time for a limited period of time.
There are four essential elements to a basic product 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 element that is critical in creating a commodity option is the strike price, or strike price. This is the guaranteed price at which the investor can exercise the option to buy or sell the product.
The third characteristic of a commodity option is the expiration date. This is the last possible date that the buyer is entitled to exercise his right to buy or sell the commodity option. The investor cannot 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 purchase the option. Rather, the option writer receives the premium for taking the risk of writing the option.
Basically, there are 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 anticipates 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 product at a specific price for a limited period of time. Many investors will buy calls and join options as part of a trading strategy, such as a spread.
An investor who buys an option does so because he feels that the price of the underlying commodity will make a substantial move in a particular direction over a specified period of time. Investors often buy options because they are less expensive than the actual product. Options not only allow investors to reduce costs, but also reduce the level of risk. Investors, who are correct about the direction of the price movement and the size of the movement, can make a substantial profit on their investment.
Conversely, an options writer believes that the price of the underlying commodity will not 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, some of the loss may be offset by the money an option seller receives for taking the risk of writing a commodity option.
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