Commodity option – what is it?
The term "option" refers to a security that gives the right, but not the obligation, to buy or sell an asset at a fixed and unchanging price. Depending on the type of underlying asset, the security can be divided into three types, one of which is the commodity option.
Differences of Commodity Options
The underlying asset is the main object of the deal. Many characteristics of the contract depend on its type, price, and quantity. Experts divide underlying assets into three types: equity instruments (securities), currencies, and commodities. Accordingly, options can be equity, currency, and commodity.
In the options market, "commodities" refer to any products of large, medium, and small-scale industries. On exchanges, options are mostly traded on precious metals and stones, minerals, ore, and crops.
Commodity deals can be either physical delivery (involving the transfer of goods) or cash-settled. The second type of deal is aimed at generating profit — neither party is interested in the physical product, viewing it only as a tool to achieve financial goals.
History of Commodity Options
The first options were commodity-based. They appeared in the Netherlands during the tulip craze. As it happened, these beautiful flowers led to the creation of a new financial instrument.
During the peak of their popularity, the massive demand needed to be covered, but existing flower shops couldn’t handle the influx, and people didn’t have the resources to open new ones.
The solution came from resourceful individuals who began issuing securities similar to early stocks but simpler. Buyers of these securities received the right to purchase tulip bulbs or flowers at very attractive prices, for which they paid a small premium. Since the deal, even with the option premium, was highly profitable, there was no shortage of people willing to engage in this “microfinancing.”
Entrepreneurs received money to open shops, gained advertising, and their first customers — in return, they had to absorb minor initial losses due to the difference between the market and strike prices.
The first exchange-traded commodity options appeared two centuries later, in 1820, when the London Stock Exchange officially introduced these new securities.
In the 1970s, two independent options exchanges were launched, but today only one remains active — the Chicago Board Options Exchange.
Use of Commodity Options
Contracts can be used both for profit through commodity price fluctuations in the stock market and for investment protection, i.e., hedging.
The nature of the market has made commodity options especially popular for the second purpose — hedging. They are mainly bought by producers of the underlying asset, especially when production is seasonal, as in agriculture, food products, or alcohol production.
The peculiarity of such production is that investments pay off only after the full cycle of manufacturing (or growing), which can sometimes take years.
During this time, many things can happen in the stock market, including factors that affect the cost of the goods. Since businesses cannot afford to operate at a loss, they insure the money and labor invested in the product by acquiring an option to sell their asset at the market price.
If during the option term the market price rises instead of falling, the producer lets the contract expire and sells the product at the higher price.
In some cases, even options are considered too risky — the premium paid to the seller can eat into profits — so producers prefer futures and forward contracts. These do not involve premiums, but in that case, both parties are obligated to fulfill the agreement.
Types of Commodity Options
In the previous section, we only briefly mentioned the possibility of earning profit through commodity options. In fact, there are two main models for making profit, depending on the type of option — call or put — while for hedging, only one model and one type are typically used.
A call option gives the right to purchase the commodity. Traders buy it during periods of significant price drops or when a sharp rise is expected soon. The investor enters into an agreement to buy the asset at the market price, waits for the price to rise, exercises the option at the lower price, and sells the commodity at the current higher market price.
A put option allows the holder to sell the asset. It is bought when prices are high, and when they fall, investors buy the commodity from third parties at the lower market price and sell it to the broker at the higher option price.