Commodity Options – Meaning, Example, Benefits, important terms & more

Know everything about Commodity Options here. Understand its meaning, about call & put commodity option, important terms under commodity options trading, example, benefits & more.

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About Commodity Options

Commodity options are derivative contracts which derive their value from the price of the underlying security.

However, this isn’t similar to the option contracts in the stock market. This is because the options in stock market derive their value from the price of an underlying stock.

On the other hand, commodity options derive their value from the futures contract of a given commodity.


Calls and Puts in Commodity Options

In every market, there are two types of options, call and put. If the trader believes that the price of a security is going to rise, he purchases calls or sells the puts.

On the other hand, if a trader believes that the price of a security is going to fall, he purchases puts or sells the calls. Let us try to understand to concept of calls and puts.

Calls: When a trader buys a call option, he gets the right of buying the underlying security at the strike price mentioned.

However, there is a specified time period for this. On the other hand, selling a call option makes it an obligation for the trader to take a short position when the contract expires.

Therefore, buying a call option leads to limited risk and unlimited profits. While selling a call option leads to unlimited risks and limited profit.

Puts: When a trader buys a put option, he gets the right of selling the underlying security at the strike price mentioned.

However, there is a specified time for this. On the other hand, selling a put option makes it an obligation for the trader to take a long position when the contract expires.

Therefore, buying a put option leads to limited risk and unlimited profits. While selling a put option leads to unlimited risks and limited profit.


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    Terms to know before entering into an Options Contract

    Here are few very important terms used in options trading –

    Lot size: Unlike shares, you cannot buy 1 unit in case of options. There is a fixed lot size which is mostly same as the lot size of the futures contract and a trader can only trade in multiples of that size.

    Type of Contract: There are two types of options contract, i.e. American and European Style. Under the American contract, the trader can exercise his rights any time before the expiration of the contract.

    Therefore, the trader has the right to buy or sell the underlying commodity for the given strike before any time before the expiration of the contract.

    On the other hand, under the European style contracts, the trader can only exercise his right on the date of expiry.

    In the Indian Markets, the European style contracts are found. The CE and PE are abbreviations for Call European and Put European.

    Date of expiry of Contract: In the commodity market, the options contract expires three days prior to the date of expiry of the futures contract for the underlying security.

    Note: The commodity options can also get converted into futures contract if they are not squared off.


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    Understanding of Commodity Options with Example

    As mentioned earlier, commodity options are different from equity options as they are based on the futures and not the spot price of the security.

    Let us now try to understand the working of commodity options with the help of an example.

    Commodity: Gold

    Option expiry date: 29th January 2020

    Value of Underlying future: Rs.37,674 per 10gm

    Expiry date of futures: 5th Feb 2020

    Strike price of Call option: Rs.38000 per 10gm

    Premium paid for call option: Rs.362.5

    Breakeven point: Rs.38000+362.5= Rs.38,362.5 per 10gm

    There are two traders, A and B in the market. The trader A is confident about gold futures rising in price. Therefore, he bought a call option.

    On the other hand, trader B felt that the prices of gold would go down. Therefore, he sold the call option.

    Let us now take a look at the various scenarios possible and try to understand the profit and loss booked by both traders in each case.

    Profit or Loss booked under different Scenario’s in Commodity Options

    Case 1:

    The futures of gold with expiry 5th Feb 2020 is trading Rs.38,500 per 10gm (More than breakeven)

    In this case, the trader A will make a profit of Rs.137.5 per 10gm. Therefore, the net profit for trader A, in this case, will be 137.5*100 = Rs.13,750.

    On the other hand, trader B, who sold the call, will end up booking losses.

    Case 2:

    The futures of gold with expiry 5th Feb 2020 is trading Rs.38,362.5 per 10gm (Equal to the breakeven)

    Since this is the breakeven point, both the traders, do not make any profit or loss if the gold futures are trading at this point at the time of expiry.

    Case 3:

    The futures of gold with expiry 5th Feb 2020 is trading Rs.38,000 per 10gm (Less than the breakeven)

    In this case, the trader A will make a loss of Rs.362.5 per 10gm. Therefore, the net lossfor trader A, in this case, will be 362.5*100 = Rs36,250.

    On the other hand, trader B gets to keep the entire premium of Rs 362.5 as he sold the call and received the premium in advance.

    Therefore, the net profit for the trader B, in this case, will be 362.5*100 = Rs.36,250.


    Understand in Detail about Commodity Market here

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    Benefits of Trading in Commodity Options

    By this time, you already know that there are two forms of derivates which you can opt for while trading, i.e. Futures and Options.

    Let us know and understand the reason behind choosing options trading.

    Only Pay Premium

    In case of options, the trader only has to pay the premium, which is significantly lower than the margin required for trading in futures.

    Although, the margin requirement for short-selling call or put options can be a little higher than the premium.

    Minimize the Risk

    Trading in options can help you minimize the risk as compared to trading in futures. For instance, you feel that the prices of gold are going to fall, but you do not want to take much risk.

    Instead of trading in the futures of gold, the trader can buy the puts as their value will be derived from the prices of futures contract only.

    In this way, the trader is safe as the maximum loss is limited to the premium paid. At the same time, trading in futures may lead to the delivery of the commodity when the contract expires.

    Hedging Tool

    Options can be a great way of hedging yourself in volatile market conditions. This is because the options can work in both ways.

    Therefore, if you have invested some capital in the futures of a commodity, you can buy a lot of puts for the same. This will help you minimize the losses if the trade turns unfavorable.


    Conclusion: Commodity Options

    In this blog, we learnt about trading in commodity options and the working of options in case of commodities. Let us now try to sum up the blog:

    The two types of options are calls and puts which are bought for upward and downward movement, respectively.

    Unlike equity options, the commodity options derive their value from the futures of the underlying commodity.

    There are two systems followed in options that are American and European. Under American options, the trader can exercise his or her rights any time before the expiry of the contract.

    On the other hand, under the European contract, the trader can only exercise his rights at the time of expiry. In this case, the trader pays the premium upfront.

    The American options are represented by CA and PA for calls and puts. In contrast, the European options are represented by CE and PE.


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