Commodity online option trading has provided an excellent tool to the hedgers and traders alike. In order to able to successful trader in commodity online option trading, it is essential to learn the intricacies of commodity options. This article tries to explain few more fundamental aspects on commodity options.

Contracts Specification

For commodity online option trading, you must understand the most important parameter known as contract specification or term sheet. Essentially speaking, any commodity options contract has four core components. Underlying commodity and its quantity, call or put, strike or exercise price and expiry date. Besides these four components, there are two more important features. Settlement terms of the contract and style of the option viz. American or European. Settlement terms can involve sash settlement or physical delivery or conversion to futures contract.

Option Pricing

Before you start commodity online option trading, you should have a fair idea about option pricing. Option price or premium is essentially derived from the futures contract which in turn tracks the cash or spot value of the underlying commodity.

In reality, the option pricing is a pretty complex task. There are many variables such as time component, implied volatility and option Greeks. Black Scholes model, stochastic calculus, and binomial pricing models are few Option pricing theories and models. Most of the commodity traders rely upon readily available calculators and analytical tools.

In the Money, At the Money and Out of Money Option:

In the money or at the money or out of money nature of option also plays a vital role in the option pricing.

When the strike price of the call option contract is less than the current market price of the underlying commodity futures then the call option is said to be in the money. Out of money call option signifies that the strike price is more than the current price.

In the money put option conveys that the strike price is more than current futures price. An out of the money put option indicates strike price is less than current futures price.

When the strike price and current price are equal then the call or put option is referred to as at the money option.

Commodity option trading is an excellent risk management tool for different segments of industry participants. Besides the hedging of profit and loss, commodity option trading is widely recognized as an excellent tool for speculative profits.

Here’s a list of basic set of jargons used in commodity options.

Options: It is a contract to buy or sell an underlying asset at a certain price on or before a given future date. There are basically two types of options in commodity option trading. Call Options and Put Options.

Call Options: Call Options give the buyer the right but not the obligation to buy an underlying asset at a certain price on or before a given future date.

Put Options: Put Options give the buyer the right but not the obligation to sell an underlying asset at a certain price on or before a given future date.

Option Buyer or Holder: A person who buys the option is referred to as the option buyer or holder.

Option Seller or Writer: A person who sells the option is called as option seller or writer.

Option Premium or Price: For acquiring a right to buy or sell an asset, the option buyer has to pay a premium to the seller who receives it as his compensation for sacrificing his right. This premium is called as option Premium or price.

Underlying asset: It is an asset or a commodity such as gold, crude oil, forex.

Strike Price or Exercise Price: It is the price at which the transaction would take place when the contract is exercised.

Expiry Date: It is the last date on which the contract expires and it would be exercised.

American Option: Here the trader can exercise the contract on or before the expiry of the contract.

European Option: Here the contract can be exercised only on the expiry date.

Settlement of Options: Upon expiry the options contracts are settled either as cash settlement or by taking physical delivery or by taking positions in a futures contract.

In Conclusion:
Commodity option trading can add a new dimension to your investment portfolio provided you have thoroughly mastered the tricks of commodity option trading. Options terminology explained above is just a tip of the iceberg. It would not be wise to start commodity option trading without learning the advanced concepts in commodity options. Read tomorrow another article “Commodity Online Option Trading: Framework of Option Contracts”