Options are contracts, or provisions within contracts, that give the option holder the right to obtain commodities from, or sell commodities to, the option writer according to specific terms. An investor might purchase a call option to buy 1,000 bushels of corn at any time during the next three months at a specified price. Options give traders investment strategies that do not exist when buying common stocks.
Put and call options are referred to as derivative instruments; put and call options trade at futures exchanges or over-the-counter; they are linked to underlying assets. Most exchange traded options have stocks or futures as their underlying assets while OTC options have more variety including currencies, commodities, swaps or groups of assets. In addition, options can take many forms; two of the most common are:
The strike price of a call options is the specific price on which the two parties agree for the underlying asset in the event that the option is exercised. The expiration date is the last date on which the option can be exercised. Commodity trading options can be exercised in one of three ways:
1. American exercise – A put or call option can be exercised at any time up to the expiration date.
2. European exercise – A put or call option that can only be exercised on the expiration date.
3. Bermudan exercise – Put or call options are futures contracts that are only allowed to be exercised on a few specific dates prior to the expiration date. While the other two do not have a specific reason for their names; the Bermudan was named this because it is halfway between Europe and America.
An example of a call option in commodities trading:
You have decided to purchase a three month, American exercised call option on 50,000 barrels of light sweet crude oil at a strike price of $50 per barrel. This call option has the following terms:
After two months, the price of oil has risen to $60 per barrel. You decide to exercise your call option and purchase a put option with the same conditions except a strike price of $60 per barrel. Once both options have been exercised, ignoring the commissions involved, you have just made $10 per barrel for 50,000 barrels or a profit of $500,000. Not a bad day’s work for successful traders who have just learned about put and call options!
Futures options are exciting investment opportunities and techniques like put and call options give investors great alternatives for making profits in commodities trading. It is important to understand the terminology and the techniques involved before implementing put and call options but these can be excellent investment strategies to use.
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