Commodity Options Trading
You may have heard of trading commodity options, but have you ever considered starting trading in it? If yes, then in this article, we will learn about commodity trading options, their types, benefits, and how it is different from commodity trading. It will help you in deciding whether commodity options are good for you.
Here's a quick look at what you'll read
Options are the financial contracts that give the holder the right but not the obligation to buy or sell the underlying assets at the specified time somewhere in the future.
- American Options
- European Options
- Call Option
- Put Option
- Cost-effective
- Flexibility to option holders
- Hedge against inflation
- Price insurance
- Time Bound
- High Risk
- Complex Trading
What are the Options?
Options are the financial contracts to trade assets like currencies, cryptocurrencies, commodities, etc.
Options contracts give buyers the right (but not the obligation) to buy or sell an underlying assets at a pre-specified price, on a specific date somewhere in the future.
Under this, if the market moves in favor of the option holder (buyer), then only he will utilize his right; otherwise, he will let it go. However, the option seller bears the obligation to fulfill the contract if the buyer chooses to exercise his or her right. And, for such a facility, option buyers have to pay a particular amount known as a premium.
What are Commodity trading Options?
Commodities options are financial derivatives to enjoy the facility of options trading while trading in commodities.
Commodity Options enable the holders to exercise the right but not the obligation to buy or sell underlying assets against the premium.
Using these derivatives, one can trade in metal commodities like gold products and silver, petroleum energy commodities like natural gases and crude oil, or agriculture commodities like coffee, cotton, wheat, etc.
Commodity Options Trading Example
Let us look at an example to understand options and commodities trading better.
Suppose you have entered into a contract to buy 100 Gold Bars at 2000 USD per Bar after three months. For this purpose, you have paid the premium amount of 5,000 USD in advance against the transaction of 200,000 USD.
Now, after three months, the price has increased to 2100 USD. As the market moves in your favor, you exercise your right to buy it at 2000 USD. In this case, the option seller will have an obligation to sell the gold at $2000 per bar, when market prices are higher at $2100.
Therefore, you have made a profit of 5,000 USD (210000- 200000 – 5000).
Now, suppose the price falls to 1850 USD. So if you go with the contract, your loss will be 15000 USD(200,000- 185000). However, in this case, you will exercise your right to let it go.
Your loss will be the amount you paid in advance, which is 5000 USD. So, you have saved 10,000 USD from the transaction. That’s how options trading makes a difference.
Types of Commodity Options
Based on the usage of the right
American Options
American options give traders the right to buy or sell the underlying asset even before the contract expiration date.
European Options
European options are quite specific and you can exercise your right only at a specific date at which the contracts expire.
Based on transaction
Call Option
Call options are for buying financial assets. It gives the traders the right but not the obligation to buy the underlying commodity at a predetermined price before or at the contract expiry date.
Put Option
Put Options are for selling the financial assets. It gives the trader the right but not the obligation to sell the underlying commodity at a predetermined price before or at the contract expiry date.
Benefits of Trading Commodity Options
Commodity options are becoming increasingly popular in the new age of trading. However, to decide whether these suit you, let us quickly analyze their pros and cons.
Cost-effective
One of the best advantages of commodity options is their cost-effectiveness. In future contracts, the cost is higher, but the returns are low, while with options contracts, the cost is lower, but the returns are higher.
Flexibility to option holders
Commodity options are the financial derivatives that give holders the flexibility to decide whether to go with the transaction on the expiry date.
The holders hold the right to buy or sell the assets if the market moves in their favor and end it if it moves against their prediction.
Hedge against inflation
Trading commodity options is amongst the best ways to fight against inflation. These financial derivatives allow traders to trade highly demanding commodities, including gold, oil, etc.
These commodities have a great price history and are considered best to invest in to fight inflation.
Price insurance
Commodity options are considered price insurance against unpredictable and highly volatile commodity market conditions. Also, traders trading in forex, stock, and other financial markets can use this derivative to diversify their portfolio investments.
Limitations of Trading Commodities Options
Time-Bound
The options contract has a time restriction or expiry date. Some allow traders to use the right before and on the expiry date, while some allow traders to use it specifically on the expiry date.
Also, even if the price moves in your favor after the contract’s time frame, you will no longer entitled to exercise your right.
High Risk
Commodity trading options may generate huge benefits. However, with the huge returns, the risk associated with options trading is also high. So, it is a must to consider risk before starting trading in options.
Complex Trading
Commodity Options Trading for beginners can be a complex process. Trading options require impeccable market knowledge, strategic planning, and risk management skills. So, it may not be suitable for beginners.
Difference between commodity and options commodity trading
Wrapping Up
Options and commodities makes an excellent combination to keep your trading game ahead and stand out. There are numerous commodity options trading platforms to start your journey.
Trading commodities options have several benefits, including limited risk, great return, flexibility, diversification, low-cost trading, etc. However, options are complex financial derivatives.
In order to get the desired result, you need to learn the art of option trading, leverage management, and risk management, while keeping the right psychology and mindset. Trading options may result in huge returns or considerable losses, so work on your approach.