Commodity Option Trading:
An Overview

What are commodity option contract?

Commodity option trading involves the buying and selling of option contracts with the commodity (futures contract or physical assets) as the underlying, which both the buyer and the seller of the option should be aware of before entering into the contract.

The buyer of an option purchase the contract for a price (premium) to own the right (but not obligation) to exercise the option before a certain due date. When the option is exercised, the buyer is considered to have entered into a commodity futures contract at the predetermined strike price, or, in some other scenario, involves a delivery of the physical assets. 

Who are the market participants in commodity option trading?

Majority of the market participants in commodity option trading are companies and institutions. More often than not companies and/or institutions enter into option contracts in order to hedge their underlying assets from adverse price movement.

It is in the interests of the commercial entities to hedge the cost of the commodity to ensure that the cost structure remain stable, as the primary objective of the companies is to provide a product (e.g. Manufacturing) and not profiteering from favorable raw material price movements.

Hedging is therefore considered to be a conservative strategy in commodity option trading as any adverse price

movements in the underlying will be offset, to varying degree depending on the extend and the “perfectness” of the hedge.

The other group of participants in commodity option trading are the speculators. In contrast to the hedgers, this group of participant is in the market to take a bet on the direction of the underlying commodity instruments, with the sole intention to make profit.

The speculators are important to the whole market dynamics as they add on to the overall pool of market participants, and therefore the liquidity of the options contracts.

For individuals, commodity option is not suitable for everyone. Given the highly volatile nature of the instrument, it is only suitable for sophisticated investors with high level of risk tolerances and appetite.


Strategy - Covered Call using Commodity Option
One common strategy in commodity option trading is using covered call. Essentially, this strategy involves a long position in the underlying futures contract and selling (writing) the corresponding number of call options that are out of the money.

The further out-of-the-money options has lower premiums but it also means that the possibility of the option being called is lower. A covered call option strategy works best when the underlying is trending up somewhat slowly or stays rather flat.

In essence, it is still of paramount importance that the selection of the underlying is correct, with the position taken up at the right time. The premium collected, while can cushion some losses, will be of little help in an adverse market condition.

Commodity Option Trading - Broker and Your Trading Success

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