Home > Articles > Business & Management > Finance & Investing

  • Print
  • + Share This
This chapter is from the book

A Brief Introduction to Commodity Options

The theory and practice of option trading is diverse and sometimes complicated. Accordingly, it is impossible to do the topic justice in such a brief mention. The purpose of this section is to merely introduce the subject.

Options can be purchased outright, in conjunction with futures contracts, or even as a package with both short and long options of various types. There are no limits to the versatility of option trading. Commodity options provide a flexible and effective way to trade in the futures markets with various amounts of potential risk and reward. For example, through the combination of long and short calls and puts, investors can design a strategy that fits their needs and expectations; such an arrangement is referred to as an option spread.

The method and strategy should be determined by personality, risk capital, time horizon, market sentiment, and risk aversion. Plainly, if you aren’t an aggressive individual with a high tolerance for pain, you probably shouldn’t be employing a trading strategy that involves elevated risk. Doing so often results in panicked liquidation of trades at inopportune times and other unsound emotional decisions.

What Is an Option?

Before it is possible to understand how options can be used, it is important to know what they are and how they work. The buyer of an option pays a premium (payment) to the seller of an option for the right, not the obligation, to take delivery of the underlying futures contract (exercise). This financial value is treated as an asset, although eroding, to the option buyer and a liability to the seller. There are two types of options, a call option and a put option.

  • Call options. Give the buyer the right, but not the obligation, to buy the underlying at the stated strike price within a specific period of time. Conversely, the seller of a call option is obligated to deliver a long position in the underlying futures contract from the strike price if the buyer opts to exercise the option. Essentially, this means that the seller is forced to take a short position in the market when the option is exercised.
  • Put options. Give the buyer the right, but not the obligation, to sell the underlying at the stated strike price within a specific period of time. The seller of a put option is obligated to deliver a short position from the strike price if the buyer chooses to exercise the option. Keep in mind that delivering a short futures contract simply means being long from the strike price.

Similar to futures contracts, there are two sides to every option trade: a buyer and a seller. Option buyers are paying for the underlying right, whereas sellers are selling that right. The most important point to remember is that option buyers are exposed to risk limited to the amount of premium paid, whereas option sellers face theoretically unlimited risk. Conversely, option buyers have the possibility of potentially unlimited gains, whereas the profit potential for sellers is limited to the amount of premium collected (see Table 1.1).

Table 1.1. Relationship Between Calls and Puts

Call

Put

Buy

bull.jpg

bear.jpg

Limited risk

Sell

bear.jpg

bull.jpg

Unlimited risk

Traders who are willing to accept considerable amounts of risk can write (or sell) options, collecting the premium and taking advantage of the well-known belief that more options than not expire worthless. The premium collected by a seller is seen as a liability until either the option is offset (by buying it back) or it expires.

Option Spreads

The majority of beginning option traders prefer trading outright options (buying or selling calls or puts), due to their simplicity. However, there are definite advantages to becoming familiar with the flexibility of risk and reward when using option spreads.

An option spread is the combination of two different option types or strike prices to attain a common goal. The term option spread can be used to refer to an unlimited number of possibilities. For example, an option spread can involve the purchase of both a call and a put with the same strike prices, or it can be the purchase and sale of two calls with different strike prices. The sheer number of possibilities makes this topic beyond the scope of this book, but if you are interested in learning more on option spreads, you might want to pick up a copy of Commodity Options, which I authored and was published by FT Press.

To add to the confusion surrounding commodity vocabulary, an option spread has its own bid/ask spread. Just as a single call or put would have a price that you can buy it for and a price you can sell it for, a spread is priced as a package and has both a bid and an ask that represent the purchase or sales price for the combination of options.

Fortunately, when dealing with a spread on a spread, most insiders identify the bid/ask spread by its full name and also refer to the option spread by its specific name. For example, if a broker calls the trading floor to get a quote for an option spread, she might say something like this to the clerk who answers the phone: “Will you get me the bid/ask on the 900/950 call spread?” Similarly, when accessing an option spread quote via an electronic trading platform, a trader inputs the appropriate strike prices and designates the query as a “vertical call spread,” or some other type of recognized spread structure.

It is important to realize that, when getting a quote for an option spread, it isn’t necessary to decipher whether you will be buying or selling the spread. This is because the broker or trading platform gives you the quote for doing each. Therefore the bid/ask spread—the spread can be bought at the ask and sold at the bid.

Once again, option spreads are too complex to discuss in any detail within this text. However, you need to realize that, when it comes to option spreads, if the price of the long option of the spread is higher than the price of the short options, the trader is buying the spread. If it is possible to collect more premium for the short legs than is paid for the long legs, the trader is selling the spread.

The increasing popularity of electronic trading platforms, and the resulting transparent option pricing, has encouraged many traders to place separate order tickets on various legs of their spreads instead of entering a single ticket to enter the trade as a package. For instance, an option spread between a long and a short call option could be entered using a spread order in which both legs are executed simultaneously. Alternatively, a trader could simply place an order to buy the desired call option, and then another to sell the other call option to complete the spread.

For margin purposes, option spreads are treated the same whether they are entered on one ticket or multiple tickets. However, some brokers with strict order entry risk policies might prefer traders to enter spreads on a single order ticket so that they know the trader’s intention before approving and executing the order. In other words, overactive risk-management desks might reject certain orders intended to be a part of a spread due to misunderstood risk and margin consequences.

In conclusion, traders are doing themselves a disservice by ignoring the potential benefits of incorporating option trading into speculation. Although option trading can seem complex on the surface, you owe it to yourself to be familiar with all the tools available to you as a trader. After all, taking the “easy road” in life often fails to be beneficial in the end, and this may be no different.

  • + Share This
  • 🔖 Save To Your Account

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.

Overview


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information


To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.

Surveys

Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.

Newsletters

If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information


Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.

Security


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.

Children


This site is not directed to children under the age of 13.

Marketing


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information


If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.

Choice/Opt-out


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information


Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents


California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure


Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.

Links


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact


Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice


We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020