Commodity futures used by companies give a hedge to the risk of adverse price movements. The goal of hedging is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that hedge use or producing the underlying asset of a futures contract. Examples of commodities hedging use include farmers, oil producers, livestock breeders, manufacturers, and many others.
Because options prices can be modeled mathematically with a model such as the Black-Scholes, many of the risks associated with options can also be modeled and understood. This particular feature of options actually makes them arguably less risky than other asset classes, or at least allows the risks associated with options to be understood and evaluated. Individual risks have been assigned Greek letter names, and are sometimes referred to simply as "the Greeks."
If there’s a company you’ve had your eye on and you believe the stock price is going to rise, a “call” option gives you the right to purchase shares at a specified price at a later date. If your prediction pans out you get to buy the stock for less than it’s selling for on the open market. If it doesn’t, your financial losses are limited to the price of the contract.
Of course, many investors, especially new investors, are skittish about options. After all, no investor is required to trade this way, and the transactions can seem complicated. But once you know the pros and cons of this type of investing, it can be a powerful part of your strategy. No investors should be sitting on the sidelines simply because they don’t understand options.
Combinations are trades constructed with both a call and a put. There is a special type of combination known as a “synthetic.” The point of a synthetic is to create an options position that behaves like an underlying asset, but without actually controlling the asset. Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options.
Options trading may seem overwhelming, but they're easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.
An equity option allows investors to fix the price for a specific period of time at which an investor can purchase or sell 100 shares of an equity for a premium (price), which is only a percentage of what one would pay to own the equity outright. This allows option investors to leverage their investment power while increasing their potential reward from an equity’s price movements.
For strangles (long in this example), an investor will buy an "out of the money" call and an "out of the money" put simultaneously for the same expiry date for the same underlying asset. Investors who use this strategy are assuming the underlying asset (like a stock) will have a dramatic price movement but don't know in which direction. What makes a long strangle a somewhat safe trade is that the investor only needs the stock to move greater than the total premium paid, but it doesn't matter in which direction.
Hedging a commodity can lead to a company missing out on favorable price moves since the contract is locked in at a fixed rate regardless of where the commodity's price trades afterward. Also, if the company miscalculates their needs for the commodity and over-hedges, it could lead to having to unwind the futures contract for a loss when selling it back to the market.
Whether the economy is hot or not, an investor can make money trading commodity options, regardless of the condition of the market. Briefly, a commodity option allows its owner to either sell or buy a commodity like corn or wheat at a future date. You will buy a so-called “put option” if you think the price of the commodity will go down and a “call option” if you think the price will rise. And never will you have to take possession of the commodity itself.
Trading in commodity futures contracts can be very risky for the inexperienced. The high degree of leverage used with commodity futures can amplify gains, but losses can be amplified as well. If a futures contract position is losing money, the broker can initiate a margin call, which is a demand for additional funds to shore up the account. Further, the broker will usually have to approve an account to trade on margins before they can enter into contracts.
Decide whether you think a commodity will sell for more or for less at some designated time in the future, then buy either a “put” or a “call” option. For example, you think that corn will cost more three months from now than it does now, so you will buy a “call” option on 100 bushels of corn which, in effect, locks in the cost of that commodity. Before the option expires, hopefully the price will go up, so your option will be worth more. Conversely, you will buy a “put” option if you think the price of the commodity will be less than it is today.
What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor wants insurance on his/her S&P 500 index portfolio, they can purchase put options. An investor may fear that a bear market is near and may be unwilling to lose more than 10% of their long position in the S&P 500 index. If the S&P 500 is currently trading at $2500, he/she can purchase a put option giving the right to sell the index at $2250, for example, at any point in the next two years.
However, for put options (right to sell), the opposite is true - with strike prices below the current share price being considered "out of the money" and vice versa. And, what's more important - any "out of the money" options (whether call or put options) are worthless at expiration (so you really want to have an "in the money" option when trading on the stock market).