Options are available as either a Call or a Put, depending on whether they give the right to buy, or the right to sell. Call options give the holder the right to buy the underlying commodity, and Put options give the right to sell the underlying commodity. The buying or selling right only takes effect when the option is exercised, which can happen on the expiration date (European options), or at any time up until the expiration date (US options).
In search of a promising commodity option trade, it is important to look at whether or not the options are priced fairly. Option prices fluctuate according to supply and demand in the underlying commodity market. At times, options on futures prices become inflated or undervalued relative to theoretical models such as Black and Scholes. For example, during the "crash" of 2008 the value of put options exploded as traders scrambled to buy insurance for their stock portfolios or simply wanted to wager that the equity market would go down forever. The increase in option premium was partly due to inflated volatility but increased demand for the instruments had a lot to do with it. Those that chose to purchase put options at inopportune times and at overvalued prices, likely didn't fair very well.
In, At, or Out of the Money: If an option is in the money, its premium will have additional value because the option is already in profit, and the profit will be immediately available to the buyer of the option. If an option is at the money, or out of the money, its premium will not have any additional value because the options are not yet in profit.
Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call option—instead of buying the stock outright—is attractive to some traders since options provide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared to the full price of a $100 stock.
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Options on futures contracts are exactly what the name implies, they give traders "options". They are capable of being used in nearly every commodity market scenario and with variable risk and reward profiles. Too many traders fail to tap the true potential and flexibility of option spreads due to their seemingly complex nature; however, things aren't always as they appear. We strongly believe that you owe it to yourself to overcome your fear of trading commodity options and open your mind to the possibilities.
Futures options can be a low-risk way to approach the futures markets. Many new traders start by trading futures options instead of straight futures contracts. There is less risk and volatility when buying options compared with futures contracts. Many professional traders only trade options. Before you can trade futures options, it is important to understand the basics.
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.
When buying or selling options, the investor or trader has the right to exercise that option at any point up until the expiration date - so simply buying or selling an option doesn't mean you actually have to exercise it at the buy/sell point. Because of this system, options are considered derivative securities - which means their price is derived from something else (in this case, from the value of assets like the market, securities or other underlying instruments). For this reason, options are often considered less risky than stocks (if used correctly).