Options are derivatives. The value of an option is impacted by a range of different underliers, such as commodities, stocks, indexes, and more.

An option contract allows the investor to trade assets. With an option contract, the purchase and sale prices are agreed upon from the outset. A time frame is also assigned to the contract and a decision must be made in that time. The trader is never obligated to trigger the purchase clause in their option contract. As the name suggests, it is an option. The one who purchases an option contract is often called the holder, while the seller of the contract is referred to as the writer.

There are two types of option contracts out there. American options contracts allow the holder to trigger the option at any point between the start date and the expiration. European options contracts can only be triggered on a pre-agreed day. In Netherlands, you can only take out European-style options contracts – American options contracts are not available. 

The Key Features of an Option Contract – 

• Option – The most important feature of an option contract is the option itself. The holder always has the option to trigger the trade, never an obligation. 
• Settlement – If the option is not triggered – and the holder has every right not to trigger the option – then there will be a settlement. This is when nothing is traded, and the contract ends.
• Strike price – The strike price is the amount the holder will pay if they trigger the option contract. The strike price is agreed between the holder and writer when the contract is first created and never changes.
• Date – The expiration date is agreed upon when the option contract is first created. It never changes. If the expiration date is reached and the option has not been triggered, the contract ends.
• Shares – The number of shares is pre-agreed when the option contract is first created. If the contract is for 25 shares, then it always stays at 25 shares. It cannot change.
• Value – You can work out the value of the contracted asset by taking the current market price away from the agreed-upon strike price.

A commodity option is a contract that involves the trading of commodity futures. These contracts allow the holder to buy or sell at a pre-determined price. The option in the contract can only be triggered on a set day, never before and never after. Commodity options and equity options are completely different, and the majority of regulators in India only allow option contracts with commodity futures.

Call options involve underlying commodity futures. The holder of a call option contract has the ability to trigger a trade at any time during the length of the contract. They also have the ability to trigger the trade for a pre-agreed price on a pre-agreed date. If the contract is triggered, the options contract will expire on a pre-determined date and turn into a futures contract. The holder aims to trigger their option if the market value is higher than the strike price they agreed to in the contract. That is how they make their profit.

Let’s take a look at a real example. A trader is looking around for potential commodity call options and they come across a futures trading at 500 USD. After looking into the asset, they expect the prices to fall, but not dramatically, leaving a window of opportunity for profit. They agree to a call option contract with the seller with a strike price of 300 USD. They pay a premium of 50 USD to create this contract. On the expiration date, the futures is now trading at 400 USD so the holder triggers the option in their contract. They pay 300 USD for an asset actually worth 400 USD, minus the 50 USD premium. That leaves them with a profit of 50 USD.

Alternatively, if the futures was trading at a price of 200 USD on the expiration date, the holder would not trigger their option. This is because they would have to pay a strike price of 300 USD for an asset only actually worth 200 USD. However, they would still have to pay the premium of 50 USD to the seller.

A commodity put option is similar to a commodity call option, but it puts the power in the hands of the seller instead of the buyer. The seller has the chance to sell an underlying commodity futures for a set price on a set date (usually the last Thursday of the month). Come the expiration date, the seller can choose to sell the commodity for a profit, or let the contract expire. Either way, they will still have to pay the premium to take out the contract in the first place. 

Let’s take a look at a real example. A trader currently owns a particular futures and expects the value to rise in the next month, but perhaps not as highly as some others expect it to. The futures is currently worth 500 USD and the trader agrees to a put option contract with a strike price of 750 USD. They have to pay a premium of 50 USD to take out this contract. One month later, the value of the futures has indeed increased, but only to 600 USD. Therefore, the trader can trigger their contract to sell at the pre-agreed 750 USD. Once the premium has been taken off, this would give them a profit of 100 USD.

Alternatively, if the value of the asset increases far more than expected, the trader’s decision will change. After one month has passed, if the futures is now trading at 1000 USD the trader would decide to let the contract expire, instead of selling at just 750 USD. However, they would still have to pay the premium of 50 USD.

The main advantage of a commodity option contract is the potential gains with minimal risks. The trader can take a short position without putting themselves at risk of major financial loss, because the premium is pre-determined and the option is always in their own hands. Either the price moves in your favour, and you trigger the option to make a profit, or the price moves against you, and you let the contract expire, only losing the premium. These contracts become far riskier when there is an obligation involved, as the power is removed from the hands of the trader.