What is a Commodity Option?
A Commodity Call Option is a contract granting the Consumer the right but the not the obligation to buy a specified quantity of a commodity from a Producer at a set price before a fixed future date.
The purpose of a Commodity Call Option is to establish the maximum cost of a future commodity purchase. The Buyer profits when the goods increase in market price.
How does it work?
An oil consumer knows they will need to purchase 500 barrels of crude in a year’s time. They do not want to pay more than $105 per barrel and do not want to pay for storage. They buy a call option with a strike of $105. If oil prices rise above this level before the expiry of the contract, the consumer can exercise the option and pay $105 per barrel. If the market price is below the strike price, (e.g. $100) they can buy barrels at the market rate and allow the option to expire.
- The Consumer knows the a maximum cost of a commodity
- Allows the Consumer to pay lower prices should the spot price fall below the strike price
- The Consumer will incur a premium cost, usually paid up-front
- If prices fail to rise above the strike price during the tenor of the option, the Consumer may feel the received no value
Commodity Call Option example: