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Commodity Put Option

What is a Commodity Put Option?

A Commodity Put Option is a contract that grants the Producer the right but not the obligation to sell a specified quantity of a commodity to the Consumer at a fixed price before a stated future date.

Objective

The purpose of a Commodity Put Option is to establish a minimum income from a future sale of a commodity. It limits the downside risk while maintaining the ability to trade at a higher spot rate if market prices rise.

How does it work?

An oil Company knows they will have produced 500 barrels of oil in a year’s time. They do not want to pay for storage any longer than necessary and do not want to sell the oil for less than $105 a barrel. They buy a put option with a strike price of $105. If the price falls below this level they will exercise the option and have the right to sell oil to the Buyer at $105 per barrel. But if the price is above the strike they can allow the option to expire and sell their barrels at the market rate.

Advantages
  • Provides the Producer with a minimum income
  • Gives the Producer the opportunity to benefit from higher prices
Disadvantages
  • The Producer will incur a premium cost, usually paid up-front
  • If prices rise above the strike rate during the tenor of the option, the Producer may feel they received no value

Commodity Put Option example:

 

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