Commodity Options

How they differ from options on other assets

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Commodity Options have fat tails.

The first option ever traded was on an agricultural product- the olive. In the sixth century BC, the Greek philosopher Thales, in the ancient city of Miletus, bought the rights to an olive harvest. According to the story, related by Aristotle, Thales made a handsome profit betting that the following year's olive harvest would be plentiful. By the year 1636, options were widely traded in Amsterdam during the period of tulip bulb mania, the first recorded market bubble.

During the first half of the following century, options were popular instruments in London until they were associated with excessive speculation and rendered illegal in 1733 via legislation called Barnard's Act. In 1860, options once again became legal financial instruments.

Options are price insurance. The buyer of an option is the insured party while the seller, or grantor, of an option acts as the insurance company. The buyer of an option is only at risk for the price paid for the instrument, which is the option premium. The seller of an option has unlimited risk, all the seller can earn is the premium received for selling the option.

There are a number of terms and concepts involved in understanding options:

  • Call option- the right but not the obligation to purchase an amount of an asset at a specified price for a specific grade (quality) during a specified period of time.
  • Put option- the right but not the obligation to sell an amount of an asset at a specified price for a specific grade during a specified period of time.
  • Option premium- the amount a buyer pays for an option and the amount the seller receives for granting (often referred to as writing) an option.
  • Strike price- the specified price of the option, not the premium but the insurance level.
  • Expiration date- the specific time period of the option
  • Exercise- the buyer has the right to exercise an option at expiration. The owner of a call option who exercises receives a long position in the underlying asset. The owner of a put option who exercises receives a short position in the underlying asset.

    Option strike prices can be at any price level, the intrinsic value of an option is one of the factors that determine an option's price (premium). There are three types of option strike prices:

    • Out of the money- an option that has zero intrinsic value. Example: call option on gold with a strike price of $1300 when gold is currently $1200 has no intrinsic value.
    • In the money- an option that has intrinsic value. Example: a call option on gold with a strike price of $1200 when gold is currently $1300 has $100 of intrinsic value.
    • At the money- a strike price equal to the current market price. Example: a call option on gold with a strike price of $1200 when gold is currently trading at $1200 is an at the money option.

     

    Many different variables go into option prices or premiums including interest rates, the supply and demand for options themselves or the number of buyers and sellers of options and the underlying price of the asset. However, the chief determinate of option prices is implied volatility. There are two types of volatility, historic and implied. Historical volatility is the measure of price fluctuations in the past. Implied volatility is the market's perception of future price fluctuations or future range from high to low.

    Options are derivatives; they trade on many different assets including equities, currencies, debt and commodities.

    Fat tails- why commodity options differ from others

    Commodities are different from other assets because they have wider price ranges or higher historical volatility. The price of a commodity can go up 100% or half over a very short period. For this reason commodity options are more expensive than options on other assets--commodities tend to have higher implied volatility. This is particularly true when it comes to out-of-the money options. Market participants are willing to pay more for these options because the odds that they will pay off are better. As the chart illustrates, this is the fat tail effect in commodity options.

    Stocks, bonds and currencies can be volatile at times but the odds of huge moves are lower than those odds in commodity markets.

    That is why out of the money options, particularly deep out of the money options in commodities trade at higher premiums than they do in other assets.

    Options are amazing instruments for buyers and sellers alike. Buyers can leverage market views for small premiums for a desired period. Sellers can earn income. In commodities, option premiums tend to be more expensive than in other options because commodities tend to be more volatile.