BUYING PUT COMMODITY OPTIONS

Let's say that you think a bubble has developed in gold prices and you are consequently expecting the price to drop sharply at any time. Gold is a volatile market and therefore risky. Is there a way to trade your price expectation while also limiting risk of loss to a known and fixed quantity? There is. You can trade your hunch by buying a commodity put option.

A put option increases in value as the price of the underlying commodity falls so a put option on gold, for example, will increase in value as the price of gold drops, all else constant. For this reason, buying a put option is a bearish strategy. An option's price typically moves by only a fraction of the price of the underlying commodity depending upon the characteristics of the option.

As an investor, your goal is to buy this commodity put option and have its value increase. If this happens, then you have an unrealized capital gain on the option trade. You can realize this gain by simply selling the put option back to the market. In other words, to take profit on an option trade does not mean that you have to exercise the option. For more details, please see Managing the Trade under the pull-down menu, TRADING TIPS, found at the top of this page.

The value of a put option will tend to decline if the underlying commodity rallies in price but the value of the option cannot fall below zero. In other words, if you pay $800 for a commodity option, then this is the most you can lose in the worst-case scenario, plus brokerage commission and other trading fees. This limited risk feature is why buying commodity options for beginners is so advantageous.

An option that has zero value at expiration is simply removed from the trading account which closes the position. As the buyer or holder, you need not do anything. Of course, you need not sit and watch the option's value steadily decay toward zero. If you no longer feel that being short the market is appropriate, then you can close the option position by selling the put option. For more details, please see Managing the Trade under the pull-down menu, TRADING TIPS, found at the top of this page.

For any given commodity, there is usually a multitude of put options available for purchase each differing in cost based on their characteristics such as strike price and maturity. These factors must all be balanced when choosing the appropriate put option to purchase. For a discussion of these practical considerations, including reading option prices and performing a break-even analysis for various commodity markets, please see the pull-down menu, OPTION TRADES, found at the top of this page. You can also practice buying commodity put options in a futures and options paper trading account found under the RESOURCES section at the top of this page along with educational books and DVD's on options trading.