Commodity Option Basics

COMMODITY OPTION BASICS

You may already be familiar with options basics on individual stocks such as a call option on 100 shares of Apple (NASDAQ AAPL) or a put option on 100 shares of Yahoo! (NASDAQ YHOO).

Yet this is only a small set of the investable options that are available to the retail trader. There are many other markets that are unrelated to stocks and that can therefore provide not only diversification but trading opportunities even when stocks are quiet. These are the commodity or futures markets.

There are a great and diverse number of active futures markets and you can buy options on any of them. For example, there are options on agricultural commodities such as wheat and soybeans, options on precious metals such as gold and silver, options on the "soft" commodities such as cotton, cocoa and orange juice, options on energy futures such as crude oil and gasoline and options on financial futures such as bonds, foreign exchange and stock market indices.

Options on commodities trade on a regulated futures and options exchange. There has been extensive consolidation among futures exchanges within the United States over the last decade leaving essentially only two players: CME Group as the industry leader and ICE Futures U.S.

According to CME Group, over 486 million option contracts were traded in 2011. Open outcry is still the most common method for executing commodity option trades though electronic execution is growing in popularity and some contracts, such as options on the E-mini® S&P 500® futures, can only be executed electronically.

When considering the purchase of a commodity option, it's important to have market data at your fingertips. Delayed prices of commodity call and put options as well as prices and charts of the underlying commodity futures, are made available free of charge on the web site of the relevant exchange. Quick links to these resources and instruction on their practical application for select popular markets can be found under the section Option Examples on the home page.

Almost Identical If you are already familiar with options on stocks or equities, then it's just a short step to understanding options on commodities. In fact, the nature of the investment vehicle, whether a call or put, is the same. The only difference is the underlying interest. Instead of 100 shares of stock, a commodity option is based on an underlying commodity futures contract. So, it is the price behavior of the underlying commodity futures that determines the value of the corresponding option and your decision about whether to buy a call or put option on a commodity will be based upon where you expect the price of the commodity futures is likely to go.

Popular Options on Futures
Jan - Dec 2011 Trading Volumes

EURODOLLARS
10-YR TREASURY NOTES
CRUDE OIL (WTI)
E-MINI S&P500
CORN
NATURAL GAS
SOYBEAN
30-YR TREASURY BOND
S&P 500
5-YR TREASURY NOTE
COMEX GOLD
SUGAR-11
EURO FX
WHEAT
COTTON
COFFEE
100,855,181
50,797,081
37,691,034
36,130,942
28,650,380
26,303,557
13,236,367
12,849,585
11,718,229
10,849,707
10,080,754
6,667,573
5,684,036
4,680,418
2,794,411
2,624,667

Source: CME Group and ICE Futures U.S.

The following trademarks and service marks are owned by Chicago Mercantile Exchange Inc.: CHICAGO MERCANTILE EXCHANGE®, CME E-mini®, CME®, E-mini® and Globex®. The following are trademarks of The McGraw-Hill Companies: S&P®, S&P 500®.

Keywords: commodity option basics, options on stocks, understanding options
Abstract: The basics of commodity options are not too different from options on stocks - it's just a small step forward.