Legal Definitions - commodity option

A commodity option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell a specific quantity of a commodity at a predetermined price (known as the strike price) on or before a specific date (the expiration date). The seller of the option is obligated to fulfill the transaction if the buyer chooses to exercise their right. Commodities are raw materials or primary agricultural products, such as crude oil, gold, wheat, or coffee. Buyers pay a fee, called a premium, for this right.

• Example 1: Farmer Hedging Against Price Drops

  Imagine a corn farmer who expects to harvest 5,000 bushels of corn in four months. The current market price for corn is favorable, but the farmer is concerned that prices might drop significantly before their harvest is ready for sale, impacting their income. To protect against this risk, the farmer could purchase a "put option" for 5,000 bushels of corn with a strike price of $5.50 per bushel, expiring in four months. This option gives the farmer the right to sell their corn at $5.50 per bushel. If, by harvest time, the market price for corn falls to $5.00 per bushel, the farmer can exercise their option, sell their corn at the higher strike price of $5.50, and mitigate their potential loss. If, however, the market price rises to $6.00 per bushel, the farmer can simply let the option expire and sell their corn on the open market for the higher price, only losing the premium they paid for the option.

• Example 2: Manufacturer Protecting Against Rising Costs

  Consider a jewelry manufacturer who uses a large quantity of silver. They anticipate needing a significant amount of silver in six months for a new product line and are worried that silver prices might surge, increasing their production costs. To manage this risk, the manufacturer could buy a "call option" for 1,000 ounces of silver with a strike price of $25.00 per ounce, expiring in six months. This option gives them the right to buy silver at $25.00 per ounce. If, in six months, silver prices have indeed climbed to $28.00 per ounce, the manufacturer can exercise their option, purchase the silver at the lower strike price of $25.00, and keep their production costs predictable. If silver prices fall below $25.00, they can let the option expire and buy silver on the open market at the lower price, losing only the premium paid for the option.

• Example 3: Investor Speculating on Energy Prices

  An investor believes that upcoming global supply issues will cause the price of natural gas to increase substantially within the next three months. To capitalize on this prediction, the investor could purchase a "call option" for 10,000 MMBtu (million British thermal units) of natural gas with a strike price of $3.00 per MMBtu, expiring in three months. They pay a premium for this right. If natural gas prices do rise to $3.50 per MMBtu, the investor can exercise their option, buy the natural gas at $3.00, and immediately sell it on the market for $3.50, profiting from the price difference (minus the premium paid). If natural gas prices remain stable or fall, the investor would not exercise the option and would only lose the premium, as it would be cheaper to buy natural gas directly from the market.