Legal Definitions - London commodity option

A London commodity option is a financial agreement that grants an individual or entity the right, but not the obligation, to either buy or sell a specific futures contract for a raw material (known as a commodity) that is traded on financial exchanges located in London. This right is exercisable at a predetermined price and must be acted upon within a specified period.

In simpler terms, it's a flexible contract linked to a future agreement for a physical good (like oil, gold, or agricultural products) where the trading takes place in London. The holder of the option can choose whether or not to complete the underlying futures transaction, depending on whether it's financially advantageous for them at the time.

• Example 1: A Coffee Importer Hedging Against Price Increases

  Imagine a large coffee importer based in Europe who anticipates needing a significant shipment of coffee beans in six months. They are concerned that global coffee prices might rise sharply before then, increasing their costs. To manage this risk, they could purchase a London commodity option for a coffee futures contract. This option would give them the right to buy a specific quantity of coffee futures at a set price (e.g., $1.50 per pound) within the next six months, with the underlying futures contract traded on a London exchange. If coffee prices indeed surge to $2.00 per pound, the importer can exercise their option, buying the futures contract at the lower $1.50 price, thereby protecting their profit margins. If prices fall, they can simply let the option expire and buy coffee at the lower market rate.

• Example 2: An Investor Speculating on Gold Prices

  Consider an investor who believes that geopolitical instability will cause the price of gold to increase significantly over the next three months. Instead of buying actual gold futures contracts immediately, which would require a larger upfront commitment, they decide to purchase a London commodity option. This option gives them the right to buy a gold futures contract, traded in London, at a specific price (e.g., $2,000 per ounce) anytime within the next three months. If gold prices climb to $2,150 per ounce, the investor can exercise their option, acquire the gold futures at the lower $2,000 price, and then sell them at the higher market rate, profiting from the price difference. If gold prices drop, their maximum loss is limited to the cost of the option itself.

• Example 3: An Airline Managing Fuel Costs

  An international airline is planning its fuel purchases for the upcoming winter season and is worried about potential spikes in crude oil prices. To mitigate this risk, the airline might buy a London commodity option that grants them the right to purchase crude oil futures contracts, traded on a London exchange, at a predetermined price (e.g., $80 per barrel) over the next nine months. This option acts as a form of insurance. If global oil prices unexpectedly jump to $95 per barrel, the airline can exercise its option, securing its fuel at the more favorable $80 price. This demonstrates the option's role in providing price certainty and protection against adverse market movements for a commodity traded in London.