Commodity Options

The business of commodity future option trading is not for the faint of heart. It is a complex and risky endeavor. Surely there are few other investments where the words written in Proverbs 23:5 are better illustrated: Wilt thou set thine eyes upon that which is not? for riches certainly make themselves wings; they fly away as an eagle toward heaven. This is not to say that some people haven't realized great profits, for unless they had, no doubt the history of trading options and futures would have been much shorter. Rather, the intent of this article is that one enter into such pursuits with eyes wide open and after investigating the issue thoroughly. Only by considering one's own financial goals and resources, -- and understanding the process and pitfalls of commodity future option trading -- can wise financial decisions be made.

The most important portion of the decision to enter into commodity future options is that of ascertaining personal goals and resources. Only funds which are not needed for living expenses should be invested. This is not the place to speculate with funds which are needed in the future for a child's education, or retirement expenses. Do not use monies set aside for that down payment on a house, or other dreams, unless one has full agreement with a spouse. There is a great deal of loss experienced in the process of commodity trading. One must be able to ride out periods of loss, or dispassionately dispose of trading contracts which are non-productive. Decisions must be made with the mind rather than the emotions, which is difficult enough without the added pressure of knowing that funds are essential to present lifestyles or future needs.

As to the process of futures trading, some basic information is needed. To understand a futures contract, it would first be helpful to understand a forward contract. A seller agrees to provide a certain amount of product, for a certain price, by a certain date -- say, a farmer agrees to provide 25 bushels of tomatoes at $1 a bushel by June 16th of that year. (This is opposed to a spot contract, where the farmer would immediately load the 25 bushels into the buyer's truck, receive his payment, shake hands and drive off.) This process works well, but it is sometimes difficult to find someone who wants to buy what one has to sell, at the price and time available. Futures, on the other hand, are sold in an exchange where terms are standardized for contract size, quality, delivery months and locations. A wide variety of futures are available not only in agricultural products, but also for precious metals, financial instruments, fossil fuels and non-traditional commodities. Interestingly, in the U.S. at least, prices (especially for agricultural products and other physical commodities) are set in an open outcry type of situation, where traders in a ring or pit call out various bids. In other countries, and increasingly in the U.S. as well, commodity future option trading is done on an electronic platform, and bids and offers are posted on a computerized system.

There are two main types of buyers of commodity future options: hedgers and speculators. Speculators, of course, are those who are seeking to profit from purchases and sales of commodity future options. Hedgers seek to eliminate some of the risk involved in the sale of an actual product or commodity. By purchasing options, hedgers try to avoid losses which could possibly occur due to price swings or the lack of a buyer. Futures are legally binding agreements to buy or sell a commodity in the future, and are standardized by quantity, grade, delivery location and date. Options are contracts which convey the right (but not the obligation) to buy a certain item at a certain price for a limited time period. Only the seller is obligated to perform. Of course, if the buyer does not exercise his or her choice, the right to do so will expire, along with the money spent to obtain it. Commodity future option trading is regulated by the Commodity Futures Trading Commission (CFTC), which reviews the terms of proposed commodity future options contracts to be sure that they include acceptable trading practices and are not subject to manipulation. Companies and people who handle funds or give trading advice must register with the National Futures Association (NFA), an organization recognized by the Commission.

Many futures contracts never arrive at the point of delivery. Instead, owners offset them by purchasing an opposing position from the exchange, which acts as both buyer and seller in each transaction. The actual commodity is sold in a spot market. The owner uses the contract as insurance or a 'hedge' against market uncertainties. This allows the owner to have a variety of options for gaining a profit. However, there is still risk involved because there is no guarantee that options prices and the actual selling prices in spot markets will result in a beneficial outcome.

Risks should be considered at the very beginning of the process of commodity future option trading. Materials outlining risks and past performances must be given to prospective customers. These should be read carefully and any questions addressed before signing contracts. It is especially important to understand the legal obligations involved. Contracts can be purchased by traders on margin. The margin account is to ensure that financial obligations can be met. If the futures market declines, loss occurs in the margin account. If the market is favorable, profits will be reflected in the margin account. However, if the market is unfavorable, at a certain point more money must be posted to the margin account. It is possible that one may find oneself responsible for far more than the original monies invested. It is imperative that an investor check out the firm's registration and disciplinary history with the NFA before commodity future options are purchased.