Commodity put option
Summary
A commodity put option is a contract that grants the producer the right but not the obligation to sell a specified quantity of a commodity to the consumer at a fixed price before a stated future date.What is a commodity put option?
A commodity put option is a contract that grants the producer the right but not the obligation to sell a specified quantity of a commodity to the consumer at a fixed price before a stated future date.
Objective
The purpose of a commodity put option is to establish a minimum income from a future sale of a commodity. It limits the downside risk while maintaining the ability to trade at a higher spot rate if market prices rise.
How does a commodity put option work?
An oil company knows they will have produced 500 barrels of oil in a year’s time. They do not want to pay for storage any longer than necessary and do not want to sell the oil for less than $105 a barrel. They buy a put option with a strike price of $105. If the price falls below this level they will exercise the option and have the right to sell oil to the buyer at $105 per barrel. But if the price is above the strike they can allow the option to expire and sell their barrels at the market rate.
Three scenarios of where the market price could settle and what the borrower will need to pay.
Advantages
- Provides the producer with a minimum income
- Gives the producer the opportunity to benefit from higher prices
Disadvantages
- The producer will incur a premium cost, usually paid up-front
- If prices rise above the strike rate during the tenor of the option, the producer may feel they received no value
An example of what a commodity put option trade could look like.
Commodity put option graph showing three potential outcomes over time.
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Disclaimers
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.
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