Commodity call option
Summary
A commodity call option is a contract granting the consumer the right but the not the obligation to buy a specified quantity of a commodity from a producer at a set price before a fixed future date.
What is a commodity call option?
A commodity call option is a contract granting the consumer the right but the not the obligation to buy a specified quantity of a commodity from a producer at a set price before a fixed future date.
Objective
The purpose of a commodity call option is to establish the maximum cost of a future commodity purchase. The buyer profits when the goods increase in market price.
How does a commodity call option work?
An oil consumer knows they will need to purchase 500 barrels of crude in a year’s time. They do not want to pay more than $105 per barrel and do not want to pay for storage. They buy a call option with a strike of $105. If oil prices rise above this level before the expiry of the contract, the consumer can exercise the option and pay $105 per barrel. If the market price is below the strike price, (e.g. $100) they can buy barrels at the market rate and allow the option to expire.
Three scenarios of where the market price could settle and what the borrower will need to pay.
Advantages
The consumer knows the maximum cost of a commodity
Allows the consumer to pay lower prices should the spot price fall below the strike price
Disadvantages
The consumer will incur a premium cost, usually paid upfront
If prices fail to rise above the strike price during the tenor of the option, the consumer may feel they received no value
An example of what a commodity collar option trade could look like.
Commodity call option graph showing three potential outcomes over time.
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