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 the 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 it will have produced 500 barrels of oil in a year. 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
Allows the producer 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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