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About Commodity Option
- It represent a right to purchase or sell commodities at agreed prices and dates
- For this right, the buyer pays a premium to the seller, normally paid 2 business days after the trade date
- Instrument shall mean exchange of fixed payments for payments depending on current prices or average reference commodity prices
- Commodity Option is intended for investors, who wish to hedge commodity risk arising from potentially adverse price movements of specific commodity and also wish to potentially benefit from the opposite movement
- It is a unilateral transaction – payments on the part of the buyer are limited to the payment of the premium (there is no credit risk for the seller associated with the buyer following the collection of the premium)
- Transaction settlement is always financial, not physical
- Clients with slightly worse financial standing may also buy options
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Commodity Option types:
- Buyer hedges risk of increasing commodity prices
- The option will be exercised if the commodity price / average of reference commodity prices exceeds Cap price on the last day of the reference period
- Buyer hedges risk of declining commodity prices
- The option will be exercised if the commodity price / average of reference commodity prices drops below the Floor price on the last day of the reference period
Available product modification:
- Product modification, where the underlying commodity is listed in currency different from the settlement currency
- Product modification, where the underlying asset is made up of several commodities (i.e. a basket)
Deferred price fixing:
- Product modification, where a the fixed price is not known on the day the transaction is negotiated
- The price is determined on the basis of average daily fixings during a specific future period
- Settlement usually takes place 2 to 5 business days after the end of each reference period, on the basis of a cash settlement price published on days agreed upon transaction negotiation (usually end of each reference period)
Settlement amount for the reference period: PA = NA * max(0, CSP – P), where:
- PA – payment amount
- NA – notional commodity amount
- P – agreed fixed price
- CSP – Cash Settlement Price or average price, as agreed
Graph: Commodity option settlement
Important information for you
- Profit or loss from commodity transactions is affected by fluctuations in the prices of the given commodity
- Risk associated with purchased options is lower than for sold options
- Maximum loss for the option buyer is limited to the paid premium
- Risk associated with sold options is much higher – loss of the option seller may significantly exceed the received premium, with the risk being virtually unlimited
- Option seller commits to purchase or sell underlying instruments
- In case an option is exercised, the option seller is in a situation, where the current market price of underlying assets sold by the seller may be significantly higher than the strike price or, conversely, the current market price of underlying assets purchased by the seller may be considerably lower than the strike price (to which the seller committed)
Entrepreneurs and legal entities – domestic and foreign.
The objective of Commodity Options is to provide protection from adverse development of commodity prices.