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Trading Options on Commodities

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Most of the subjects we tackle here in Know Your Options are about equity options. The bulk of Zacks’ research is in equities, so I assume that most of our readers who trade options are looking to speculate on a stock, protect a position in a stock or make income from selling options on a stock.

Lately, though, there’s been a lot of news that has affected the prices of agricultural commodities, so I’d like to provide a quick primer on how someone might speculate or hedge with commodity options.

Some of the news is man-made – primarily the effect of trade wars on the price of agricultural exports. The market for soybeans in particular has been crushed by huge reductions in exports to China.

Some of the news is natural – heavy rains and generally poor weather in the Midwest have delayed the planting of crops, especially corn.  As farmers in various states reach the date at which they must choose to plant or file crop insurance claims, it appears that 2019 might be a lean year for the corn harvest.

If you have an opinion on the direction of commodity prices, there are liquid futures and options available at the CME Group’s (CME - Free Report) Chicago Board of Trade.

Trading futures and futures options can seem intimidating, but the basic concepts aren’t really all that different from equity options. You’ll just need to familiarize yourself with some small mechanical  differences.

First, you’ll need to be able to trade futures in your brokerage account. This process is different at each brokerage house, but almost all of the popular online brokerages now offer futures trading.

Next, you’ll need to understand the contract specifications. In the case of agricultural commodities, each contract is for 5,000 bushels of the underlying and the prices are quoted per/bushel. So if you were to buy one Corn futures contract for a price of $3.75/bushel, you now own 5,000 bushels. If the price increases to $4.00/bushel and you sell, your profit would be $1,250 (net of commissions and fees.)

5,000 * $0.25 = $1,250.

Note: You’re generally going to want to close a futures position prior to expiration. Though there are colorful anecdotes about a trader who neglects to close a position and has 5,000 bushels of corn deposited on his front lawn. It’s good comedy, but it’s not true. Physical delivery occurs at railway junctions or ports and if you accidentally take delivery, it’s not going on your lawn, but you will pay steep fees to dispose of the product.

Options

CME’s commodity options settle to futures contracts. That means that if you own a call option that expires in the money, you are now long a futures contract at the strike price. In the same example as above, if you purchased a call with a strike of $3.75 for $0.10, you’d be risking $500 (5,000 bushels times the $0.10 premium)

If the price of a bushel of corn was $4 when the call expired, you’d buy one futures contract for $3.75 which you could either liquidate for a total profit of $750 ($1,250 – the $500 premium you paid) or which you could continue to hold.

If you didn’t want the futures contract, you could simply sell the option in the open market prior to expiration. If it’s 25 cents in the money, there’s a good chance it will be trading for something very close to that amount on the final day of trading.

CME

Your most important resource is going to be the CME’s website. It’s full of information about contract specs and the mechanics of trading and expiration – including especially dates and times.

Trading futures and options on futures doesn’t need to be confusing. Just make sure you’re acquainted with the products you’re trading and then go take your position. 

-Dave


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