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With Energy and Metals on the Move, Consider Commodity Options

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With Gold near recent highs and Oil hitting recent lows, many investors might be considering speculative trades in those – and other – commodities as an opportunity for profits during a period in which they're difficult to find.

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.

Before the recent swings in energy and metals, there was a lot of news that has affected the prices of agricultural commodities. In general, those prices have recovered from their ows, but still trade well below the levels of 2016-2018.

Some of the news is man-made – primarily the effect of price wars on the price of Oil. The Saudis and Russia are on the way to resolving a recent dispute that briefly saw them both vowing to pump out oil at capacity levels.

Some of the news is natural – like the way the global shutdown and isolation orders because of Covid-19 have decimated demand for transportation fuels.

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 and well as on the Intercontential Exchange.

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.

I’ll use the (fairly simple) agricultural commodity contracts for an example, but the same principles about contract size and units of measure apply to all commodities.

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

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 5,00 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 and ICE

Your most important resource are going to be the websites of the Chicago Mercantile Exchange  and the Intercontinental Exchange (ICE). They’re 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

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.


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