Learn OTC derivatives — 36 products, short lessons and quizzes.
Cap or floor a commodity price
A commodity option gives its buyer the right, but never the obligation, to transact at a fixed strike price — a call to buy, a put to sell. That asymmetry is what a hedger pays for: unlike a swap or a forward, an option protects against the move that hurts while leaving the move that helps intact. The price of that one-sidedness is the premium, paid up front and gone whether or not the option is ever exercised.
Open in the app · Commodity · intermediate
A right to buy (call) or sell (put) a commodity at a strike price by expiry, often cash-settled against a reference price rather than physically delivered. The buyer chooses whether to use it; the seller has no choice and must perform if it is exercised.
At expiry the reference price is compared with the strike, and if the option is in the money the seller pays the difference on the contract volume. Many commodity options are Asian-style, settling against an average price over a period instead of a single date, which matches a hedger that buys or sells its physical commodity steadily through the month.
Averaging reduces the volatility of the settlement price, so an Asian option is normally cheaper than an otherwise identical option settling on a single date.
A call caps a consumer’s purchase cost; a put protects a producer’s selling price — both while preserving upside if prices move favourably. Because the premium can be uncomfortable, hedgers often fund it: a consumer buys the call it wants and sells a put below the market, so the two premiums roughly offset. That zero-cost collar keeps the cap but gives back the benefit of a large fall.
A collar is not free. The premium is paid in optionality rather than cash — the consumer that sells a put has agreed to buy at that floor no matter how far the market drops below it.
Strike, premium, underlying reference price, and expiry — the buyer’s maximum loss is always the premium paid. Contract volume sets how much the payoff is multiplied by.
Premium is quoted per unit of volume and paid up front: $2.50 a barrel on 100,000 barrels is $250,000, payable whether or not the option ever pays out.
Premiums can be steep for volatile commodities, and the whole premium is lost if the option expires worthless. Basis risk remains between the reference index and the physical grade actually bought or sold, and sellers face heavy losses if prices gap sharply — a sold call has no ceiling on what it can cost.
The effective cost is capped at the strike plus the premium — $104 — no matter how high the index goes. Had the average come in at $95 the option would have expired worthless, and the firm would have paid $95 + $4 = $99, still better than the cap.
Airlines and hauliers buy calls when they want a budget ceiling without forfeiting the windfall of a price collapse, and oil producers buy puts to guarantee a minimum realised price to lenders financing a field. Banks and trading houses write the other side and hedge the resulting exposure dynamically in futures.
The app adds a twelve-question bank for Commodity Option, drawn differently every sitting, and a review queue for whatever you miss.
A subscription adds 3 further sections on Commodity Option — Average price options are the default, Options on what, exactly, Volatility with a season in it — and 12 more questions to its bank.
Educational content only. Nothing here is financial advice, an offer to trade, or a recommendation to buy or sell any instrument.