Reading Commodity Option Quotes
Below is market data from a commodity option trading market. First look to the far left on the blue bar. The text “milk options” (green circle) tells us that these are options on milk. The product that the option is for is called “underlying”. There is commodity option trading for loads of different underlying products. For example Soy beans, lean cattle and crude oil.
Further below the name of the underlying, in the white field it says “MTH/STRIKE” (blue circle). In the column below this heading there are two pieces of information. MTH means “month” and strike means “strike price”. The month is simply the time when the milk is to be delivered. That is right. Commodty option trading is not for delivering the underlying right now. Delivery takes place at a later time, the delivery date. In our example the delivery month is December 2006. In the exchange's’s product specification you can find out exactly which day and time.
The strike prices are the numbers in the column below the delivery month. The lowest strike price is 1050$, second lowest 1075$ and so on. So how can there be many prices for the same thing? Remember that the milk will be delivered in the future. Not now. You can choose which price you want to agree on. This will be clearified further down the page. Look at the row that says which delivery month these options are for again. Just after “DEC06 MILK OPTIONS” (red circle) it says “CALL”. Call means that these options are for the right to buy milk. Right to buy? Is it an agreement or not? Well, that is exactly the point with commodity option trading. It’s not a fixed agreement. It’s flexible where one guy gets to decide if the milk will be delivered and paid for, or if there will be no delivery and no payment. The other one just has to do the first guy says. The first one has the option but the second does not. That’s why it’s called an option. One more important fact is that the decision doesn’t have to be made now. You can wait all the way to delivery date to decide if you want to.
So why on earth would anyone make an agreement, and then leave it up to the counterparty to decide if the deal will be carried through or not? Off course you would ask for compensation to do that. The person who wants the choice would have to pay for it otherwise you’d never agree to it. Exactly. Look at where it says “STRIKE” again. On the same row, four columns to the right it says “LAST” (black circle). This column shows the price of the that right. That’s correct, an option comes with two price tags. The strike price is the price to be paid for the milk IF delivery takes place. The second is the compensation for the right to choose. The guy who wants the choice/option to decide has to pay this amount to the guy who does not get to choose. Right now. Not when the milk is delivered. In commodity option trading this is sometimes refered to as the option premium but most often just “price”. Now it make more sense why someone would let the counterparty choose. One guy get to choose and the other guy gets some money up-front. Now we’ve covered the basics of the information every commodity option trader needs about an option. Next step is to understand what determines the size of the up front payment. How option traders value options.
Commodity Option Trading : The Option Price
Let’s say that you and I enter into opposite sides of the commodity option in row three of the quote table.
We’re talking a Dec-06 milk call with a strike of 1100$. You are the buyer and I am the seller. Remember, we’re talking about buying and selling the right to choose, not the milk. It’s a call option, so you get the option to buy or not to buy milk from me for delivery at 1100$ in December. For this you pay me 2.4$ right now. Is that a good idea? To start with you would want to check what prices people agree on for fixed milk delivery in December. Milk that will surely be delivered, no choice. Fixed agreements for delivery in the future are futures. So you check the futures market and find out that Dec-06 futures trade at 1036$. This is the first thing to do in commodity option trading when considering a trade. Check the futures market. On the next page we'll look closer at the value of an option.
