What is an option and how does it work in the commodity derivatives market? Here is all you need to know about options.
An option is a contract that conveys the right, but not the obligation, to buy or sell a particular item at a certain price for a limited time. Only the seller of the option is obligated to perform.
An option gives the right but not the obligation to buy (call option) or sell (put option) an underlying commodity or financial instrument at a specified price (exercise price or strike price) by or at a certain date in the future.
In the context of commodity options, the underlying instrument is usually the commodity future. It is therefore a derivative of a derivative. Options on commodity futures can be thought of like insurance.
An option buyer (the insured) pays a premium to an option seller (the insurance company) for the right to buy or sell a futures contract at a specific price. However, just like with insurance, the option buyer may or may not exercise his right (use his insurance).
Options on futures are different from futures themselves in the sense that the most a buyer can lose is the cost of purchasing