The Handbook of Commodity Investing

CHAPTER 24

Commodity Options

Carol Alexander

Chair of Risk Management and Director of Research

ICMA Centre

University of Reading

Aanand Venkatramanan

Doctoral Researcher

ICMA Centre

University of Reading

There are three reasons to trade commodity options: diversification, hedging, and speculation. Options are included in investment portfolios because they have a limited upside or downside, compared with futures. Commodity options provide diversification because they have low correlations with equities and bonds. For that reason it is optimal to diversify by adding commodity options to standard portfolios despite their being risky instruments.

Risk managers use commodity options to hedge price risk. For instance, calendar spreads can be used to protect producers in a market that tends to swing between backwardation and contango. Average price options (where the payoff depends on the difference between some average of underlying prices and the option strike) are also popular for risk management because they are much cheaper than standard options—yet they still allow the purchaser to secure supplies at a fixed price.

Speculators use options as highly leveraged bets on price direction. For instance, a U.S. calendar spread call on the difference between the one-month futures price and the three-month futures price is a bet that futures will move to stronger backwardation at some time before the option's expiry. At exercise the purchaser receives a long position on the one-month futures ...