3 Steps to Understanding Commodity Option Trading

Commodity option trading is setting a price today for a purchase that will take place in the future. Here are three simple steps to understand what is occurring.

#1 Use an Example

Today, a purchaser would like to set a price of $200 a head for cattle six months from now. The seller agrees. In six months, the price rises to $220 a head. The buyer can exercise the contract, getting a discount on the cattle, and then reselling them for a profit. 

#2 Differentiate the Two Parties

There are two parties in every commodity trade: the speculator and the seller. These parties can flip flop from trade to trade depending on who is holding what commodity at what time. The seller wants to set a price higher than the actual price, and the speculator wants a set price to be lower than the market price at the time of trade.

#3 Understand the "Trade"

It is important to realize "trade" does not mean physically changing hands in most cases. It is rare for a commodity to actually be delivered in an options contract. More often, the speculator who purchased the cattle will pocket the $20 profit per head into his trading account without ever seeing the product.


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