Commodity Options: A New Opportunity

A relatively new investment vehicle has been approved by the Commodity Futures Trading Commission. The public will soon be able to trade in commodity options written on futures contracts traded on commodity exchanges. Although commodity options have been offered in the United States in the past several years, the underwriters were always undercapitalized and went bankrupt. Currently Americans can buy commodity options in London, but their prices are very high, going through at least two middlemen before the investor receives the offer. In addition, London commodity options have several deleterious features that will be mentioned shortly.

A commodity option is the right to buy or sell a futures contract, at a price specified in the option agreement, during a certain period of time known as the life of the option. In exchange for this right the purchaser pays a premium, or right, to the seller of the option. American commodity options will be traded similarly to stock options on the Chicago Board of Trade Options Exchange. Trading is scheduled to commence in July 1977, although a delay of one or two months would not be surprising. All options will be guaranteed by the exchange clearing houses, and the sellers will have to provide adequate margin daily. The pilot program will include option trading in silver and gold futures, as well as in copper, coffee, cocoa, sugar, and perhaps one or two other commodities.

American commodity options will have distinct advantages over London options. They will have an active secondary market. Unlike London options, in which each option sold has a different striking price (price at which the purchaser can buy the futures contract) and a different expiration date, American options will have standard striking prices and identical expiration dates. All calls (the right to buy a futures contract at a specified price—the striking price—any time between the date of purchase and expiration of the futures contract) purchased on December gold, for example, will expire on the same day in December. Instead of each striking price being determined at the moment of purchase, there will be active trading in a few standard striking prices. For example, if December gold is trading at $140 per ounce, there may be striking prices for December gold calls at $130, $135, $140, $145, and $150. Thus any $150 call on December gold will be a standard product, the same as hundreds or thousands of other calls written on December gold at $150. Because of this, there will be an active market for December gold calls at $150. Your investment will be liquid.

With London options, once the premium is paid your money is tied up until the option expires. If you change your mind about the investment, there is no way to liquidate the option. Even if you profitably exercise the option, your money is held until the option expires—perhaps several months later. In the American commodity option market, selling your option at any time will be as easy as calling your broker and placing a sell order. The price of purchase or sale will be determined by the auction bidding at any given moment. Importantly, and in contrast to London options, your option will not have to reach the striking price to have a value. If the price moves adversely, instead of losing the entire premium, your loss will be only a portion of the premium, as it can be resold to someone else at a lower price than the price at which you purchased it.

Commodity options can be used in a variety of ways. The basic purpose of a call is to profit, with limited risk, from an expected bullish price move. The price you pay for the option is the extent of your liability. If the price declines, you will face no margin calls or forced liquidations. You merely resell the option or permit it to expire. If the price moves favorably, you resell the option at a higher price and take your profit.

With the purchase of a call option you need only be concerned with the long-run price movement and can disregard the short-term fluctuations that in other investments require constant attention. With a long futures market position, a one- or two-day price decline can force your position into liquidation. Even if you were ultimately correct, with the price subsequently moving upward dramatically, you may no longer be in the market. But with a call position, once you've paid the premium, there will be no margin calls or liquidations. If you believe that silver, over the next several months, will rise to $5.50 per ounce, and the price is now $4.50 per ounce, a temporary price decline to $4.25 will not affect your position. As long as your ultimate forecast is correct, you will profit. Commodity options are the proper instrument for investors who cannot devote all their time to the market, who cannot constantly place additional margin into their account with every temporary decline, but who have strong convictions about the ultimate movement of prices.

Let us give an example of the purchase of a gold call. The call is written on a 100-ounce contract traded on Commodity Exchange, Inc., in New York (you can purchase it through any commodity broker, for a commission of between $50 and $75, negotiable). Let us say December gold is trading at $140 per ounce (December gold is gold deliverable in December), and you expect that between now and late December, when the contract expires, gold will experience a large price increase.

If you choose to buy a December gold call with a striking price of $145, you are buying the right to purchase a futures contract (for December delivery of gold at $145) anytime between the time of purchase and the expiration of December gold. For this right you pay a premium, or price. The price of the option would be something like $7.40 per ounce, or $740 for the 100-ounce contract. If the price of gold for December delivery rises, the value of your call will increase. If gold declines, the value of your option declines. The value is determined in the open market, in active trading, by bidding among potential buyers and offering among potential sellers.

If the price of gold shortly increased to $155, your call would have a higher value. The value would be at least $10 per ounce, because any purchaser of the $145 striking price call could purchase the call, exercise it, receive a futures contract at $145, and sell it at $155 in the futures market. But the value would in fact be higher than this, just as it had the $7.40 per ounce speculative value when you bought it. Its speculative value would also have increased because, as prices rise, option buyers become more optimistic. Its price would include the intrinsic value of $10 per ounce plus an increased speculative value of something like $8.50 per ounce, leaving a total price of $18.50 per ounce. If you sold the call then, you would have a profit of $1,850 less $740, or $1,110, an increase of over 100 percent. Calls are as leveraged as futures contracts themselves. Unlike with futures contracts, however, you can never lose more than you invest, for no matter how low the price of gold falls, the call can never be worth less than zero.

Although this explanation is brief, the reader can easily find detailed information on options trading from several books written on the subject or through his brokerage firm.

Stephen Wolf lives in New York and is in the business of trading commodities.