Introduction to Commodities
 
A commodity is any physical substance, textiles and food products such as grains and metals, which is interchangeable with another product of the same type and which investors buy or sell, usually through futures contracts.  The term is sometimes used more generally to include any product which trades on a commodity exchange; this would also include foreign currencies and financial instruments and indexes.  The price of the commodity is subject to supply and demand factors.  Risk is actually the reason exchange trading of the basic agricultural products began.  For example: a former risks the cost of producing a product ready for market at sometime in the future because he doesn't know what the selling price will be.  A speculator can pay the farmer or anyone else producing commodities because the speculator wants to make a profit.  This is called trading in futures.                                                                                                                                                                                                                                                                                        
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
                                                                                                                                                                        
The following is a list of commodities available for futures trading:

• Agricultural - grains, oils, livestock, wood 
• Metallurgical - metals, petroleum and chemicals
• Interest Bearing Assets - T-bills, bonds and notes
• Stock In-dices
• Currencies

 Most of these contracts are used by corporations to hedge positions taken elsewhere.  Some futures contracts (notably those for stock in-dices) are settled in cash because they are not deliverable goods.  The contracts also vary in terms of the transaction date and the quality level of goods to be bought and sold.  New futures contracts are created continuously, but many are not liquid enough to trade regularly and are used only as hedges.

Other ways to Trade Commodities

Options On Futures Contracts

What are known as put and call options are being traded on a growing number of futures contracts.  The principle attraction of buying options is that they make it possible to speculate on increasing or decreasing futures prices with a known and limited risk.  The most that the buyer of an option can lose is the cost of purchasing the option (known as the option "premium") plus the transaction costs.  Options can be most easily understood when call options and put options are considered separately, since, in fact, they are totally separate and distinct.  Buying or selling a call in no way involves put and buying or selling a put in no way involves a call.

Buying Call Options

The buyer of a call option acquires the right but not the obligation to purchase (go long) a particular futures contract at a specified price at any time during the life of the option.  Each option specifies the futures contract which may be purchased (known as the "underlying" futures contract) and the price at which it can be purchased (known as the "exercise" or "strike" price).

A March Treasury bond 84 call option would convey the right to buy on March U.S. Treasury bond futures contract at a price of $84,000 at any time during the life of the option.  One reason for buying call options is to profit from an anticipated increase in the underlying futures price.  A call option buyer will realize a net profit if, upon exercise, the underlying futures price is above the option exercise price by more than the premium paid for the option.  Or a profit can be realized it, prior to expiration, the option rights can be sold for more than they cost.  Example: you expect lower interest rates in higher bond prices (interest rates and bond prices move inversely).  To profit if you are right, you buy a June T-bond 82 call.  Assume the premium you pay is $2,000.  If, at the expiration of the option (in May) the June T-bond futures price is 88, you can realize a gain of 6 (that's $6,000) by exercising or selling the option that was purchased at 82.  Since you paid $2,000 for the option, your net profit is $4,000 less transaction costs.
 As mentioned, the most that an options buyer can lose is the option premium plus transaction costs.  Thus, in the preceding example, the most you could have lost--no matter how wrong you might have been about the direction and timing of interest rates and bond prices--would have been the $2,000 premium you paid for the option plus transaction costs.  In contrast if you had an outright long position in the underlying futures contract, your potential loss would have been unlimited.  It should be pointed out, however, that while an option buyer has a limited risk (the loss of the option premium), his profit potential is reduced by the amount of the premium.  In the example, the option buyer realized a net profit of 44,000.  For someone with an outright long position in June t-bond futures contract, an increase in the futures price from 82 to 88 would have yielded a net profit of $6,000 less transaction costs.  although an option buyer cannot lose more than the premium paid for the option,  he can lose the entire amount of the premium.  this will be the case if an option held until expiration is not worthwhile to exercise.

Buying Put Options

Whereas a call option conveys the right to purchase (go long) a particular futures contract at a specified price, a put option conveys the right to sell (go short) a particular futures contract at a specified price.  Put options can be purchased to profit from an anticipated price decrease.  As in the case of call options, the most that a put option buyer can lose, if he wrong about the direction or timing of the price change, is the option premium plus transaction costs.  Example: expecting a decline in the price of gold, you pay a premium of $1,000 to purchase an October 320 gold put option.  The option gives you the right to sell a 100 ounce gold futures contract for $320 an ounce.  Assume that, at expiration, the October futures price has--as you expected--declined to $290 an ounce.  The option giving you the right to sell at $3,000.  After subtracting $1,000 paid for the option, your net profit comes to $2,000.  Had you been wrong about the direction or timing of a change in the gold futures price, the most you could have lost would have been the $1,000 premium paid for the option plus transaction costs.  However, you could have lost the entire premium.

How Option Premiums are Determined

Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers.  three major variables influence the premium for a given option:

• The option's exercise price or more specifically the relationship between the exercise price and the current price of the underlying futures contract. All else being equal, an option that is already worthwhile to exercise ( an "in-the-money" option) commands a higher premium than an option that is not yet worthwhile to exercise (an "out-of-the-money" option).  For example: if a gold contract is currently selling at $295 an ounce, a put option conveying the right to sell gold at $320 an ounce is more valuable than a put option that conveys the right to sell gold at only $300 an ounce. 

• The length of time remaining until expiration.  All else being equal, an option with a long period of time remaining until expiration  commands a higher premium than an option with a short period of time remaining until expiration because it has more time in which to become profitable.  Said in another way, an option is an eroding asst.  Its time value declines as it approaches expiration.

• The volatility of the underlying futures contract.  All rise being equal, the greater the volatility the higher the option premium.  In a volatile market, the option stands a greater chance of becoming profitable to exercise.

Selling Options

At this point, you might as well ask, "Who sells the options that option buyer purchase?"  the answer is that options are sold by other market participants known as option writers or granters.  Their sole reason for writing options is to earn the premium paid by the option buyer.  If the option expires without being exercised (which is what the option writer hopes will happen), the writer retains the full amount of the premium.  If the option buyer exercises the option, however, the writer must pay the difference between the market value and the exercise price.  It should be emphasized and clearly recognized that unlike and option buyer who has  a limited risk (the loss of the option premium), the writer of an option has unlimited risk.  This is because any gain realized by the option buyer if and when he exercises the option will become a loss for the option writer.

Reasons for using Options

Options differ considerably from futures.  When used prudently, options can be of immense importance, especially in attempting to preserve the value of an existing fixed-income portfolio.  To many in the financial markets, options are considered "insurance" against diverse price movements while offering the flexibility to benefit from possible favorable price movement.  The reasons for using options on futures are reflected in the structure of n option contract...
First, an option, when purchased, gives the buyer the right, but not the obligation, to buy or sell a specific amount of a specific commodity at a specific price within a specific period of time.  By comparison, a futures contract requires a buyer or seller to perform under the terms of the contract if an open position is not offset before expiration.  Second, the decision to exercise the option is entirely that of the buyer.  Third, the purchaser of the option can lose no mare than the initial amount of money invested (premium).  That is not the case, however, for the buyer of a futures contract.  Finally, an option buyer is never subjected to margin calls.  This enables the purchaser to maintain a market position, despite any adverse moves without putting up additional funds.

Options Terminology

There are several important terms the would-be user of options on futures should understand.  They include:

Call Option - gives the buyer the right, but not the obligation, to put a specific futures contract at a predetermined price within a limited period of time.

Put Option - gives the buyer the right, but not the obligation, to sell a specific futures contract at a predetermined price within a limited period of time.

Holder - the buyer of the option.

Premium - the dollar amount paid by the buyer of the option to the seller.

Writer - the option seller.

Strike Price - the predetermined price at which a given futures contract can be bought or sold.  Also called the exercise price, these levels are set at regular intervals.  Example: if Treasury bond futures were at 79-00, T-bond option strike prices would be at 74, 76, 78, 80, 82 and 84.

At-the-Money - an option is at-the-money when the underlying futures price equals, or nearly equals, the strike price.  Example: if Treasury bond futures are at 80-00 and the T-bond call option strike price is 78, the call is in-the-money.  The put option is in-the-money when the strike price of the option is greater than the price of the underlying futures contract.  Example: if the strike price of the put option is80 and the T-bond futures are trading at 77-00, the put option is in-the-money.

Out-of-the-money- a call option is out-of-the-money if the strike price is greater than the underlying futures price.  For Example: if  T-bond futures are at 80-00 and the T-bond call option has an 82 strike price, the option is out-of-the-money.  The put option is out-of-the-money if the underlying price is greater than the strike price.  For example: if T-bond futures are at 77-00 and the T-bond put option strike price is 76, the put option is out-of-the-money.  Options are considered "wasting assets."  In other words, they have a limited life because each expires on a certain day, although it may be weeks, months, or even years away.  The expiration date is the last day the option can be exercised, otherwise it expires worthless.  For every option buyer the is an option seller.  In other words, for every call buyer there is a call seller; for every put buyer, a put seller.  The buyer of the option, unlike the buyer of the futures contract, does not need to worry about margin calls.  However, the seller of the option is generally required to post margin.  If an option position is covered, the seller holds an offsetting position in the underlying commodity itself or a futures contract.  For example: the seller of a Treasury bond call option would be covered if he actually owned cash market u.S. Treasury bonds or was long the Treasury bond contract.  If the writer did not hold either, he would have uncovered or a "naked" position.  In such instances, margin would be required because the seller would be obligated to fulfill terms of the option contract in the event the contract is exercised by the buyer.  It is imperative, therefore, that the seller demonstrate the ability to meet any potential contractual obligations beforehand.  In addition, the seller of uncovered options on interest rate futures assumes the potential for significant losses.

Why Use Options?  Reasons for Buying and Selling Options

One may be a buyer or seller of call or put options for a variety of reasons.  A call option buyer, for example, is bullish.  That is, he or she believes the price of the underlying futures contract will rise.  If prices do rise, the call option buyer has three courses of action available.
  
The first is to exercise the option and acquire the underlying futures contract at the strike price. 

The second is to offset the long call position with a sale and realize a profit. 

The third, and least acceptable, is to let option expire worthless and forfeit the unrealized profit.  The seller of the call option expects futures prices to remain relatively stable or to decline modestly.  If prices remain the stable, receipt of the option premium enhances the rate of return on a covered position.  If prices decline, selling the call against a long futures position enables the writer to use the premium as a cushion to provide downside protection to the extent of the premium received.  For instance: if T-bond futures were purchased at 80-00 and a call option with an 80 strike price was sold for 2-00, T-bond futures could decline to the 78-00 level before there would be a net loss in the position (excluding, of course, margin and commission requirements).  However, should T-bond futures rise to 82-00, the call option seller forfeits against him and acquire a futures position at 80-00 (the strike price).  The perspectives of the put buyer of the put option believes prices for the underlying futures contract will decline.  For example: if a T-bond put option with a strike price of 82 is purchased for 2-00, while T-bond futures also at 82-00, the put option will be profitable for the purchaser to exercise if T-bond futures decline below 80-00.
In many instances puts will be purchased in conjunction with a long cash or long T-bond futures position for "insurance" purposes.  For instance: if an institution is long T-bond futures at 82-00 and T-bond put option with an 82 strike is purchased for 2-00, the futures contract could, theoretically, fall to zero and the put option holder could exercise the option for the 82 strike price, assuming the option had not yet expired.  The seller of put options on fixed-income securities believes interest rates will stay at present levels or decline.  In selling the put option, the writer, of course, receives incomes.  However, if interest rates rise, the buyer of the put option can require the writer to take delivery of the underlying instrument at a price greater than that in the new market environment.  since an option is a wasting asset, an open position must be closed or exercised, otherwise the option expires worthless.

Option Premium Valuation 
 
The price (value) of an option premium is determined competitively by open outery auction on the trading floor of the CBOT.  The premium is affected by the influx of buy and sell orders reaching the exchange floor.  An option buyer pays the premium in cash to the option seller.  This cash payment is credited to the seller's account.  Prices for T-bond and T-note futures contracts are quoted differently from the option premiums on these futures.  Options on these contracts are quoted in 64th of a point.  Therefore, a quote of -01 in options means 1/64, in futures, 1/32.  The option premium has two components: "intrinsic value" and "time value."  The intrinsic value is the gross profit that would be realized upon immediate exercise if the option.  In other words, intrinsic value is the amount by which the portion is in-the-money.  (An option that is out-of-the-money or at-the-money has no intrinsic value).  For example: in December, a June Treasury bond futures contract is priced at 82-00, while the June 80 call is priced at 3 10/64.  The intrinsic value of the option is 2-00: bond futures 82-00 option strike price 80-00 intrinsic value 2-00.  Time value reflects the probability the option will gain in intrinsic value or become profitable to exercise before it expires.  Time value is determined by subtracting intrinsic value from the option premium: time value = intrinsic value = 3 10/64 - 2-00 = 1 10/64. 
 Several other factors also have an impact on the premium.  One is the relationship between the underlying futures price and strike price.  The more an option is in-the-money, the more it is worth.  A second factor is volatility.  Volatile prices of the underlying commodity can stimulate option demand, enhancing the premium.  The greater the volatility, the greater the chance the option premium will increase in value and the option will be exercised; thus, buyers pay more while writers demand higher premiums.  A third factor affecting the premium is time until expiration.  Since the underlying value of the futures contracts changes more within a longer time period, option premiums are subjected to greater fluctuation.  Some parallels can be drawn between the time value component of an option premium and the premium charged for an automobile insurance policy.  The longer term of the policy, the greater the probability a claim will be made by the policyholder.  This, of course, presents a greater risk to the insurance company.  To compensate for this increased risk, the insurer charges a greater premium.  For example: the total dollar cost of a one-year policy to insure the vehicle will be greater than a six-month policy since the vehicle is being insured for twice as long.  The same is true with options on interest rate futures, the longer the term of expiration, and the more volatile the underlying market, the greater the option premium.
The foregoing is, at most, a brief and incomplete discusion of a complex topic.  Options trading has its own vocabulary and its own arithmetic.  If you wish to consider trading in options on futures contracts, you should discuss the possibility with your broker and read and thoroughly understand the Options Disclosure Document which he is required to provide.  In addition, have your broker provide you with educational and other literature prepared by the exchanges on which options are traded.  Or contact the exchange directly.  A number of excellent publications are available.  In no way, it should be emphasized, should anything discussed herein be considered trading advice or recommendations.  That should be provided by your broker or advisor.  Similarly, your broker or advisor - as well as the exchanges where futures contracts are traded - are your best sources for additional, more detailed information about futures trading.