Options on Commodities, Simplified

by: FXedu

By Matthew Bradbard

When trading commodities, there are 2 basic ways to trade: Futures or options. Depending on the portfolio size, the risk tolerance and ultimate goals we will suggest assorted strategies to take advantage of the same anticipated move in an underlying commodity. That may mean an individual speculating on gold moving higher if they foresee inflation, a farmer buying put options in agriculture as a hedge or perhaps a combination of futures and options depending on the exact plan. Trading futures ultimately means one is trading on margin which some are not comfortable, with while trading options may offer an alternative without the sleepless nights.

When purchasing options, one’s risk is limited to the premium paid plus any fees for the transaction. When writing or granting options the risk becomes greater, and without going into intricate details, it may be useful to be more familiar with the terms below when trading commodity options. Find below an explanation of the “option Greeks.” It is important for an active options trader to at least become familiar with these characteristics since he/she may need to make quick decisions about trading strategies and risk management on the fly.

Delta
Delta is the amount by which the option changes compared to the underlying commodity. It is a measure of the probability that an option will expire in-the-money. Call deltas can be interpreted as the probability that the option will finish in-the-money. Put deltas can be interpreted as -1 times the probability that the option will finish in-the-money. An at-the-money option, which has a delta of approximately 0.5, has roughly a 50/50 chance of ending up "in-the-money". For example, if an at-the-money sugar call option has a delta of 0.5, and if sugar makes a 100 tick move higher, the premium on the option will increase approximately by 50 ticks (0.5 x 100 = 50), or $560 (each tick in premium is worth $11.20).

An explanation of delta values is below:

Call options: 0 to 1 Put options: -1 to 0
In the money options: Delta approaches 1 (call: +1, put: -1)
At the money options: Delta is about 0.5 (call: +0.5, put: -0.5)
Deep out of the money options: Delta approaches 0
Long calls have a positive delta: You want the market to go up
Short calls have a negative delta: You want the market to go down
Long puts have a negative delta: You want the market to go down
Short puts have a positive delta: You want the market to go up

Gamma
Gamma, measures the rate of change of delta. When call options are deep out-of-the-money, they generally have a small delta. This is because changes in the underlying commodity bring about only minute changes in the price of the option. But as the call option gets closer to the money, resulting from a continued rise in the price of the underlying commodity, the delta gets larger.

The gamma of a long option position (both calls and puts) is always positive. At-the-money options have the largest gamma. The further an option goes "in-the-money" or, "out-of-the-money" will affect the gamma. If you are long gamma you expect the underlying to make large moves. Traders with long positions expect positive gamma. If you are short gamma you expect the underlying to remain relatively inactive. Traders with short positions expect negative gamma. Gamma is a useful indication of the risk associated with a futures position. A large gamma number, whether positive or negative indicates a high degree of risk and a low gamma number indicates a low degree of risk.

Theta
Theta is defined as the change in the price of an option for a 1 day decrease in the time left before expiration. At-the-money options have the greatest time value and the greatest rate of time decay (theta). The further an option goes "in-the-money" or "out-of-the-money", will affect the theta. As volatility falls, the time value declines and hence theta will also decline. Simply put, Theta is the rate at which an option loses its value as each day passes. The inherent assumption is that the options are a decaying asset. The way I explain this is like a melting ice cube on a warm summer day. Long options have negative theta. Short options have positive theta. As time passes, the theta of at-the-money options increases, the theta of deep-in-the-money and out-of-the-money options decreases.

Theta has the exact opposite characteristics of gamma. Thus the size of a gamma position correlates to the size of the theta position. A large positive gamma position goes in hand with a large negative theta position, while a large negative gamma position goes hand in hand with a large positive theta position. What this means is that every option position is a tradeoff between market movement and time decay.

Vega
Vega is the change in the value of an option for a 1 percentage point increase in implied volatility of the underlying commodities price. Implied volatility is measured as the annualized standard deviation of a commodity’s daily price changes. The Vega of a long option position (calls and puts) is always positive. At-the-money options have the greatest Vega. The further an option goes "in-the-money" or "out-of-the-money", the smaller the Vega. As time passes, Vega decreases. Time amplifies the effect of volatility changes.

As a result, Vega is greater for longer dated options than for shorter dated options. Simply put, Vega is the option’s change in theoretical value with a change in volatility. Most options have a positive Vega because they gain value with rising volatility and lose with falling volatility. Vega of most options decline as time decreases and you get closer to expiration. Vega tells you approximately how much an option price will increase or decrease given an increase or decrease in the level of implied volatility.

In conclusion it would be beneficial to be at least familiar with these terms when trading options. While it is not a necessity to be an expert we believe knowledge is power and it helps to know when you are making or losing money and WHY?

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