Commodities trading can be a little ambiguous, but if you know the right tool to use,
things become more straightforward. Two of the fundamental concepts in Commodities trading are futures and options. They may
sound all technical jargon, but it's simply making a promise-like, buying or
selling something at a later time, or having the option to do so. Break it down
into something a little more relatable!
1. Futures: A commitment to buy or sell 'promise.
Suppose you agree with a friend who sells you his bicycle in one month
for $100. Today you shake hands and the deal is made. Whatever between now and
then you both do, you must buy that bicycle for $100 on that date in the
future. That's how futures contracts work in commodities trading. A futures
contract is an agreement between two people who say to one another, "I
agree to buy or sell for you some commodity oil, gold, or wheat-at a fixed
price on a certain date in the future." The requirement here is
commitment-like your promise to buy that bicycle. You can't back out of it
without some consequence.
2. Option: The Right, but Not the Obligation
Now, imagine you could pay a friend a small fee to retain the right but
not the obligation to buy his bicycle in the future for $100. If you decide you
no longer want the bicycle, you can "walk away" and only lose the
small fee you paid. That is really the heart of the options in commodity
trading.
An option contract grants the buyer the right-but not the obligation-to
buy or sell a commodity at a set price by a certain date. There are two types
of options: the call option, representing the right to buy, and the put option,
the right to sell. So if you went out and purchased a call option for oil, then
you pay a premium for the right to buy oil at some price. If the price of oil
climbs above that price, you can exercise your option and buy at the lower
price, realizing the profit. If the price does not climb, you are under no
obligation to buy, and you simply lose the premium you paid for the option.
3. Futures vs Options: The Big Difference
The striking difference between futures and options is the obligation.
Futures put an obligation that requires performing the contract at its time of
maturity, regardless of the case. Options, however, do not obligate you to
perform the contract, though there is the chance to exercise such an option.
For example, futures will be like committing to a confirmed date in purchasing
your friend's bicycle. It means, therefore, that if you have chosen options,
then it is like purchasing a ticket for the bike-buying show-if you want to
attend but are not obliged to.
4. Why employ futures and options in commodities trading?
Both futures and options are hedging instruments for traders who wish to avoid price risks. Again, however, with each tool come associated risks and rewards. An example of helpful futures is the locking in of a price, especially for firms which need a specific quantity of commodities at a specific time, say a roasting firm that wishes to buy coffee beans in advance. Options provide the trader with much more flexibility. Buying options enables traders to exploit the price movements while keeping a lid on the risk going to the premium paid for the option.
Futures and options in commodity trading are like promises made in life.
A futures contract is a firm promise, while an option gives the freedom to
decide whether to go for a commitment or not. Of course, both have merits, of course,
based on the risk tolerance and strategy on the trader's side. You can opt for
futures if you want to lock in a price or you can opt for options and keep your
choice open; both of them play a very important role in Commodities trading. Well, keep practicing and
staying up-to-date, and you will learn to use those tools for your own good in
no time!
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