Hedging with commodity options
Typically the underlying of an options contract will be a futures contract for the commodity, rather than the physical asset. As options can be settled in cash instead of physical delivery, they are a popular means of hedging against commodity risk.
Companies involved in the supply of commodities often hedge with options as it enables them to lock in a price and protect their produce from adverse movements. For example, if a farmer wanted to hedge against their crop of wheat losing its value, they could take out an option to sell their product at the current market price.
This would ensure that regardless of market movements, they have the choice to sell it at the expiry date – but not the obligation. For individual traders and investors, hedging with commodity options can be a great way to protect existing positions on commodity markets or commodity-linked stocks and ETFs.
Example of a commodity options hedge
You own 50 shares in an ETF that tracks the price of gold futures – which you bought at $150 each, giving you a total exposure of £7500. You believe that the price of gold is going to fall from the current market price of $1960 within the next week, which would impact the price of your ETF position.
So, you decide to buy a gold put option with a strike price of 1950. The buy price – or premium – for this option is 7.7 points. As one CFD is the equivalent to an exposure of $100 per point, you’d have a total exposure of $770 (7.7 x $100).
The price of gold subsequently falls, with the underlying settling at $1940 at the time of expiry. Shares in your ETF have also fallen, down to $120, giving you a loss of $1500.
However, your option is ‘in the money’ by 40 points, giving it a value of $4000 (40 points x $100). Factoring in the initial premium paid ($770), your options position would be in profit by $3230 ($4000-$770). So, although your initial ETF investment lost money, you remained in profit by $1730.
Say the price of gold had increased instead, your ETF position would have increased in value and you could let your option expire worthless. You would have lost the $770 you used to open the trade, which could be offset by any profits made.
