Commodities Explained

What are commodities?

Commodities are usually raw materials like orange juice, wheat, cattle, gold and oil. Individuals buy options on these commodities speculating that the price will either go up or down.

Ex. You believe that stock xyz is about to go up. You could buy a call option.

What is a call option?

A call option is where you enter into an agreement to buy this stock at a pre-agreed upon price .This gives you the right but not the obligation to buy it at that price. If the price goes up within a specified period of time then the option is worth more. If you are wrong and price goes down then the options are worth less.

If you thought that there was going to be some bad financial data on the company coming out and that they price of the stock would go down you might buy a put option.

What is a put option?

A put option is where you believe that the price will go down. You buy the right sell a stock at a specific price on or before a certain date. If you are correct and the price goes down you make money, as long as this occurs before the option expiration date.

What is the Option Premium?

The option premium is the price that you purchase the option at.

What is the option expiration date?

Options expire on the third Friday of the month.

What is the strike price?

The Strike Price is the price at which the underlying security ( orange juice, stocks, etc...) can be bought or sold as stated in the option contract.

What are the benefits and risks of trading options?

Let's say you own stock XYZ and you believe that it will go up but you want to safe guard as much as possible if it goes down. You could buy a put option for that stock at a fraction of the cost of the stock. If the stock went down you could make money on the put while holding on to the stock until the stock reversed.

The downside of buying an option is that it must go in the direction that you want before the expiration date or it could expire worthless. Yes you can lose the entire amount that you invested in the call or put.

There are ways to safeguard against your money further by hedging, a technique that we will go into later in our next commodities explained lesson.