An Overview of the Risks of Commodity Options Trading

Founder and CEO Bernie Schaeffer breaks down commodity options risk

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Adding commodity options to your investment portfolio may be used as a method to decrease your overall portfolio risk. Most solid trading brokerages often both equity options and commodity options to clients. Understanding which security is best for you involves an analysis of the risk associated with them. For a beginner who is trying to learn to trade options, learning about the different varieties available in the market is key.

The Myth about Commodity Options

It is a straight-up myth that commodity options are safer than equity options. It is true that the scope for profit in commodity options is unlimited if prices fortuitously skyrocket. However, a prudent trader also knows that potentially unlimited profits can be accompanied by a high level of risk as well.

In order to learn to trade options, one needs to understand which variant is appropriate for his or her investment plan and trading goals. As you learn to trade options, you can diversify your portfolio with both equity options and commodity ones. Equity options are good if you are interested in a short-term play on an equity traded on the U.S. stock market. Commodity options will give you short-term, high-profit gains on a commodity that exists outside of the standard U.S. stock market.

Minimize Risk with Precision Timing

For a commodities trader, it's typically suggested to buy commodity options when the targeted market is at a low. This is because the most predictable course that will follow is that the commodity price will increase and allow the options trader to capitalize exponentially on the increased underlying price. By correctly calling a commodity's bottom, a trader decreases his risk of a losing position. Obviously, it is not set in stone that if prices for commodities are low, they will always subsequently bounce back up. In some circumstances, the commodity's value may decrease even further. However, as there is always a degree of uncertainty in options trading (regardless of the underlying asset), the odds of the trade going against you are always going to be higher than the likelihood of the trade going In the correct direction during the specified timeframe. 

It is typically not recommended to buy commodity options when the commodity pricing is near highs. It may seem like an attractive prospect to do so because of the support of price growth, but beware of the forces working behind the commodity market. Since commodities are tangible items directly available to consumers, the market forces of demand and supply regulate the market. If the price of a commodity is extremely high, there is no logical guarantee that the next step is that the commodity price will continue to increase, because the demand and supply principles will stabilize the price. As you learn to trade options, be wary of relying too greatly on momentarily attractive market trends and be sure to have an edge before trading options.

What Level of Risk is Associated with Selling Commodity Options?

The best options trading strategy, whether it is commodity options and/or equity options, is diversification of strategies. Traders can spread out risk by having a variety of long and short options. We understand that most traders choose not to sell commodity options as it exposes the trader to significant risk if the option is assigned to them. However, it's strongly recommended that traders apply the strategy of diversification, aka application of risk management, to the usage commodity options as well.

If a trader writes an option over a relatively stable asset (i.e., the prices of which do not fluctuate), it is highly unlikely that the option will be exercised. This means that the trader keeps getting a premium and the option expires as the holder sees no benefit in exercising it. Contrastingly, it is advisable to buy commodity options when the price of a volatile asset is low. This means that the trader can exercise the option when the price fluctuates and make gains depending on whether he or she has a call or put option open.

Can Commodities be Volatile, Too?

As a general rule of thumb, commodities tend to be less volatile than equities. This is where the idea that commodity options are "safer" than equity options stems from.

However, as we have mentioned above, there are quite a few different kinds of commodities. The risk that an investor is exposed to depends solely on the type of commodity being played. As you learn to trade options, you will realize that no commodity market is completely risk-free. Two of the most commonly traded commodities are crude oil and gold. The global markets for these goods fluctuate the most out of all commodities. As a consequence, the prices at which the commodities are traded in markets also fluctuates and makes them the most volatile commodities.

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