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Commodities Contracts - The Basics

Remember that freshman Human Anatomy class you had to take in college? The professor pulled out “Mr. Bones” or whatever name the class skeleton had and the following drill was the same. The professor would proceed to quiz the class while teaching the underlying structure of the human body. The same exercise is valuable in commodities trading as well; looking at the “skeleton” of a commodities options contract is helpful for understanding its body.

Dissecting the Body of an Options Trading Contract
While these features do not represent all of the aspects of an options trading contract, they do create its structure:

  • Underlying Asset – In order to write an options trading contract, you certainly have to include the commodities that contract is buying. Corn futures, gold and silver are all examples of commodities that can be underlying assets.

  • Strike Price – The strike price, which is also known as the exercise price, is amount for which the commodities will be sold or bought if the commodity trading occurs as detailed in the contract. It is the difference between the current price and the strike price that gives either the buyer or seller their profit.

  • Exercise Style – The exercise style is important to the successful trader because of the impact it has on investment strategy. An American style contract means that the contract can be exercised at any time up to the expiration date. European style contracts can only be exercised on the expiration date. This information is included in the contract.

  • Expiration Date – For European contracts, this date is when the contract will be executed. For American contracts, this is the last day for futures trading on this contract.

Factors Affecting Commodities Contracts
There are a number of factors that can have an effect on commodities contracts. These factors can determine when a contract is implemented, when it is exercised and how much it costs. Futures contracts have variables such as:

  1. Current Price Relative to the Strike Price. Depending on the investment philosophy involved, a trader might buy commodities that are “in the money”, “out of the money’, or “at the money.” These terms are comparative between the strike price and the current price.

    1. In The Money – If a commodities contract is already profitable when it is purchased, it is referred to as in the money. Sellers will sometimes use this investment strategy when they believe that a commodity price will fall, taking it out of the money.
    2. Out Of The Money – If a commodities contract is purchased while it is still losing money; it is referred to as out of the money. If a call option is purchased when the current price is below the strike price, it would fall into this category.
    3. At The Money - If the current price and the strike price are the same, the contract is at the money.
  2. Premium Price. The premium is the amount that the investor will pay to purchase a particular futures commodity. This amount is affected by several factors but it is basically the cost of a commodities contract.
  3. Length of a Contract. The time from the purchase date of a contract until its expiration date can affect the cost of the premium. The longer the contract, the more likely that the terms of the contract will be met; this means that the premium would go up to reflect that probability.
  4. Complexity of the Contract. The type of contract written on futures options can affect the premium price. A simple market order that is out of the money will cost less than selling covered calls.

Conclusion
Commodities can be complex and their contracts can contain many things. Looking closely and examining the skeleton? of a commodities contract and understanding its investment basics can help pass the test of being a successful investor. And you don't have to worry because we won't even need Mr. Bones!

 

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