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Before you can begin commodity trading is; you need to understand the language.
Here Are The Basics of Commodity Options Trading
A commodity is a good for which there is demand
That’s great but what’s a good.
A good can be almost anything. Typical goods include, gold, silver, wheat and other items too numerous to mention. If you can physically touch it, then it is considered a good. Normally, Commodities are raw or unfinished goods. For example a silicon wafer is a commodity, while a fully assembled computer is not.
So what is demand?
Demand is the amount of a particular economic good or service that a consumer or group of consumers will want to purchase at a given price
In order for a good to be considered a commodity, some one has to want it, or demand it.
So commodity trading is the process of buying and selling commodities. Much like stock, the prices of the goods change constantly. These goods are traded on a commodities market or commodities exchange , which is kind of like the stock market. Keep in mind that you are not buying one item. Just like the stock market, you are buying these items in bulk. For example, you might be buying a railroad car full of oranges. However before you start worrying about refrigerator trucks, What you are doing is acquiring the ownership of the goods. In most cases you don’t take physical possession of the commodity. Instead it’s an electronic transaction.
There are many different ways to trade commodities. Some of the most popular are futures and Forex or currency trading as its commonly called.
A futures contract is a contract to make or take delivery of a product in the future, at a price set in the present. It is not ownership of a stock or commodity.
In formalized trading of futures contracts on exchanges, standardized agreements specify price, quantity and the month of delivery. Futures markets have their roots in agriculture, but today futures and options on futures are traded on a wide range of products from wheat to natural gas to stock indexes, precious metals and currencies.
Options on futures can be thought of like insurance. An option buyer (the insured) pays a premium to an option seller (the insurance company) for the right to buy or sell a futures contract at a specific price. However, just like with insurance, the option buyer may or may not exercise his right (use his insurance). ALC’s focus is being (the insurance company) or option seller.
People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.
Below are some terms and definitions that are important to commodity options trading.
Calls and Puts
The two types of options are calls and puts:
A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a futures contract. Buyers of calls hope that the price of the underlying commodity contract will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on the underlying commodity contract. Buyers of puts hope that the price of the underlying commodity contract will fall before the option expires.
Participants in the Options Market
There are four types of participants in options markets.
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
Here is the important distinction between buyers and sellers:
-Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.
-Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.
To trade options, you’ll have to know the terminology associated with the options market.
The price at which a commodity can be purchased or sold is called the strike price. This is the price that the commodity contract price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.
For call options, the option is said to be in-the-money if the underlying commodity contract price is above the strike price. A put option is in-the-money when the underlying commodity contract price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value.
The total cost (the price) of an option is called the premium. This price is determined by factors including the underlying commodity contract price, strike price, time remaining until expiration (time value) and volatility. These three factors are contributing factors to the premium of an option.
To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%-15% of the contract’s value.
To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty.
Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.
Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers’ open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.
Customer margin Within the futures industry, financial guarantees are required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin.
Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange.
If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned.
In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as “variation margin”, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day.
Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the client’s account.
Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term “initial margin” and “variation margin”.
The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets).
A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account.
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn’t want to be subject to margin calls.
Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.
Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.
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