Why Commodity Options Often Reference Futures Contracts

# Why are options on commodity futures traded instead of options on spot commodities?


# Why are options on commodity futures traded instead of options on spot commodities?












When people mention "commodity options", they almost invariably mean "options on commodity futures contracts". Why do commodity options have futures as underlying, and not the commodities themselves as underlying? In other words, why do people trade options on commodity futures rather than options on commodities?

## Answer by ThatDataGuy (score 2)

https://quant.stackexchange.com/a/53408

Because futures offer better price transparency.

Futures contracts have well established mechanisms for establishing settlement prices. There's no need to duplicate that work again for a option contract.

There's also a self fulfilling aspect here - options on futures have higher liquidity, and therefore more people trade them, making them more liquid.

EDIT

I forgot to add that options are inherently forward looking contracts, so it wouldn't make sense to mark to market them vs spot. We could use the OTC forward rate vs a future, but the liquidity of OTC commodity forwards is much less than commodity futures, the futures price discovery process will be more accurate. This is not the case for FX however, as the OTC foward market is much larger than the equivalent FX futures contracts.

## Answer by Ilnaz Asadzadeh (score 0)

https://quant.stackexchange.com/a/53460

By Commodity I assume you mainly refer to energy and base metal and not precious metal. Commodities transactions are both financial and physical whereas for other asset classes it is all financial. This characteristics makes spot trading difficult for energy or base metal.

For spot trading, delivery takes place immediately which is rarely in the case of crude oil, natural gas or base metal so intuitively there exists lag due to technical constraints between the trade and delivery. Therefore, most of the trading in commodities are in the form of futures and forward contracts and this makes the liquidity of these contracts to be high (the spot trading for energy and base metal is not common). This results to see options are mainly written on liquid assets (forwards and futures) instead of spot prices.

## Answer by ZRH (score 0)

https://quant.stackexchange.com/a/54287

There are indeed both options on spot prices and on forward/futures prices, and that is not necessarily related to observability or liquidity.

Options on futures: Whereas securities like stocks or bonds have no physical constraints on storage, many energy commodities have low or no storability (gas, but especially power, where hydro storage and battery storage capacities are very limited). Therefore trading usually takes place via contracts that refer to a constant delivery of commodity over a period (gas/power delivered over the period of a month/year). Such commodities being essentially non-storeable, forward curves are more complex, i.e. will have more non-parallel moves than forward curves on non-financial assets, i.e. a lot of different maturity futures will be actively traded. A lot of options therefore reference futures contracts

Options on spot: Where most players in commodity markets manage price risk via futures, some prefer spot delivery of commodities, i.e. they pay/receive floating prices for short-term delivery of commodities. Typically spot prices are substantially more volatile than term prices. Some therefore resort to options that reference spot prices. For convenience, such options again reference longer periods of time, e.g months, quarters or years. They are usually of two types: 1) Strips, i.e. daily series of options which reference spot prices for daily delivery 2) Asian options, which reference the average spot delivery price during a period. Asians are financial, and will delivery a payoff at the end of the referenced period

As a closing remark, in commodity markets, spot prices are typically the most widely publicised price data, observability is not an issue.