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I am trying to understand who would be a non-speculative buyer of options contracts on futures. There are a plenty of descriptions of how options work online, but mostly they omit this crucial part of the deal: who would be the genuine buyer of a CALL contract on a commodity?

I came up with the following possible explanation and would like to confirm whether my understanding is correct.

  1. On 1st of June 2000 Palm Oil Front Futures contract is valued at 70 USD
  2. A speculative investor purchases CALL options contract (1000 multiplier, 1.33 per contract) with strike 100 and expiry in Dec 2000 on Palm Oil DEC 2000 Futures contract (valued at 50 USD at the time - backwardation is in place), paying 1,330 USD
  3. Palm Oil price rises to 110 USD in November 2000
  4. Palm Oil shampoo manufacturer decides that they need to purchase 1000 Palm Oil units to be delivered in December 2000, so they look at the market and decide that they would now have to pay 110 USD per unit of palm oil, if they purchased the front futures contract (at a total of 110,000 USD).
  5. Palm Oil shampoo manufacturer reasons that if they could purchase an options contract from the speculator they can save some money.
  6. The intrinsic value of the contract that our speculator now holds is 10,000 USD (110 USD current price - 100 USD strike price, times 1000). If the speculator sells this contract at 9,000 USD to the Palm Oil shampoo manufacturer, the former will gain 9,000 USD - 1,330 USD = 7,670 USD, and the latter will get a 1,000 USD discount on their Palm Oil if they execute the options contract.

Is that how it actually works? Who is the potential buyer of the options contract that the speculator purchases?

Thank you!

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  • Why would you sell options with an intrinsic value of $10k for $9k?
    – glibdud
    Jun 13, 2021 at 23:03
  • Ahh, you see, the question is: why would our Palm Oil non-speculative purchaser buy them for $10k, if the discount they give him is precisely $10k?
    – Tony Sepia
    Jun 14, 2021 at 8:15
  • Just to clarify - let's leave the time value out of this for the moment!
    – Tony Sepia
    Jun 14, 2021 at 8:26

1 Answer 1

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There is little point to an industrial company buying an option for immediate exercise. The point is rather to buy an option to hedge a future risk.

For example, suppose the shampoo manufacturer wants to cap their risk if the palm oil price rises, while still being able to benefit if the palm oil price falls. An ordinary futures contract would simply "lock in" a price and would not allow for the desired "windfall" if the price drops. Rather, the manufacturer can pay a call option premium in exchange for a one-sided hedge: They can exercise at a fixed strike if the price rises, but just buy palm oil on the market if the price falls.

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  • Thank you, nanoman. Please let me specify my question! Within my example, the industrial company would be buying the options for hedging risk in advance - somewhere around step 1. The examples we get online about speculators making profit on the options, however, imply that someone would be buying the now appreciated option closer to its expiration. Who would that be and in what scenario?
    – Tony Sepia
    Jun 14, 2021 at 9:05
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    @TonySepia If the manufacturer benefits from the call option, then the speculator who "wrote" (sold) the option loses. Conversely, if the option expires worthless, then the speculator who wrote the option wins. This is oversimplified because the option may change hands between several speculators before expiration. But fundamentally, a speculator willingly takes the risk of an adverse movement, hoping to profit, thereby allowing the manufacturer to hedge the risk.
    – nanoman
    Jun 14, 2021 at 9:13
  • Hi nanoman, I am sorry for not making myself clear. Could you please consider the example in my question? The situation implies that the speculator (not the writer of the option) has correctly predicted the price movement. But who (in real world) would be the potential purchaser of this contract that has appreciated in price? It's all good and well that the price prediciton was correct - who would actually buy the contracts given in the example, close to the expiry date? The manufacturer? The marketmaker?
    – Tony Sepia
    Jun 14, 2021 at 9:27
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    @TonySepia An in-the-money option very close to expiration might be bought by an arbitrage trader or market maker. They will offer to buy it for slightly less than intrinsic value so they can immediately and profitably exercise it. The speculator who holds the option might accept this offer because they don't have the capital to exercise it themselves.
    – nanoman
    Jun 14, 2021 at 9:37
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    @TonySepia It seems unlikely unless the company is effectively also running a trading operation.
    – nanoman
    Jun 14, 2021 at 10:04

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