Part 1 of this two-part series discusses the factors that have contributed to the recent popularity of short-term options in commodities. Part 2 explains commodities market risk events and their hedges with these options

Short-term options belong to a class of options with shorter tenors than the conventional long-dated ones (Table 1). In Energy and Metals, short-term options are known as Weekly options where options expire on the corresponding day of the contract week. For example, a Gold Weekly Monday option terminates on Monday of the contract week.

In Agriculture, there are three types of short-term options¹: Weekly options, New Crop Weekly options and Short-Dated New Crop options. While the products have the same commodity and expire on Fridays, they have different underlying commodity crops they are associated with (December for Corn futures and November for Soybean futures) as the new crop contracts represent grain that has not yet been harvested. These options correspond to crops with specific harvest seasons; therefore, they have different dynamics and drivers like weather, expected yield, etc. 

Short-term options have the following features:

1. Manageability/flexibility: Short-term options have a short tenor which provides more flexibility to traders to adjust their portfolios more frequently in response to sudden market events regardless of their time horizons. Market participants with long-term positions can still use Weekly options to rebalance their portfolios and insulate them from a specific market risk in the short run. The granularity of the short-term tenors may enable traders to time a specific market event and react more quickly when market conditions change. This adaptability makes these types of options effective and precise in both risk management and tactical trading strategies to capitalize on short-term price fluctuations and price shocks. Additionally, short-term options can be used to structure different strategies including directional bets and relative-value trading (spreads).
2. Lower premium: Short-term options have lower premiums because there is less time for market conditions to change. Subsequently, traders can get exposure to a market at a lower cost which may allow them to deploy their capital more efficiently.
3.  Higher gamma: Gamma measures how much an option’s intrinsic value changes for every $1 move in the underlying instrument. In essence, gamma estimates how much an option’s delta changes in response to a change in the underlying futures. Short-term options tend to have a higher gamma compared to longer-dated options with the same strike because they have a shorter time to expiry. This implies that their delta is more sensitive to fluctuations of the underlying futures prices.
4. Greater sensitivity to time decay (theta): Theta measures the amount by which the option value decreases with the passing of time. The short-term options have higher sensitivity to time erosion than longer-dated options as the option value decreases faster as the expiration approaches. Theta is typically higher for short-dated options, especially near-the-money.

The volume of short-term options in commodities has expanded significantly. The increased interest and fast adoption are attributed mainly to these main reasons:

High volatility: Commodity prices have experienced an increased volatility as the result of a complex interplay between macroeconomic conditions and commodity-specific demand/supply dynamics. The current economic environment is characterized by a high degree of uncertainty. Central banks around the world have embarked on increasing interest rates to curb inflationary pressure which has subsequently discouraged investment and consumer spending. Also, the high debt levels are adding another layer of uncertainty to the economic picture. These market conditions have increased volatility of commodities prices. In addition, the increased volatility in commodity prices

In addition, weather events have heightened the volatility of certain commodities, especially the soybean market. For illustration, Chart 3 shows the heightened volatility of the soybean market, reflected in the CME Group Volatility Index known as CVOL. This sophisticated tool measures the expected volatility implied from options prices based on the collective market sentiment of future price movements.

Elevated geopolitical risk: The Ukraine-Russia war has considerably impacted commodities and caused supply disruptions in oil, natural gas, corn, and wheat. For example, oil prices reached $120 per barrel in March 2022 and wheat rose to $12 per bushel while corn spiked to $8 per bushel in March 2022. Prices have since fallen, but they are still higher than prior to the war. On the other hand, the Israel-Hamas war that recently broke out is increasingly destabilizing the region and impacting oil prices.

Listing of new set of expiration dates: The expansion of the listing has offered greater customization opportunities for traders. This optionality allows traders to mitigate short-term risks of either macro- or commodity-specific market events in a precise fashion. The extensive listing has attracted a wide range of market participants with different risk profiles and trading strategies. In addition, more frequent listing of expiration enhances market efficiency and price discovery function because the market has more data points to determine the fair price.

A trader is concerned about the jump risk or sudden price increase in the gold market. As a result of an upcoming Federal Reserve announcement to inject more liquidity into the economy, leading to an increase in demand for gold. The trader decides to buy a weekly gold call option to hedge against the jump risk.

Strategy: Long weekly gold call option

Current Gold Futures price: $1,800 per ounce
Strike: $1,820
Premium: $40 per ounce (reflecting higher implied due to the anticipated event)
Premium paid: $40 x 100 ounces = $4,000
Contract size: 100 ounces

After the Federal Reserve announcement:
New Gold Futures price: $1,900 per ounce
Intrinsic value of call option: Max ($1900-$1820),0) x 100 ounces = $8,000
P/L= $8,000-$4,000 = $4,000

Using this example, the trader has effectively hedged against a jump risk and can now buy gold at $1,820 per ounce which is significantly below the current price of $1900 per ounce.

Early November, suppose a soybean producer wants to hedge during the harvest time against a decline of the soybean prices because of the upcoming USDA report release in two weeks.

Strategy 1: Long Weekly Soybean Put Option

Current Soybean futures price: $13.00 per bushel
Strike: $13.00 (At-The-Money)
Premium: $0.10 per bushel (lower due to the shorter tenor)
Contract size: 5000 bushels
Expiry: Two weeks
Cost: $0.1x 5000 bushels = $500

After the release of USDA:
New Soybean futures price: $12.50 per bushel
Intrinsic value of put option: Max (0, $13-$12.5) x 5000 = $2,500
PL after exercising the option: $2500-$500 = $2,000

Strategy 2: Long Monthly Soybean Put Option

Strike: $13.00
Premium: $0.25 per bushel (lower due to the longer tenor)
Expiry: Four weeks
Cost: $0.25 x 5000 = $1,250

After the release of USDA:
Current Soybean futures price: $12.50 per bushel
Net price received after exercising the option: $13.00-$0.25 = $12.75
Intrinsic value of put option: Max (0, $13-$12.5) x 5000 = $2,500
PL after exercising the option: $2500-$1,250 = $1,250

Using the weekly option (Strategy 1) seems more cost effective under this scenario.

Weekly options are flexible and versatile tools to hedge against losses, generate profits and capitalize on short-term price fluctuations. Their growth in commodities is driven by many factors, including the increased uncertainty and volatility in the market.