In what type of a business situation would it be a sound strategy to buy a lookback call option on a commodity?

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justaguide eNotes educator| Certified Educator

A call option on a commodity is a contract that gives the holder the right, but not the obligation, to buy the commodity at a price that is fixed when the option is bought, also known as strike price. A lookback call option is a more complex form of a call option where the holder does not have to pay the option seller a fixed price when the option is exercised, instead the lowest price that the commodity touched after the option was issued is the strike price.

This could be used in almost all business situations where the option buyer needs to purchase a commodity in the future and wants to be able the least price for it. As an illustration, a cloth manufacturer requires 200 tonnes of cotton after 3 months to produce cloth. A call option is bought by the manufacturer as a protection from any increase in the price of cotton. But a situation could arise when  due to excessive cotton production in India there is a large drop in prices a month after the call option is bought. This is immediately utilized by manufacturers of cloth in China to make large purchases of cotton that soon push the price of cotton up. If the manufacturer had bought a lookback call option he would have the right to demand that the cotton be sold to him at the lowest price it touched after the option was bought. This could save the manufacturer a lot of money.

Lookback options have a higher premium as compared to options with a fixed strike price as the option seller has to deal with a higher level of risk. The buyer of the option would have to consider this when deciding to buy a fixed price option or a lookback option.