In what types of business situations could a down-and-out call option on a commodity be used.

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justaguide eNotes educator| Certified Educator

A down and out call option for a commodity is a contract that gives the option holder the right to demand that a commodity to sold to the holder at the price fixed in the option, called the strike price when the option expires. But in addition to the features of a plain call option, in a down and out call option the option is made void if the price of the commodity falls below a specified price before it expires.

For example, a down and out option for gold could be designed such that it has a 3 month validity and the strike price is at expiration is $1020 pounds per ounce but if the price of gold falls below $950 during the three month period the option becomes void and the option seller has no obligation to deliver anything after 3 months. Assume a jeweller has a continuous requirement for gold and as a protection against a sharp increase in the price of gold after three months would like to buy a call option. If it is possible for the jeweller to buy gold when the prices fall sharply before the end of the three month period and store it for future use a down and out call option could be used.

From the characteristics of a down and out call option, the option seller stands to benefit if the price decreases sharply before the expiration date and this should reduce the premium that the buyer would have to pay.