As derivative markets develop, options (and even some other types of derivatives) have begun to emerge on such underlyings as electricity, various sources of energy, and even weather. These instruments are almost exclusively customized over-the-counter instruments. Perhaps the most notable feature of these instruments is how the underlyings are often instruments that cannot actually be held. For example, electricity is not considered a storable asset because it is produced and almost immediately consumed, but it is nonetheless an asset and certainly has a volatile price. Consequently, it is ideally suited for options and other derivatives trading.
Consider weather. It is hardly an asset at all but simply a random factor that exerts an enormous influence on economic activity. The need to hedge against and speculate on the weather has created a market in which measures of weather activity, such as economic losses from storms or average temperature or rainfall, are structured into a derivative instrument. Option versions of these derivatives are growing in importance and use. For example, consider a company that generates considerable revenue from outdoor summer activities, provided that it does not rain. Obviously a certain amount of rain will occur, but the more rain, the greater the losses for the company. It could buy a call option on the amount of rainfall with the exercise price stated as a quantity of rainfall. If actual rainfall exceeds the exercise price, the company exercises the option and receives an amount of money related to the excess of the rainfall amount over the exercise price.
Another type of option, which is not at all new but is increasingly recognized in practice, is the real option. A real option is an option associated with the flexibility inherent in capital investment projects. For example, companies may invest in new projects that have the option to defer the full investment, expand or contract the project at a later date, or even terminate the project. In fact, most capital investment projects have numerous elements of flexibility that can be viewed as options. Of course, these options do not trade in markets the same way as financial and commodity options, and they must be evaluated much more carefully. They are, nonetheless, options and thus have the potential for generating enormous value. Again, our emphasis is on financial options, but readers should be aware of the growing role of these other types of options in our economy. Investors who buy shares in companies that have real options are, in effect, buying real options. In addition, commodity and other types of options are sometimes found in investment portfolios in the form of “alternative investments” and can provide significant diversification benefits. To this point, we have examined characteristics of options markets and contracts. Now we move forward to the all-important topic of how options are priced.

Options in which the asset underlying the futures is a commodity, such as oil, gold, wheat, or soybeans, are also widely traded. There are exchange-traded as well as over-the-counter versions. Over-the-counter options on oil are widely used.
Our focus in this blog is on financial instruments so we will not spend any time on commodity options, but readers should be aware of the existence and use of these instruments by companies whose business involves the buying and selling of these commodities.