What is a Dealer Option
A dealer option is a contract issued on the physical inventory of a commodity. A dealer option is typically issued by companies that buy, sell, or otherwise use a commodity in conducting business. This type of option is not traded on an exchange. Rather, it is traded as an over-the-counter (OTC) security, and is thus less subject to scrutiny and regulation.
Breaking Down the Dealer Option
Dealer options are typically written by firms, such as clearing houses, that hold the physical commodities and then offer them to the public on the OTC market. While dealer options exist outside of traditional trading markets, their sale is still heavily scrutinized because they represent a contract between parties. The firms that deal in these types of contracts typically hold sufficient quantities of the physical commodity or cash to satisfy either a call or put contract, whichever they opt to enter.
How Dealer Options Work
Since dealer options are traded over the counter, typically by people involved with the physical commodity, the options can be used to take physical possession of a commodity, or transfer that commodity to another party via the contract.
Since the contracts are traded OTC, the parties can agree on personalized terms. Unlike an exchange-traded futures contract which involves a specific amount of a certain grade of the commodity, the dealer option could be for any amount or grade the two parties agree to.
A dealer may have 150 ounces of gold to sell. Another party is interested in buying 150 ounces of gold, in the future, if gold prices continue to rise. Exchange-traded futures and options are standardized to 100 ounces, leaving both the seller and buyer with 50 ounces to get rid of/acquire. A dealer option solves this problem.
The price of gold is $1,500. The two parties agree that the buyer will buy at a call option with a strike price of $1,550. The call option will expire in three months. In exchange for the right to buy the gold at $1,550 per ounce, even if it goes much higher in the next three months, the option buyer agrees to pay the option seller a premium.
If the price doesn't rise above $1,550, then there is no need for the option buyer to exercise the contract and buy the gold at $1,550, since it is cheaper to buy the gold on the open market where it is trading below $1,550. In this scenario, the option seller gets to keep the premium as well as their gold.
If the price of gold moves above $1,550, the option buyer will exercise their option. It is worthwhile to do so since the price of gold is now above $1,550 an ounce. The seller will provide the 150 ounces of gold, potentially via a vault receipt, and the option buyer will pay the option seller $1,550 x 150 ounces.
Dealer options are traded OTC, and require that the other party be able to hold up their end of the deal. Therefore, these types of agreements are made between firms or individuals that know each or have financially verified each other.