Simple Option Contracts For Hedging
Options can be a scary topic for those unfamiliar with the concept. And I won't lie - there can be some extremely complex option structures for those looking to dive into options trading. However, there are situations for certain companies in which taking a relatively small amount of risk to capture an upside reward may be worthwhile. They do not need to invest in full-time options traders but using the techniques broken down in this article, they can potentially add significant profits to their trading.
There are two types of options: a call option and a put option. A call option gives the holder the right to buy futures at a predetermined price-also known as the strike. A put option gives the holder the right to sell futures at a predetermined strike price. Option contracts will be entered into with a specific expiration date-this is the date on which the holder of the option will either exercise the option (buy or sell the underlying futures contracts) or abandon the option and take no market action.
There is, of course, a cost you are required to pay when buying options. You pay for the right to buy or sell a commodity at a given price at some point in the future, be it days, weeks, months, or even years in some cases. This is known as the option premium. The exact cost of an options contract premium is composed of various factors, including the price of the underlying market compared to the strike price of the contract, volatility, and time to expiry. Countless books and articles have already been written about calculating premiums, the Greeks, and trading options on a speculative basis-so we will not go into those details here. What we will do is look at two simple scenarios that commodity companies can consider when deciding on their hedging strategies.
If you were purely speculating on a market, you might buy a call option if you were bullish on the price of a commodity, because the call option gives you the right to buy at a given strike price. Therefore, if the price of the underlying commodity increases, you can sell at market and exercise your option to buy at the lower price, locking in a profit. The opposite is true for puts. Buying a put gives you the right to sell at a given strike price, so if the underlying commodity decreases, you can buy at market and exercise your option to sell at the higher price. When utilizing options from a hedging perspective where you will own the underlying commodity, it actually works in reverse.
Let’s take a buyer of physical metal; this could be a trader, or a smelter that is buying concentrates. If they were to hedge their physical purchase contract exactly as we have discussed in prior chapters, they would look to sell futures at the same time and price they agreed on for their physical purchase. However, if they believed that the price of that commodity was going to increase and were willing to pay for the right to sell at the price of the physical contract, they could buy a put option.
The option contract essentially acts as insurance in the case that the market falls in price; the option holder has paid for the right to sell at the physical contract price. However, if the market rises, they can sell at market and capture the difference between their physical contract purchase price and the market price at which they have sold futures. They will not exercise their option contract in this scenario. They will have made an additional profit if the difference between the physical contract price and the executed futures price is larger than the premium they paid to buy the put option.
If they wanted to guarantee the same price as their physical contract, they would buy a put option with a strike price that matched their physical contract price. Let’s say their physical contract priced on the cash settlement of the third Wednesday of January at $2,500/mt; they would use that same price as the strike for their put option. This is known as an at-the-money option where the strike price of the option is the same as the current market price. If they wanted to have a two-month window for prices to develop, they would set the option expiry date for March. If the premium they paid for that option was $50/mt, then they would be profitable (vs. simply hedging the contract by selling futures) once the price was above $2,550/mt. If the price stayed below $2,500/mt, they would exercise their option and would receive a March-dated futures sale with a price of $2,500/mt.
The above physical contracts were priced on a single cash settlement. For contracts that price using a single date price, a fixed price, or a live screen pricing then the trader would utilize European options. Options with a strike that is linked to an average price are known as Asian options. If the physical QP was pricing over a monthly or partial average instead of a single cash settlement or live screen price, the company would enter into an Asian option contract. It is important to familiarize yourself with the difference between the two before considering this type of trading so that you are receiving the correct quotes from your broker.
This is the same structure a miner could use when comparing their cost of production to the current market price. A straight-forward hedge for a miner would be to sell futures at market in order to lock in a gross profit margin against its cost of production, rather than waiting to receive the market price at the time they sell the concentrates. If instead of selling futures, the company buys put options, it is paying a premium in order to see if the market will rise vs. hedging at the current market price. If the market does rise more than the cost of the option, it will make additional profit. If the market falls, the insurance of the put option guarantees a futures short at the chosen strike price.
Those selling physical metal-such as a refined metal producer, or a trader-would look to buy a call option. If they were to hedge their physical sales contract exactly as we have discussed in prior chapters, they would look to buy futures at the same time and price as they had agreed on for their physical purchase. However, if they believed the price of that commodity would decrease and were willing to pay for the right to buy at the price of the physical contract, they could buy a call option. The call option provides the same insurance as in the previous example, but it gives the holder the right to buy futures at a given strike price if the market rises. However, if the market falls, they can buy futures at market and capture the difference between their physical contract sales price and the market price at which they have bought futures. If the market does fall, they will not exercise their option. They will have made an additional profit if the difference between the physical contract price and the executed futures price is larger than the premium they paid to buy the call option.
If they wanted to guarantee the same price as their physical contract, they would buy a call option with a strike price that matched their physical contract price. Let’s say their physical contract priced at $2,500/mt in January, they would use that same price as the strike for their call option. If they wanted to leave a two-month window for prices to develop, they would set the option expiry date for March. If the premium they paid for that option was $50/mt, then they would be profitable (vs. simply hedging the contract by buying futures) once the price was below $2,450/mt. If the price stayed above $2,500/mt, they would exercise their option and would receive a March-dated futures purchase with a price of $2,500/mt.
This is the same structure an end consumer could use when comparing their cost of production to the current market price. A straight-forward hedge for an end consumer would be to buy futures at market in order to lock in a gross profit margin against its cost of production, rather than waiting to receive the market price at the time of actually purchasing the raw material. If instead of buying futures, the company buys call options, it is paying a premium in order to see if the market will fall vs. hedging at the current market price. If the market does fall more than the cost of their option, it will make additional profit. If the market rises, it has the insurance of the call option to guarantee a futures long at the chosen strike price.
One important factor to take into account when venturing into the options market is that there may be an open position that needs a carry trade so it does not become a physical obligation. Let’s take the physical seller that wants to buy a call to give two months to see whether the price will drop. The company may have an open short position sitting in January. By potentially waiting until March to close that position out, they will create a need to borrow futures out of January. This is not necessarily a bad thing-if the market is in contango it will profit from this carry trade, and that profit can offset some of the premium it paid for the call option. But if this is not taken into consideration, it could easily end up having to borrow through a backwardation, which could negate any profit it makes on the call option.
The opposite would be true for companies that bought a put option. In this instance, those companies may have open long futures positions that would then need to be lent forward. In our example, this would be a January long futures position being lent to March. Similar to borrowing, this could be beneficial if there is a backwardation, because that carry trade would be profitable and could offset some of the premium paid for the put option. However, if there was a contango, the cost of the lend may negate the profits they might make on exercising the put option.
Depending on a company’s risk tolerance, and the premiums it is willing to pay, it could utilize options for some, all, or none of their price exposure. It is simply another form of risk mitigation they can explore. Options do have a higher up-front cost compared to a traditional hedging program, and require more specialist knowledge than executing simple outright futures. However, with the potential for large additional profits that are not attainable from simple hedging, some companies may find options an appealing alternative form of risk management.
