Classical hedging strategies

This is the third paper in a planned series of risk management topics by Inside Out Advisors.  Last week we introduced basic producer hedging strategies using futures, forwards and swaps. In this paper we investigate a more sophisticated set of strategies utilising options.

An option gives the buyer the right, but not the obligation, to buy (in the case of a ‘Call’ option) or sell (in the case of a ‘Put’ option) a commodity at a specified price (the ‘Strike Price’) at a specified time1 (the ‘Expiry Date’).   When a producer sells a future, forward or swap contract it is contractually obliged to honour that sale whether the commodity price goes in its favour or not.  However, when a producer buys a Put Option it has the option to sell the commodity at the Strike Price (which it will normally do if the market goes below that level), but can choose not to exercise its option to sell (which it will normally do if the market trades above that level)2.   The producer has achieved a guaranteed Floor Price on the downside whilst maintaining the ability to sell at higher prices (upside price participation) should the market rally.  The buyer of an option must pay an up-front Premium to the seller of the option to compensate her for taking on those risks.  When the put options are negotiated and settled Over-The-Counter, the potential non-performance of the option seller should also be considered.

Simply buying put options to hedge production has many benefits. In addition to providing a guaranteed price floor and maintaining upside participation, this strategy will not strain the producer’s liquidity due to cash calls from daily variation margin requirements.  The downside is that the option premia must be paid for up-front, impacting short-term cash flow (although there are strategies available to defer the cost to a later date).

When the up-front cost of a Long put option strategy is impractical or unpalatable, the producer can look at more complex strategies that, in addition to the purchase of puts, involve the selling of call options to reduce or eliminate the net premium outlay. Indeed there is an infinite combination of puts, calls, strike prices, volumes, tenors, and so on, that can be constructed to suit a particular risk profile but there are several popular combinations which we will explore now.

A Collar strategy involves buying a put option with a Strike Price below the current market level and selling a call option with a Strike Price above the current market level.  The payoffs associated with the long put option are the same as those described above, creating a guaranteed floor price. The sold call option creates a ceiling price above which the producer is obligated to sell their commodity (the buyer of an option has the option to transact, whereas the seller of that option has a liability contingent upon the buyer choosing to Exercise the option).  For example, consider a copper producer that enters into a LME Copper collar, buying $5,000/mt strike put options and selling $7,000/mt strike call options.  At expiry, if the copper price is

  • less than $5,000/mt
    • the producer will exercise its right under the put option to sell its copper to the option seller at $5,000/mt (the ‘floor’ price).
  • Within the range $5,000/mt and $7,000/mt
    • it is neither optimal for the producer to exercise the put option he owns nor for the buyer of the call option to exercise his right to buy, and therefore the producer is free to sell his copper at the prevailing market price
  • Above $7,000/mt,
    • the buyer of the call option will exercise his right to buy at that level, obligating the producer to sell at $7,000/mt (the ‘ceiling’ price).

The risk associated with the sold call option is said to be ‘covered’ as the producer is long the underlying asset. In addition, exposure from the sold call option only occurs when the commodity price is higher.  As a higher price environment generally translates into increased profitability for the producer, this type of exposure is referred to as Right-Way Risk.

All other things equal, increasing the strike price on a put option increases its premium, and vice versa.  Conversely, increasing the strike price of a call option decreases its premium, and vice versa. See the table below for a summary of the main option price sensitivities (a thorough explanation of these relationships is beyond the scope of this article but will be explored in a future publication).  In this manner the strike prices of the puts and calls in a collar can be adjusted to solve for a desired net premium amount.  It is common to solve for strike prices that net each other out exactly.  Such a collar is referred to as a Zero Cost Collar, although it should be noted that regardless of the zero up-front premium cost a producer using this strategy incurs the ‘opportunity cost’ of forgone upside price participation.  In addition, the Short call option part of this structure can introduce credit and liquidity considerations.

The addition of a third option into the structure results in a strategy called a Three-Way’ Collar.  There are two types of producer three-way strategies.  The first type consists of the original collar structure (buying a put option, selling a call option) and then buying an additional call option with a higher strike price.  In this way the producer’s upside participation is only capped between the range of the call option strike prices.  Above the higher call option strike price the producer participates in all further price appreciation.  The diagram below shows the producer’s pay-off for a three-way structure where they buy the $5,000/mt strike put option, sell the $7,000/mt strike call option and buy the $9,000/mt strike call option.

  • Below $5,000/mt,the producer is completely protected
  • Within the range $5,000/mt and $7,000/mt
    • it is neither optimal for the producer to exercise the put option he owns nor for the buyer of the call option to exercise his right to buy, and therefore the producer is free to sell his copper at the prevailing market price
  • Within the range $7,000/mt and $9,000/mt
    • The producer gives up all the upside, up to a maximum of $2,000/mt
  • Above $9,000/mt
    • The producer once again participates fully in the rising price and is able to sell his production optimally at prevailing market levels

So, for example, if the copper price was at $10,000 at the expiry date of the options, the producer would owe $2,000/mt from the call option package and sell their production at the market price of $10,000/mt, achieving a net price of $8,000/mt. This strategy is more costly than the equivalent collar but represents a good compromise between an effective hedge, up-front cost and upside price participation.

This kind of 3-way structure is a favoured hedge structure with producers as it both

  • Satisfies lenders on security of cashflows
  • Satisfies investors by retaining upside exposure

The second, more aggressive three-way structure involves the original collar (buying a put option, selling a call option) plus the sale of an additional put option with a lower strike price. By doing this the producer earns an additional premium for the extra option sale, reducing the overall price of the package.  As a result, the downside price protection only exists up to a maximum of the difference between the strike prices of the two put options.  An example will clarify this: the copper producer buys a $5,000/mt strike put option, sells a $3,500/mt put option and sells a $7,000/mt strike call option.  In this structure

  • Below $3,500/mt the producer is no longer protected from falling prices
  • Within the range $3,500/mt and $5,000/mt the producer is protected from price declines but only to a limit of $1,500/mt
  • Within the range $5,000/mt and $7,000/mt
    • it is neither optimal for the producer to exercise the put option he owns nor for the buyer of the call option to exercise his right to buy, and therefore the producer is free to sell his copper at the prevailing market price
  • Above $7,000/mt,
    • the buyer of the call option will exercise his right to buy at that level, obligating the producer to sell at $7,000/mt (the ‘ceiling’ price).

Although this type of three-way collar is sometimes used by producers due to its lower up-front cost, it has one critical deficiency: the hedge stops working when the producer needs it most.  Selling put options generates Wrong-Way Risk for a producer as the liability that they create increases as the commodity price falls, an environment where the company’s ability to meet this liability is likely to be increasingly impaired.

For simplicity we have described the mechanics of these option structures as if they were ‘European’ style (exerciseable at maturity, and settled into the underlying future or forward contract).  However, as discussed in our first article (“Risk isn’t always where you expect it to be”), producers typically sell their material at the average price over a loading period against a benchmark index.  As a result, the relevent ‘style’ of option for the producer to employ is the ‘Asian’ style, where the option is cash-settled against the monthly average of the observed daily benchmark prices.  The net cash-flow due to (or from) the producer arising from the asian option structure compensates for the fall (or rise) in the benchmark used to price the physical commodity sales more closely.

In our next article we will explore hedging strategies for the commodity consumer.

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Notes

1  It is common for exchange-traded commodity options to be ‘American’ style, meaning that they can be exercised at any time up to and including the expiry date.
2  Unless the option has automatic exercise rules (as some exchange traded options do) the right to exercise or abandon the option rests with the option owner.  There are some situations (normally where underlying market liquidity is low) where an option holder may not exercise a slightly In The Money option, or may exercise a slightly Out Of The Money option, but these situations are rare.