Using Options

Hedging Secondary Price Exposures  

Here are some basics on taking advantage of the various alternatives available to protect price commitments while gaining a participation opportunity.  

Options offer the best of both worlds--protection and participation. Still, this benefit does not come without a cost--the premium of the option. Thus, the key to using options is to minimize this expense and define precisely the firm's cost exposures, revenue targets, cash-flow restrictions, and profit-margin objectives.

Options Basics

There are two types of options, a call and a put. A call gives the holder the right (but not the obligation) to buy a futures contract at a specified level (the strike price) on or before the option's expiration date. It's the strategy used by firms wanting to fix a forward sales price for scrap or secondary metal before securing (pricing) a raw material supply. Conversely, a put option gives the holder the right (again, without the obligation) to sell a futures contract. Puts are used by holders of unpriced inventory, such as secondary smelters. Thus, options are fundamentally different from futures in that the holder of the option is not obligated to take or make delivery.

Options are classified as "in the money," "at the money," or "out of the money." An in-the-money call option occurs when the futures price exceeds the strike price. At-the-money calls are those made when futures and strike prices are equal. And an out-of-the-money call option occurs when the strike price is greater than the futures price. In put options, the opposite is the case: A put is in the money when the futures price is below the strike price.

There are two basic components that make up an option cost, or premium: intrinsic value and time value. Intrinsic value is the amount by which the futures price is above the strike price in a call option or below the strike price in a put option. The lowest intrinsic value an option can have is zero, since no one would exercise an option to realize a loss. As the price of the futures contract rises above the striking price of a call (or below the striking price of a put), its intrinsic value becomes positive. Again, an option with positive intrinsic value is said to be in the money, and one that has no intrinsic value is either at the money or out of the money.

While intrinsic value is fairly straightforward and simple to calculate, the fair time value of an option is neither obvious nor easy to compute. Several factors affect the time value of an option: the volatility of futures price; the difference between the futures price and the strike price; the time until expiration; the short-term, risk-free interest rate; and supply/demand factors.

Impacts on Premiums

The higher the futures price, the greater the absolute variability in price, and therefore, the higher the premium. Basically, if futures prices increase by 1 percent, the fair value of the premium increases by 1 percent.

Higher premiums also are expected when the option is close to being at the money, since that increases the probability that the option will expire with value. In addition, the further the option is in the money, the lower the probability is that the option will expire without value (and the higher the probability the option will expire with value and the greater the intrinsic value) and thus, the lower the time value. Time value also is low when the option is out of the money. It's greatest for options at the money.

An at-the-money option has a relatively high premium 12 months prior to expiration. But as expiration approaches, time value declines until it reaches zero at expiration. It is important to note that time value decays quite rapidly four to five weeks before expiration. A wise investor would choose not to liquidate his position but rather roll over long positions well before expiration. Conversely, short (or sell) positions increase considerably in the final two to three weeks before expiration. When options are far in the money or far out of the money, the impact of time decay is less pronounced as the option approaches expiration.

Perhaps the most important factor affecting an option's premium is volatility. The more volatile a futures price is, the higher the probability that the option will expire in the money. The volatility in an option's premium--referred to as the implied volatility--reflects the expected future variability of the underlying futures instrument. Implied volatility is calculated indirectly by starting with an option's premium--taking into account all the knowns, such as the time until expiration, the interest rate, and the strike price's distance from the futures prices--and solving for the unknown: volatility.

A benchmark estimate of implied volatility is the particular commodity's historical volatility. Historical volatility is the standard deviation of percentage changes in past prices and is usually expressed on an annualized basis. The spread between implied and historical volatility reflects supply-demand factors, the difference between past and future volatility, and statistical inconsistencies in the derivation of volatility.

Option Strategies

The most expensive option is an at-the-money option. For example, a three-month, 100-cent option with a futures price of 100 cents and a volatility of 26 percent has a premium of 5 cents. To reduce the premium, a hedger can purchase an option contract with a larger deduction, making it an out-of-the-money option. For example, a 5-cent deduction--which translates to a 95-cent put or a 105-cent call--with the same contract parameters would cost 3 cents instead of 5 cents.

For firms wishing to minimize this deduction in the event of an adverse price move, but at the same time wishing to participate in a favorable price move, the strategy is to sell futures and cover the futures hedge with an out-of-the-money call, or buy futures and cover the hedge with an out-of-the-money put. If prices were to move in a favorable direction, the offsetting option position provides a mechanism to cancel the futures hedge and allows participation in the favorable price move after the deduction.

Another strategy that can be structured at zero premium outlay is to set floors and caps-or minimum and maximum price levels. Through the purchase of an out-of-the money put (or call) and the sale of an equivalent out-of-the-money call (or put), a firm sets a minimum sales price (or a maximum buy price) and a maximum sales price (or a minimum buy price)--all at a zero premium outlay. The strike of the puts and the calls determines the minimum and maximum price levels; the range in between these two options provides an area of participation for the hedger (here, the options positions expire worthless).

The table on page 116 details the abovementioned strategies for two commercial situations: a firm holding unpriced inventory (scrap, for example) and a firm with a fixed-price product sale without fixing raw material purchase prices (secondary ingot, for example). The parameters used in the table are simplified and do not take into account a volatile forward structure (such as contango--when the futures price exceeds the spot price--or backwardation--when the futures price is below the spot price), basis risk (the changing relationship between quoted exchange prices and raw material or final product prices), and gap risk (the difference between options/futures expiration dates and physical pricing terms). These areas of risk can add value or detract from the "perfect hedge." When they represent a problem, it is important to manage or structure a hedge to minimize the cost; when they add value, the goal is to capture the benefits, thus building in bigger margins.

The table does add in physical exposures to the futures and options profits and losses for a combined net position (or a net hedge result). The goal of hedging is to reduce the overall risk of volatile prices and create a known in exchange for an unknown. Physical losses are offset by exchange market profits, whereas physical profits are offset by exchange market losses.

Hedge Results

In the table, physical exposures vary from a 15-cent profit to a 15-cent loss. Futures hedges in these examples offset perfectly the physical market exposures with 15-cent losses and 15-cent profits, offering full protection and no participation. The 100-cent at-the-the-money options have a cost of 5 cents and provide downside protection (less the 5-cent premium outlay) and upside participation. The maximum loss is a known, the 5-cent premium; the upside participation is infinite.

The cost of the out-of-the-money puts and calls--the 95-cent put and the 105-cent call--has a lower premium outlay (3 cents in these examples), provides downside protection (less the premium deduction of 3 cents and the out-of-the-money deduction of 5 cents), and upside participation.

The futures/option combination provides downside protection (less the premium outlay) and upside participation (less the premium outlay and the out-of-the-money deduction of 5 cents). Finally, the minimum/maximum hedges provide a floor price of 95 cents and a ceiling price of 105 cents. Losses are fixed at a maximum of 5 cents, while profits are capped at 5 cents. Between 95 cents and 105 cents, the firm is unhedged and participates with the market. Moreover, with the minimum/maximum hedge, there is no premium outlay: The cost of the option is offset by the income of the option sale.

The option markets allow a variety of techniques to hedge price exposures, and strategies can be constructed to fit precisely a firm's margin objectives. The examples discussed are meant to provide a flavor of the various alternatives available using COMEX or London Metal Exchange futures and options. The number of strategies, however, are virtually limitless.

Hedging Secondary Price Exposures  

Here are some basics on taking advantage of the various alternatives available to protect price commitments while gaining a participation opportunity.  

Options offer the best of both worlds--protection and participation. Still, this benefit does not come without a cost--the premium of the option. Thus, the key to using options is to minimize this expense and define precisely the firm's cost exposures, revenue targets, cash-flow restrictions, and profit-margin objectives.

Options Basics

There are two types of options, a call and a put. A call gives the holder the right (but not the obligation) to buy a futures contract at a specified level (the strike price) on or before the option's expiration date. It's the strategy used by firms wanting to fix a forward sales price for scrap or secondary metal before securing (pricing) a raw material supply. Conversely, a put option gives the holder the right (again, without the obligation) to sell a futures contract. Puts are used by holders of unpriced inventory, such as secondary smelters. Thus, options are fundamentally different from futures in that the holder of the option is not obligated to take or make delivery.

Options are classified as "in the money," "at the money," or "out of the money." An in-the-money call option occurs when the futures price exceeds the strike price. At-the-money calls are those made when futures and strike prices are equal. And an out-of-the-money call option occurs when the strike price is greater than the futures price. In put options, the opposite is the case: A put is in the money when the futures price is below the strike price.

There are two basic components that make up an option cost, or premium: intrinsic value and time value. Intrinsic value is the amount by which the futures price is above the strike price in a call option or below the strike price in a put option. The lowest intrinsic value an option can have is zero, since no one would exercise an option to realize a loss. As the price of the futures contract rises above the striking price of a call (or below the striking price of a put), its intrinsic value becomes positive. Again, an option with positive intrinsic value is said to be in the money, and one that has no intrinsic value is either at the money or out of the money.

While intrinsic value is fairly straightforward and simple to calculate, the fair time value of an option is neither obvious nor easy to compute. Several factors affect the time value of an option: the volatility of futures price; the difference between the futures price and the strike price; the time until expiration; the short-term, risk-free interest rate; and supply/demand factors.

Impacts on Premiums

The higher the futures price, the greater the absolute variability in price, and therefore, the higher the premium. Basically, if futures prices increase by 1 percent, the fair value of the premium increases by 1 percent.

Higher premiums also are expected when the option is close to being at the money, since that increases the probability that the option will expire with value. In addition, the further the option is in the money, the lower the probability is that the option will expire without value (and the higher the probability the option will expire with value and the greater the intrinsic value) and thus, the lower the time value. Time value also is low when the option is out of the money. It's greatest for options at the money.

An at-the-money option has a relatively high premium 12 months prior to expiration. But as expiration approaches, time value declines until it reaches zero at expiration. It is important to note that time value decays quite rapidly four to five weeks before expiration. A wise investor would choose not to liquidate his position but rather roll over long positions well before expiration. Conversely, short (or sell) positions increase considerably in the final two to three weeks before expiration. When options are far in the money or far out of the money, the impact of time decay is less pronounced as the option approaches expiration.

Perhaps the most important factor affecting an option's premium is volatility. The more volatile a futures price is, the higher the probability that the option will expire in the money. The volatility in an option's premium--referred to as the implied volatility--reflects the expected future variability of the underlying futures instrument. Implied volatility is calculated indirectly by starting with an option's premium--taking into account all the knowns, such as the time until expiration, the interest rate, and the strike price's distance from the futures prices--and solving for the unknown: volatility.

A benchmark estimate of implied volatility is the particular commodity's historical volatility. Historical volatility is the standard deviation of percentage changes in past prices and is usually expressed on an annualized basis. The spread between implied and historical volatility reflects supply-demand factors, the difference between past and future volatility, and statistical inconsistencies in the derivation of volatility.

Option Strategies

The most expensive option is an at-the-money option. For example, a three-month, 100-cent option with a futures price of 100 cents and a volatility of 26 percent has a premium of 5 cents. To reduce the premium, a hedger can purchase an option contract with a larger deduction, making it an out-of-the-money option. For example, a 5-cent deduction--which translates to a 95-cent put or a 105-cent call--with the same contract parameters would cost 3 cents instead of 5 cents.

For firms wishing to minimize this deduction in the event of an adverse price move, but at the same time wishing to participate in a favorable price move, the strategy is to sell futures and cover the futures hedge with an out-of-the-money call, or buy futures and cover the hedge with an out-of-the-money put. If prices were to move in a favorable direction, the offsetting option position provides a mechanism to cancel the futures hedge and allows participation in the favorable price move after the deduction.

Another strategy that can be structured at zero premium outlay is to set floors and caps-or minimum and maximum price levels. Through the purchase of an out-of-the money put (or call) and the sale of an equivalent out-of-the-money call (or put), a firm sets a minimum sales price (or a maximum buy price) and a maximum sales price (or a minimum buy price)--all at a zero premium outlay. The strike of the puts and the calls determines the minimum and maximum price levels; the range in between these two options provides an area of participation for the hedger (here, the options positions expire worthless).

The table on page 116 details the abovementioned strategies for two commercial situations: a firm holding unpriced inventory (scrap, for example) and a firm with a fixed-price product sale without fixing raw material purchase prices (secondary ingot, for example). The parameters used in the table are simplified and do not take into account a volatile forward structure (such as contango--when the futures price exceeds the spot price--or backwardation--when the futures price is below the spot price), basis risk (the changing relationship between quoted exchange prices and raw material or final product prices), and gap risk (the difference between options/futures expiration dates and physical pricing terms). These areas of risk can add value or detract from the "perfect hedge." When they represent a problem, it is important to manage or structure a hedge to minimize the cost; when they add value, the goal is to capture the benefits, thus building in bigger margins.

The table does add in physical exposures to the futures and options profits and losses for a combined net position (or a net hedge result). The goal of hedging is to reduce the overall risk of volatile prices and create a known in exchange for an unknown. Physical losses are offset by exchange market profits, whereas physical profits are offset by exchange market losses.

Hedge Results

In the table, physical exposures vary from a 15-cent profit to a 15-cent loss. Futures hedges in these examples offset perfectly the physical market exposures with 15-cent losses and 15-cent profits, offering full protection and no participation. The 100-cent at-the-the-money options have a cost of 5 cents and provide downside protection (less the 5-cent premium outlay) and upside participation. The maximum loss is a known, the 5-cent premium; the upside participation is infinite.

The cost of the out-of-the-money puts and calls--the 95-cent put and the 105-cent call--has a lower premium outlay (3 cents in these examples), provides downside protection (less the premium deduction of 3 cents and the out-of-the-money deduction of 5 cents), and upside participation.

The futures/option combination provides downside protection (less the premium outlay) and upside participation (less the premium outlay and the out-of-the-money deduction of 5 cents). Finally, the minimum/maximum hedges provide a floor price of 95 cents and a ceiling price of 105 cents. Losses are fixed at a maximum of 5 cents, while profits are capped at 5 cents. Between 95 cents and 105 cents, the firm is unhedged and participates with the market. Moreover, with the minimum/maximum hedge, there is no premium outlay: The cost of the option is offset by the income of the option sale.

The option markets allow a variety of techniques to hedge price exposures, and strategies can be constructed to fit precisely a firm's margin objectives. The examples discussed are meant to provide a flavor of the various alternatives available using COMEX or London Metal Exchange futures and options. The number of strategies, however, are virtually limitless.