Commodity traders – as well as most other traders – tend to be risk averse. That is to say, they prefer situations with low uncertainty over situations with high uncertainty. Or better yet, no uncertainty at all. However, in economics and finance, as well as in life, things are never one hundred percent certain, nor do the most certain outcomes yield the best results. Luckily, there are tons of tools to deal with uncertainty as a solution to your risk aversion. In this article, our first hedging 101 article, we dive into the world of agricultural trade options: tools for managing agricultural price risk exposure.
When talking about risk aversion, the term hedging is never far away. Hedging here has nothing to do with gardening or trimming and maintaining the perimeter of your property, but literally means seeking a strategy that tries to limit risks in financial assets. It is not a way to make a profit, but rather to prevent or at least minimize possible losses.
In life we all hedge – it’s not limited to financial markets. The best way to understand hedging is by comparing it to insurance. Do you have a health insurance policy or coverage against fire damage to your house, theft of your car or loss of your belongings? Then you’ve already done some hedging, right? Now, your insurance policy does not prevent accidents from happening – but when they do, you have some form of financial compensation. Traders, portfolio managers and investors seek the same techniques to reduce their exposure to risk. At the same time, hedging in the financial markets is not quite as easy as taking out insurance and paying your fees. If it was, you wouldn’t need this article.
Hedging is an insurance method for commodity traders, producers and end-users to cover themselves against negative price movements. We’ve written about it extensively in our Commodity Knowledge Center, where you can also find all the basics on the most common hedging techniques. The futures exchange is commonly used to hedge against price risks. Market participants obtain derivatives on the exchange to cover themselves against price movements. These futures contracts and options on these exchanges are rarely executed. The position will be offset, which means obtaining an opposite contract to settle the contract. The commodity will then be sold on the cash market and the profit or loss made by offsetting the futures position will be added to the final cash price. The possible profit or loss is then covered by the profit or loss made by the futures contract.
Ok, we were moving a little too fast just now. Let’s take a step back. When we are talking about hedging in the context of (commodity) trade, we are talking about the use of derivates as a financial instrument. A derivative is a financial security, such as futures, forwards, options and swaps. Their value is determined by an underlying asset on which it is based. In other words, the underlying asset determines the price and if the price of the asset changes, the derivative changes along with it.
The design of these securities is to give producers and manufacturers the possibility to hedge risks. For the purpose of hedging in the agricultural commodities market, there are essentially two ways to go about that, as the two most common derivates are options and futures. The latter will be covered in a different article, but as mentioned before, you can find an example of hedging with futures in our Commodity Knowledge Center.
By using derivatives both parties agree on a sale at a specified price at a later date. Various properties are documented such as the relation between the derivative, type of underlying asset and the market in which they are traded. It is essential to understand the strengths and weaknesses of each derivative to employ them to their fullest potential.
Options are a form of derivatives, which gives holders the right, but not the obligation to buy or sell an underlying asset at a pre-determined price, somewhere in the future. When you take an option to buy an asset it is called a ‘call’ and when you obtain the right to sell an asset it is called a ‘put’. To determine whether it is profitable to exercise an option, the current market price (spot price) and the price in the option (strike price) need to be compared. By comparing both prices, a choice can be made to either exercise the option or let it expire, depending on the difference in outcome.
When exercising an option there are three positions on which the holder can find themselves. The first is ‘in the money’ (ITM), where the strike price is more favorable than the spot price and thus it will be advantageous to exercise the option. The second is ‘at the money’ (ATM) in which the strike and spot price are equal and so no advantage can be gained. The third is ‘out the money’ (OTM), where the strike price is higher than the spot price. In this case it is better to let the option expire and buy the commodity at the current market price.
There are two ways of settling an option between two parties. The first way is to physically deliver the underlying commodity. The other way is to cash-settle the option. In this way the difference between the spot and strike price is paid to the holder of the option upon exercising of the option.
Advantages of options
An option has a few advantages over other derivatives. The most important advantage is that an option is not binding, in the way that it does not obligate one to buy a commodity. It gives you the right to buy it and so when the price of the option is higher than the current market price you can just let the option expire and buy at the spot price. The only loss made therefore will be the premium which is the cost for maintaining the option. Another advantage is the usefulness of options as a hedging tool. Options offer the tools to successfully hedge price movements with a small investment risk.
An option is simply the right, but not the obligation, to buy or sell something at a specific predetermined price (strike price) at any time within a specified time period. A commodity option, also known as an option on a futures contract, contains the right to buy or sell a specific futures contract.
Hedging with options
Hedging allows you to lock in a certain price level and protects you against adverse price moves. In other words, you are committed to a specific buying or selling price and are willing to give up any additional market benefit if prices move in your favor because you want price protection.
There are two distinct types of options: call options and put options. Call options contain the right to buy the underlying futures contract and put options contain the right to sell the underlying futures contract. They are completely separate and different contracts, and explicitly not each other’s opposites. For instance, a seller of commodities could either buy call options, or sell put options. Option buyers pay a price for the rights contained in the option, option sellers collect the premium for their obligations to fulfill the rights.
Have we covered the basics? No, not yet. We’ve mentioned buying and selling call and put options, but there’s more financial lingo to throw into the mix. When speaking of options, we (also) refer to investors having either long positions or short positions. In the context here, long positions and short positions are a reference to what an investor owns and what an investor needs to own. In other words, going long means that you have the right to buy or sell the security, whereas going short means you are obligated to buy or sell.
Buying a call or put option is a long position because the investor owns the right to buy or sell the security at a specified price. Selling a call or put option is a short position because you are obligated to sell the shares to or buy the shares from the long position holder.
Pricing: option premiums
Let’s wrap up our introduction to hedging with options by looking at pricing. Whether or not buying and selling derivatives and going short or going long yields an interesting position comes down to the price of the contract, known as the option premium.
An option premium is the current market price of an option contract. It is the income received by the seller (writer) of an option contract to another party. That premium is determined, as so many things are, by the basic fundamentals of supply and demand. Buyers are keen to find the lowest possible price for an option and sellers want to earn the highest possible premium. There are of course some basic variables that ultimately affect the price of an option as they relate to supply and demand.
First off, an option premium consists of two parts: the intrinsic value and the time value. The former is defined as the amount of money that could be currently realized by exercising an option with a given strike price. It is therefore determined by the relationship of the option strike price to the underlying futures price. An option has intrinsic value if it is currently profitable to exercise the option.
At any point in the life of an option, puts and calls are classified based on their intrinsic value. In other words, the same option can be classified differently throughout time. A call option has intrinsic value if its strike price is below the futures price. A put option has intrinsic value if its strike price is above the futures price. So, it’s relatively easy to determine value by turning to basic maths. For call options, intrinsic value is calculated by subtracting the call strike price from the underlying futures price. For put options, intrinsic value is calculated by subtracting the underlying futures price from the put strike price.
If an option doesn’t have intrinsic value, the option premium is based solely on its time value. Because option premiums consist of the intrinsic value and the time value (sometimes called extrinsic value), the time value of any option is the difference between the total premium and the intrinsic value. Time value reflects the amount of money buyers are willing to pay in expectation that an option will be worth exercising at or before expiration. It is usually expressed in the number of days until expiration.
Agricultural options are referred to as trade options because, unlike exchange-traded options, which are bought and sold on a designated contract market, agricultural trade options are bought and sold off-exchange directly between commercial market participants for business-related purposes.
The market for physical agricultural commodities is an over-the-counter (OTC) market, where two parties agree on a contract to deliver and buy a commodity. These contracts are in many cases unique because they are set up in such a manner that they meet the specific needs of both parties. A contract is however not written from scratch for every single transaction. Usually a standard contract from a leading company is used as a basis for an individual contract. Thus a contract is relatively standard, with the exception of certain aspects. A number of aspects are determined for each contract – one of which is the price.
The price of the commodity is obvious an essential part of a contract. The other sections of the contract all generate input for determining the price. A price can be settled in many different ways, ranging from a fixed price to a market related price.
Of course, our Agiblocks CTRM solution can help you with all those steps, as physical contract management is where it excels; it supports trading management as well as financial management from the same source of data and within the same easily accessible application. Designed by traders, Agiblocks enables its users to focus on the essence of their trading. Find out more.