Hedging with options - Hedge price risks by using options

We’ve told you about hedging with futures. There is also a possibility to hedge price risks by using options, which grant the right but not the obligation to buy or sell a futures contract at a fixed price, which in this case will be called the strike price. Unlike using futures to hedge, hedging with options offers more possibilities for the holders of an option. They may lose their investment in the option when the price moves against them, but when the price moves in their favor they can let the option expire and take advantage of the favorable market price. Therefore the eventual result of option hedging can vary much more than when hedging with futures.

There are costs involved in obtaining an option. The price for an option is called a premium and is based on intrinsic and time value. The intrinsic value is the difference between the strike price and the underlying asset’s market price. This will be the profit made by exercising the option or offsetting the option. The time value is determined by the possibility of the price increasing over time. When the maturity date of an option draws near, it becomes more unlikely the price will make significant changes and thus the time value decreases. The premium of an option can influence the decision to hedge a commodity using options and how and when the hedge will be placed.

Similar to hedging with futures, hedging with option also offers two positions a hedger can occupy, which is either long or short. And just like futures, the basis can play an important part in the final price paid for a commodity. The opportunities, threats and method for each position will be explained hereafter.

Long hedging

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A long position in option hedging gives the holder of the call the right but not the obligation to buy a futures contract. A holder of a long position expects the price of the futures contract to rise, hereby exercising the option and obtaining the futures contract at the lower strike price, or gaining the profit from offsetting his position. There are a number of different scenarios which can occur when hedging with options.

In the first scenario the futures and cash price increase, while the basis remains unchanged. This will result in a profit, when the hedger offsets his position. The cash price will be decreased with the difference between the original premium and the premium upon the moment of settling the position.
A hedger can also choose to exercise the option when the price has increased significantly, but the premium for options increases only slightly. In this cast the hedger would be able to buy the futures contract for the strike price and sell it for the current futures prices, which would result in a substantial profit. The net buying price will be based on the cash price reduced with the profit made on exercising the option. 

The prices of both the market and futures price can however also decrease, which will result in a increased net buying price. The offsetting of the position will now cost the hedger money and thus the cash price will increase with the difference between the original premium and the premium upon the moment of settling the position.

Another situation can occur where the price doesn’t make a substantial change and the option will expire worthless. This will result in losing the entire premium paid for the option. Consequently this result in an increased net buying price, which is constructed of the cash price with the addition of the premium.

Short hedging

Source: wallstreetmojo.com

Short hedging with the use of option is mostly implemented by producers, who want to ensure themselves of a profitable price upon the delivery date. Therefore they will obtain a put with a favorable strike price. similar to long hedging, short hedging can result in different results.
The first and most favorable situation, in case of a short position with a put, is when the price decreases. The hedger is now able to sell his option for a higher price than the current futures price and thus additional profit is made. This profit along with the cash price will form the net selling price.
In a different situation the price may decrease significantly while the premium only increases slightly. This may cause the hedger to exercise the option, which would result in selling a futures contract for a higher price than the current futures price. He can buy back this contract for the lower market price and sell his commodity on the cash market. The net selling price will be the cash price plus the profit made on offsetting the futures position.
There is also the possibility the prices will increase. This will cause the offset of the option to cost the hedger money. The cash price will be decreased with the difference between the premium upon obtaining the put and offsetting this position upon the maturity date, this forms the net selling price.
The final situation is when the price makes no significant change. This will result in the option expiring worthless and the commodity being sold on the cash market. This results in the net selling price being composed of the cash price reduced with the premium paid for the option.

As the different situations above illustrate, the use of options never comes free and thus must be used in a sensible manner. Despite the costs, the use of options is a solid form of hedging due to the possibility to still gain additional profit from price increases. Whereas futures are a far more binding contract. The use of options as a hedging tool is not to make additional profits, but to limit potential losses.

For more information about hedging with options, check out our in-depth article ‘Hedging 101: hedging with agricultural options’.