Managing Risk using Options

26

Hedging Using Options

The easiest way to consider an option is as price insurance.

  • call option offers protection against a rising market. A pig producer can use this in place of a forward grain purchase, which gives an absolute maximum price and the ability to benefit if the market falls.
  • put option offers protection against a falling market. A pig producer could use this in conjunction with a grain purchase, to benefit if the market falls.

Options in the UK are based upon the UK LIFFE feed wheat futures market. An option gives the right, but not obligation, to buy or sell a futures contract at a specified price at any time in the future prior to the expiry of the option.

The key difference between futures and options is that the owner of an option is not obliged to the contract as they have bought the right to abandon it if they so wish.

Ker terminology: See glossary for more

      • Strike price: This is the price that the owner of the option is insuring, which relates to the futures price not the physical price. For a call option, if the futures market price rises above the strike price the option makes money. For a put option, if the futures market price falls below the strike price the option makes money.
      • Premium: As with any insurance policy, a premium is payable. Premiums are related to the length of time being covered, recent market volatility as well as the strike price.
      • Expiry: As with any insurance product, options have a defined period. The expiry date of a UK wheat option is defined as the second Thursday of the month preceding the futures month. E.g. for a November option, the expiry is the second Thursday of October.

 

£ per tonne November  call option purchased in March Outcome in October Physical wheat bought on spot market @ £2/t above futures Net wheat purchase price
Futures Price Strike Price Premium Futures Price Hedging Margin*
2005 70 70 -3 69 -3 71 74
2006 74 74 -3 96 19 98 79
2007 88 88 -5 161 68 163 95
2008 155 155 -16 92 -16 94 110
2009 122 122 -10 101 -10 101 111
2010 103 103 -8 161 50 163 113
A B C D E=D-A+C* F=D+2 G=F-E

*Note: If negative, the hedging margin can not be greater than the option premium

The above example looks at the six years 2005-2010 and examines how a November call option would have performed, having been purchased in March.

Unlike futures hedging, the use of options allows the pig producer to set a maximum wheat price, but still benefit if the market falls.

In the years of 2006, 2007 and 2010, the wheat market rose from March to October. This meant that the call option made money and so compensated the pig producer against the higher physical wheat price.

In the years of 2005, 2008 and 2009, the wheat market fell from March to October. The call option did not yield any profit and in this circumstance the owner of the option would abandon it, which is of course the owner’s right. The option premium has been paid, which gives rise to the negative hedging margin. However, with options the negative hedging margin can’t be greater than the option premium, a huge advantage over forward or futures hedging.

A pig producer may well be disheartened if they have purchased a call option and the market hasn’t risen. However, the presence of the call option gives the pig farmer confidence not to buy forward, thus allowing them to benefit from the falling market.

2008 is a classic example of this:

      • Simply buying forward in March 2008, to secure a price, would have meant a wheat purchase price of £157/t (Futures plus £2/t)
      • Buying the call option allowed a maximum ‘worst case scenario’ price of £173/t to be put in place (Futures plus £2/t plus the option premium)
      • With the security of the maximum price in place, the farmer confidently did not buy forward, watched the market decline and then procured wheat on the spot market at net price of £110/t.