Following inquiries from some of our subscribers, we thought we’d cover the basic principles of hedging risk with options.
Derivatives serve one primary function. They allow for an efficient transfer of risk between parties. Almost all firms have risk associated with the future price of an underlying asset. Examples include:
- A corn producer’s future revenue is determined by the future corn price.
- A gold miner is susceptible to the future price of gold.
- A bank’s revenue is affected by future interest rates.
- Firms that trade goods/services in foreign currencies have risk associated with appreciations and depreciations of those currencies.
If companies are to get involved in derivatives and financial markets, they’re generally interested in hedging and minimising risk (financial institutions being the main exception) as opposed to speculation.
Speculators can take on some of this risk firms are willing to shed for a potential profit. We are a prime example of this – along with other trading operations - since we take on risk for speculation purposes.
The two parties in an option contract need not be speculator and hedger. Parties can shed their risk by mutual benefit if they have different exposure to the same underlying asset.
Now imagine a corn grower is expecting a harvest of 1,000 bushels in 6 months. The current price is $7.50 per bushel. The current price is of little interest to the grower as they have no corn to sell. Only the future price when they are ready to sell their harvest is relevant. The future price is random and unforeseeable which means future revenue is also random and unpredictable.
Say the grower wants to buy a new tractor on credit, to increase productivity. With an uncertain future income it becomes a big risk to buy the tractor now. If there is a bumper harvest the price per bushel will fall drastically and the grower may be unable to make repayments on the tractor, or worse still feed and clothe his family.
If the grower has expenses of $5,000, his profit exposure to the future price of corn looks like this:
The break-even point is $5 per bushel. Any price below this is very worrying, any price above is good.
The upside is good, but the downside plagues the grower with uncertainty. His future planning is very hard when future revenue is so uncertain.
A solution is available in the form of options.
(Futures would be another good derivative for hedging this sort of exposure, but we are an options trading service and this is purely an example to explain the mechanics of hedging and speculation with options. We’re not presenting the best method to hedge exposure to the corn price, as that is a matter of opinion).
The grower could buy some puts to hedge his future income. Puts give him the right to sell his corn at a specific price at an agreed date. For this example we’ll imagine he buys 10 put contracts at $7.50. There are 100 bushels per contract, so he has the right to sell 1,000 bushels at $7.50 in the future.
Options give the right but not the obligation to sell at expiration. So if the price is above $7.50, our grower friend is not forced to sell 1,000 bushels at $7.50. He will simply not exercise the contract because he can sell his corn in the spot market for a better price.
The orange line gives the growers profit at different prices. You can see that at the very least, he’s guaranteed $2500 profit, regardless of how worthless corn becomes in the future. If things go very well and the price rises above $7.50, he still has upside potential.
The payoff of the put (black line) directly opposes the payoff of selling his corn in the market (blue line) and hence the two cancel out giving a predictable, certain result (orange line).
The above chart ignores the option premium. The put in this example was priced at $0.00 Of course something with value as a hedging tool will not be free. That value comes at a cost. If the price of that $7.50 put is $1.00 the structure changes to this:
Profit has been reduced by $1000 at all price levels. This is intuitive because the puts cost $1 each and the grower has bought 10 put contracts at 100 bushels per contract. $1*10*100 = $1000 cost. The grower trades some of his potential upside profits for a certain profit should the price of corn move against him. He is paying some money in the form of a put premium to insure against an undesirable outcome.
That’s the basic rationale behind hedging risk with options. We now move on to a different example:
Many people like to invest in precious metals mining stocks. We do not share this view, citing unequal compensation for the inherent risks in mining stocks. We have covered this topic several times. For further explanation of our opinion on this subject please click here and here. But that isn’t the topic of this article, here we look at hedging big losses in share prices with puts.
Mining stocks are susceptible to stock market shocks where equities across the board lose ground. Gold often, but not always, rises at these times. Its appeal as a safe haven asset pushes it higher in times of financial uncertainty.
So although one would expect mining stocks to rise in unison with gold, this is not always the case.
Thankfully, options can provide protection for this downside risk. To explain this point we’ll talk about GDX – A Gold Miners Index ETF.
As at Friday 28th September GDX trades at $53.69. An investor in GDX may want to protect their investment from significant downward stock market shocks. Some fluctuations up and down may be acceptable, within say 25% of the purchase price, but any more than that may be too uncomfortable for our theoretical investor.
The current price for a January 2014 GDX $45.00 Put is $4.60. Therefore, for the put to be worth more than what it cost, GDX must trade below $40.40 in January 2014. If GDX is above $40.40 in January 2014, the value of the put will be less than the premium paid for it and a loss is made. The payoff structure for this example looks like this:
Only having exposure to the share price, the profit for a GDX investor is shown by the blue line. There is as much downside as there is upside.
The orange line shows the net payoff with the addition of a $45 put, bought for $4.60. This has two main consequences.
Firstly, upside is reduced slightly. The return at any given price is reduced by $4.60 (cost of the Put). EXCEPT for prices below $45. Below a share price of $40.40, the losses sustained are much lower and limited to $13.29. The orange net payoff line clearly shows the effect of the downside insurance the Put is giving the investor. The investor’s loss is limited to 24.75%.
This all sounds very appealing, to limit losses and still have unlimited upside potential but in reality the judgement call on whether or not to go ahead with insurance such as this is a lot more complicated.
The value of insurance depends on one’s assessment of the probability of an adverse event occurring. Everyone wants to eliminate risk, but only at a price they assess as advantageous to them. Or in other words, the cost of the insurance does not exceed the probability of the undesirable event occurring.
One of the reasons our trading is focused on options is because they are the most flexible tool for hedging and speculation to have ever existed. Options allow hedgers and speculators to customize their risks and payoffs very precisely and manage their risks very flexibly.
Our strategy is to look for speculative options we think are under-priced on a probability basis. We take on risk when we believe the potential return of an option over compensates the price we pay for it. 91.35% of the time we have been correct and our performance has replicated our accuracy.
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