Commodity Hedging Using Options

Commodity markets are well-known for their volatility. In addition to the general volatility of most commodities, agricultural commodity products have the seasonal uncertainty also built into their market behavior mechanism. In this article, we are looking at how you, as a commodity trader, particularly a buyer, could protect yourself from the market’s wild movements by hedging using options.

The main ways of hedging commodities

Commodity traders whose business might be affected by substantial seasonal fluctuations may hedge their risks in two main ways - using futures or forward contracts. Futures have traditionally been the staple of hedging against volatility in commodity markets. By entering into a futures contract, you are committing to buying or selling a commodity at a pre-specified time and at a pre-specified price.

Futures have been a popular way of hedging in many commodity markets. They feature a wide variety of products available on the leading commodity exchanges. Liquidity levels are also high for the majority of popular commodities. Some of the commodity futures specify the requirement to physically deliver the target product. However, many others are settled only financially, making the futures a flexible trading tool.

The advantages of futures are their standardized format and the wide availability on exchanges. However, as a commodity trader, you might also utilize forward contracts to secure a pre-specified asset price. Forwards are an OTC product and have lower levels of standardization. Their advantage is greater flexibility compared to futures. You may specify custom terms for your commodity trade in a forward contract.

Options - Going beyond futures and forwards

The biggest downside of futures and forward contracts is their binding nature. Traders are using these products to hedge volatility, and this works most of the time. However, excessive volatility, which is far from an unknown phenomenon in commodity markets, can lead to significant losses even when using futures and forwards.

This is when options, another popular derivative product type, can be of tremendous help to commodity traders. Commodity options are agreements that give transacting parties the right to buy or sell a commodity product at a specific time in the future. Options are often called non-binding but this is not entirely correct, as we will see further. Options simply have the advantage of greater flexibility in terms of the contract execution terms compared to the rather stringent binding conditions of futures and forwards.

Options contracts have premiums associated with them. In fact, the prices for options listed on commodity exchanges are exactly those premiums, not the underlying asset prices.

A call option is the one you use for an option to purchase an asset in the future. A put option is used for an option to sell an asset in the future. Buyers of options pay a premium to options sellers under these contracts. For sellers, the premium serves as an advance income source. Similar to futures, options are often used with significant leverage.

The biggest advantage of options is their flexibility. Options are a great product if price forecasts are all over the place. Do note, however, that the greater the market uncertainty, the more you will pay for options premiums. Options can be a useful way of hedging commodity risks, but there is a caveat – buyers and sellers in the options market don’t always share equal trading risks!

The uneven risk equation of options

Options offer tremendous benefits to commodity traders on the buying side of the equation. As a buyer, the most you are going to lose is the premium that you have paid under an options contract. This will happen if you walk away from the deal and don’t purchase the target commodity by the options’ expiration date. As such, your risks are quite limited. When filling up your buy-side commodities portfolio, options are a great product to consider.

In contrast, under some scenarios, options sellers deal with a substantial risk of potential losses. These losses may occur if the buyer decides to execute the contract terms at the asset’s strike price - the price at which the buyer could purchase the asset under the options contract. For instance, if a call option holder moves to buy the asset at the strike price, the seller now has the obligation to execute the contract terms. If the strike price is lower than the asset’s market price, the seller is in the red. In fact, the seller’s loss is limited only by the price differential between the strike price and the market price. Add here the ample use of leverage so common in options trading, and some options sellers might find themselves in deep trouble.

In general, options are a great risk hedge, particularly for buyers, when market uncertainty rules supreme. Do note, however, that options premiums in volatile markets tend to rise. The decision to make options a part of your hedging toolbox will be driven to a large degree by the nature of your specific commodity product. If premiums are reasonable and you are on the buying side of the options playground, consider this derivative product type when trading volatile commodities.