Oil producers, refiners, resellers, and traders benefit from the flexibility options offer in hedging programs and in generating income for profit centers.
Producers planning future sales of reserves can protect their inventories against a possible decline in prices by buying puts as insurance. If prices decrease, puts increase in value and can be exercised or liquidated at a profit to offset declines in cash market prices.
If oil prices rise, the higher market prices can be realized fully, less the cost of the premium.
If instead, a producer had chosen to protect against downward price movement by selling futures, he would be effectively locked out of the benefits of future price increases. Refiners can buy calls to hedge against higher crude oil costs. If prices rise, so will call values. Refiners can either exercise their calls and obtain long futures positions to lock in crude oil costs, or they can liquidate their options at a profit. Refiners can still benefit from declines in crude oil prices by letting the calls expire or by liquidating them. At the same time, refiners are at risk of declining prices in the products markets.
The oil industry has also found useful applications and opportunities for writing options. For example, an oil trader with a cargo could sell calls to earn income and protect against a decrease in oil prices up to an amount equivalent to the premium collected. If prices fall, the premium will offset some or all of the loss on the cash position.
If prices rise above the strike price plus the premium, the trader will lose money on his calls. However, these losses would be offset by appreciation in the value of the oil.
Heating oil and unleaded gasoline options offer a wide range of hedging strategies for refiners, wet barrel traders, marketers, and end users of refined products. A marketer can guarantee customers a maximum price over a specific time by buying calls. The strategy is frequently used when heating oil dealers set up seasonal price protection plans for their retail customers. Using calls, the marketer has the right, without the obligation, to purchase heating oil or gasoline at a specified price for a specific amount of time.
For example, assume that October 78¢ heating oil (or gasoline) calls are trading for 2¢ per gallon ($840 per contract). In this case, the marketer's maximum cost is established at 78¢, the strike price, plus 2¢, the premium, for a total of 80¢ per gallon. The marketer would add a margin to his costs and could then guarantee his customer a ceiling price over the terms of the contract.
No matter how high prices rise, the marketer has contracted the right, but not the obligation, to buy futures at 78¢. However, should prices decline sharply to 69¢, the marketer is able to participate in the lower priced market. He has no obligation to buy futures at 78¢; the call expires worthless. The marketer's effective purchase price is now 69¢ plus the two-cent premium on the call for a total of 71¢.
Natural gas options offer wellhead producers, pipelines, marketing companies, and end-users opportunities to hedge their price risk. Producers are most often on the sell side of the market, end-users are almost always on the buy side, and marketers, processors, and utilities have exposure on both sides.
As an example of how natural gas options can be used, take the case of an industrial gas user who is worried about the impact of a cold winter on his fuel costs. Instead of buying January futures, at, say $6.00 per million Btus, he can buy a January call options contract with a strike price of $6.00 for 40¢ per million Btus. Assume that on December 21, when he concludes a deal for his spot gas, the spot market and the futures contract are both trading at $6.70. Even though he pays his regular supplier $6.70, this cost is partially offset with the profit derived from the options transaction.
The options contract was purchased for 40¢ per mmBtu. Assume that on December 27, the last day of trading for the option, it is worth 70¢ – the difference between the strike price ($6.00) and the futures price ($6.70). So, netting the 30¢ profit against the $6.70 spot cost of gas yields a net cost of $6.40.
Electricity options offer power producers, utilities, marketing companies, power purchasing co-operatives, and end-users opportunities to hedge their price risk. Producers, of course, and many utilities, are most often on the sell side, while end-users are usually on the buy side. Power marketing companies, some utilities, and purchasing entities such as cooperatives have exposure on both sides of the market, similar to the position of an oil refiner, and as such can use puts and calls to mitigate their exposure.
Gold suppliers and industrial purchasers can use puts and calls to help protect their sales or purchase prices as is done in other metals and energy markets. Those holding inventory without an obligation to supply product can use out-of-the-money options to earn income in a stable market.
A central bank, holding an inventory of gold that is not yielding a return, sells calls to generate income from what it believes will be a stable market. Spot gold prices are $266 per ounce, and futures one year forward are priced at $272, so the bank sells a call for one year forward with a strike price of $280, $8 over the market, for $11.30 per ounce.
As the contract month of the call becomes the spot month, the contango of the gold market works in the bank's favor. Assuming there has been no change in the market, a year after the position is established, the spot month price is still $266, and the call, sold at a higher strike price, is abandoned, leaving the bank to pocket the premium, receiving income from a non-producing asset.
If the market should rise to $291.30 (the strike price of the call plus the premium) or higher, the option will be excised by the buyer and the metal will be "called away."
The bank, therefore, also incurs the risk that it may be required to covered its obligation.
Investors can use precious metals options to mitigate market risk.
On September 1, December silver futures are trading at $5 per ounce (each contract is for 5,000 troy ounces). An investor who believes that silver prices are about to rise buys a $6 call options contract for December silver futures at the current premium of 10¢ per ounce, or $500. By early November, December silver futures are trading at $6.50 an ounce and the $6 December call is trading for a premium of 50¢ per ounce. The investor sells his options contract for $2,500 realizing a profit of $2,000.
If, instead, silver futures prices had failed to rise above $6 per ounce by options expiration, the investor would have lost his premium. That loss, however, is considerably less than the loss on a comparable investment in physical silver. In addition, depending on the timing and magnitude of the silver price decline, the call options might have retained some value prior to expiration, allowing the trader to recoup a portion of his $500 investment.
Investors can write options to earn premium income. Purchasers of Exchange options have unlimited profit potential with limited loss potential, therefore the options writer must assume the other side of the risk/reward equation – limited income and unlimited price risk. For this reason, it is common for the options writer to sell calls during periods of flat to slightly bearish markets, and to sell puts in neutral to mildly bullish markets. In the event that futures prices move against the options writer, his loss is reduced by the premium he collects.
On March 16, platinum is trading at $588 per ounce on the cash market, but a precious metals refiner is concerned that prices will be lower in December when he will have to ship product. January futures are trading at $569 per ounce, but the refiner hesitates to lock in that price in the event supplies tighten and prices rise. He buys a December put with a strike price of $563 for $4.
By December 1, cash market platinum prices are $554, but the price of his put has risen to $11. He liquidates the options contract, gaining $7, and giving him a net platinum price of $561 per ounce.
On the other hand, if cash platinum prices increased to, say, $597, the put would expire out-of-the-money. The refiner's cost of the now worthless options contract is $4, the premium, giving him a net metal price of $593 per ounce.
Out-of-the-money options can be used for economical price protection in markets with high volatility.
On December 3, a copper producer considers hedging against a weakening market. He knows his cost of production is 45¢ a pound, and wants to protect the most margin at the last cost. He does not want to hedge with futures, which would effectively lock in a price for July of 80¢, nor does he want to spend 6.5¢ a pound for a July at-the-money put. He does want to protect his profitability against a significant drop in prices to 70¢, so the producer decides to purchase a put with a strike price of 70¢ for which he pays a 2¢ premium. He considers this to be the optimum cost efficient price protection while allowing participant in any favorable upward price move.
If the market price drops sharply, he will net no less than 68¢ per pound (70¢ for the metal, less the 2¢ premium for the option. If prices rise, the premium if the option is the cost of the price insurance. If the market rises to 90¢, he will realize 88¢.
Sometimes the cost of buying an options contract can be more expensive than a company's budget allows. One solution to this is a collar strategy. It allows a hedger to lower the cost of the hedge by using the proceeds from the sale of one type of option to help defray the premium for purchasing an opposite options position. Collars involve the purchase of a call and the sale of a put or, conversely, the sale of a call and the purchase of a put. The call and put both have out-of-the-money strike prices and expire in the same month.
A metals fabricator that needs to cap its exposure to rising wholesale aluminum costs considers the cost of a call option too expensive by itself. To help defray the premium, the company sells a put option and buys the call option. A collar is now in place, with the income earned from selling the put approximately offsetting the premium paid for purchasing the call. (This is known as a "costless" collar even though costs may not be fully offset; some collars can cost money, and some can actually earn revenue.) The collar means that while the company will pay no more than the price of the call option, it will also pay no less than the price of the put option. A floor and a cap are set.
If aluminum prices rise, the company has two choices. It may decide to liquidate its call option prior to expiration by selling it at a profit. It can then use that profit to offset the higher cash market prices. Or it can exercise the call option at expiration. This allows it to purchase aluminum futures at the predetermined "strike" price. It then liquidates the futures, which are selling above the options strike price, and uses the profit to offset the higher cash market price for aluminum. Either way, it has effectively capped its costs.
If aluminum prices decline, the company will have to meet its put options obligation, which means it must buy aluminum futures at the price specified in the options contract. The company has thus effectively found itself at the "floor" it created with the collar. It might have paid less for the aluminum if it had not been forced to honor its put options, but the company was willing to take that risk in order to be sure that it did not pay more for aluminum than the call options required.
On the other side of the market, a company concerned about falling prices could use the same strategy in reverse. Instead of buying a call, it would sell a call on the assumption that aluminum prices are not likely to rise. The company understands that if prices do climb, it may be obligated to honor its call by selling futures at the specified price. It is willing to take that risk, however, in order to make sure it will remain profitable if prices fall. To do so, it purchases a put, using the revenue earned from selling the call options to defray the premium needed to purchase the put. Once the collar is set, the company may not make as much profit as it could if prices rise by a certain amount, but it will not lose profit if prices decline below the level of its put option. The put gives the company the opportunity to sell aluminum futures at a predetermined price. If prices decline, the aluminum producer has two choices. It can sell the option for a profit – and use that profit to offset the lower cash market price it will receive for its aluminum – or it can hold the option and exercise it at expiration, acquiring the underlying futures and then selling them for a profit. Either way, it has effectively built a floor to support its aluminum price.
Warehouse receipts for physical gold, silver, platinum, copper, and aluminum are accepted as collateral for the financing of margin calls against a short call position in the metals options markets.