HEDGING COMMODITIES 

PREFACE

All articles addressing financial derivatives arouse interest by default. This is especially pronounced since the global financial pandemic in 2007–2009.

At the end of June 2007 Bank for International Settlements reported that the notional amount of all derivatives contracts reached the level of astonishing $600 trillion exceeding by and large the value of world’s total financial assets.

The growth in credit default swaps from $2.69 trillion in 2003 to $54.6 trillion in 2007 has been particularly prodigal.

A derivative, by definition, is a financial instrument whose value is derived from an underlying asset; typically interest rate, currency, equity contracts and commodity.

Financial derivatives are among the most dominant, versatile, and applicable tools available to investors. To understand what makes the derivatives escalating popularity you have to recognize also the inherently dual capacity of their practical use— hedging versus speculating.

Over the past couple of decades, the derivatives market increased at the pace of geometric progression. Contemplating evidently disproportionate size of the derivative risk in the financial system, and their burgeoning versatility and complexity, Warren Buffet once described them as “financial weapons of mass destruction.”

Towards the end of 2008, following the collapse of five major banks in US, the derivatives crisis came crashing down. In October 2008 the Federal Reserve Bank triggered

the Troubled Assets Relief Program (TARP), a bizarre $800 billion bailout of the failed Wall Street banks and institutions in an attempt to prevent financial disaster spreading all over the globe.

The latest educated guess on the size of derivatives market point to the incredible figure of $1.4 quadrillion. In this book the author invested a remarkable endeavour to explain typical derivative instruments and develop a framework for efficient and effective risk mitigation

approaches or—hedging.

Hedging Commodities is well rounded study of some of the most fundamental conceptions related to derivatives contracts and risk management. It defines the role of risk management

played by businesses, enterprises and individuals exposed to price volatility and uncertain market environment. No pre-existing knowledge is needed to follow the main entries structured in five parts and 28 equally informative chapters.

This straightforward and up-to-date examination covers all aspects of hedging techniques vis-a-vis most widely traded metal contracts—gold and copper, within the context of major commodity exchanges: LME and CBOT.

SCOPE AND APPLICATION:

Amid continuous markets instability and frequent shocks the role of risk management has become much more important in recent years.

Open commodity positions are vulnerable to inconsistency of market forces. The ensuing market risk is one of the risk categories that falls within the company’s control. Once identified these risks must be efficiently managed. Successful risk management tailor their hedging concepts to reduce vulnerability to increasingly uncertain economic landscape.

The author initially examines the two OTC (over-the-counter) derivatives:

forwards and swaps, focusing in the next stage on the typical Exchange traded contracts—futures and options—and its role in containing and eliminating the market risk. There are many reasons why futures and options are considered to be the ideal hedging vehicle; the ability to transfer or otherwise manage the commodity price risk and versatility of their application, to name just a few.

The choice of hedging strategies range from the basic to more complex.

In extension to a detailed elaboration of futures and options most basic features and characteristics, the author identifies and then describes a variety of hedging strategies with powerful graphical applications designed to remove the potential risk impact from company’s future returns.

As its ultimate goal this book aims to propagate and promote the responsive awareness about commodity’s faltering fortunes and emphasise the priority of hedging over speculative aspect of trading and investing. 

BASIC FEATURES: 

• Futures, Forwards and Swaps: Basic characteristics, similarities

and dissimilarities with numerous examples

• Hedge Patterns with Futures: Concrete examples situated in different market

environments with visual recognition, and performance analysis.

• Futures Spreads: Learn the most comprehensive way how to make

a winning trade using futures spreads.

• Real-context strategies key mechanics and payoffs.
• Hedging strategies tailored to best suit different market scenarios
• Explanation of the “Greeks”
• Black-Scholes: Simplified intuitive approach to understanding the

famous formula.

• Binomial Options Pricing Model.
• Put Call Parity: Find out how Options, Futures and Underlying

Assets relate to each other in one integrated diagram.

• Options One Page Lesson: The most concise presentation of options main features.
• Hedging with Options: Four essential strategies to protect the

commodities from an adverse price rise or price fall.

• Options Spreads: Range-bound strategies for lower risk.
• Options Combinations: Learn to identify market imperfections

and initiate a strategy to your advantage.

• Advanced Options Strategies—collars, fences, conversion and reversals.
• Put Call Parity equations
• Arbitrage: Learn how to recognize mispriced options and close an

arbitrage trade

• The Logic of Creating The Synthetic Instruments

CONTENTS

PREFACE iv

CORE OBJECTIVES v

1          PART 1 FORWARDS, FUTURES & SWAPS

3          Chapter 1 Evolution of Trade: From Physical to

Derivative

4          Evolution of Trade: From Physical to Derivative

6          Forwards Overview

7          Principles for Calculating a Forward Price

8          Summary

9          Chapter 2 Introduction to Futures

10         Futures Overview

12         Commodity Market Participants

13         Futures Trade Illustration

16         Definition & Futures Building Blocks

16         Building Block No 1. Standardization

16         Building Block No.2 Centralized Market; Exchange

16         Building Block No.3 Longs and Shorts

17         Building Block No.4 Maturity

17         Building Block No.5 Initial Deposit

18         Building Block No. 6 Daily Settlements

19         Building Block No. 7 Leverage

20         Building Block No. 8 The Clearing House

22         Summary

23         Chapter 3 Commodity Futures Pricing

24         Cost of Carry Concept

25         Cash and Carry Arbitrage

26         Reverse Cash and Carry Arbitrage

28         Convenience Yield

33         Forwards vs. Futures

34         Forwards Payoff

34         Futures Payoff

36         Summary

37         Chapter 4 Hedging Basics

38         Defining Hedge

39         Hedging Mechanics

39         Hedging Definition

40         Different Types of Hedging

40         Long Hedge

42         Short Hedge

45         Different Types of Hedgers

45         Price Fix Hedgers

45         Price Offset Hedgers

46         Summary

47         Chapter 5 Hedge Patterns with Futures

48         Hedge Patterns with Futures

49         Price Fixing Hedge-Selling Forward

50         Price Fixing Hedge; Selling Forward-Price Falling

50         Price Fixing Hedge; Selling Forward-Price Rising

51         Price Fixing Hedge-Buying Forward

51         Price Fixing Hedge; Buying Forward-Price Rising

51         Price Fixing Hedge; Buying Forward-Price Falling

51         Offset Hedge Basic Patterns

52         Offset Hedge Basic Patterns-Buying Forward

52         1.1 Perfect Hedge; Closing a Buy Hedge on the Prompt Date

53         1.2 Imperfect Hedge; Closing a Buy Hedge before the Prompt Date

54         1.3 Carry by Borrowing; To Bring Nearer the Prompt Date

55         1.4 Carry by Lending; Extending the Prompt Date

57         Offset Hedge Basic Patterns-Selling Forward

57         2.1 Perfect Hedge; Closing a Sell Hedge on the Prompt Date

58         2.2 Imperfect Hedge; Closing a Sell Hedge before the Prompt Date

59         2.3 Carry by Lending; To Bring Nearer the Prompt Date

60         2.4 Carry by Borrowing; Extending the Prompt Date

62         Rolling a Futures Hedge

62         Rolling a Long Futures Hedge

63         Rolling a Short Futures Hedge

64         A Case of a Notorious Hedging Debacle

Metallgesellschaft AG; When a Hedge is not a Hedge

69         Average Price Hedging

72         Average Spread Costs

74         Futures Order Placement

75         3 Basic Order Types on Futures Contract

75         1. Market Order

75         2. Limit Order

75         3. Stop Order

78         Summary

79         Chapter 6 Commodity Futures Spreads

80         Commodity Futures Spreads

80         Calendar (Time) Spread

80         Buying a Spread: BiB & LiC

81         Selling a Spread: BiC & LiB

84         Summary

85         Chapter 7 Basis Controversy

86         Different Concepts of Basis

88         Basis and Maturity of Futures Contract

91         Hedging and Basis Risk

91         A Primer from CBOT

92         Short Hedge

93         Basis Movement—Three possible scenarios

93         Case No.1: Basis Strengthening

94         Case No.2: Basis Unchanged

95         Case No.3: Basis Weakening

95         Long Hedge

96         Basis Movement—Three possible scenarios

96         Case No.1: Basis Weakening

97         Case No.2: Basis Unchanged

98         Case No.3: Basis Strengthening

99         A Primer from LME

101       Long Hedge-Buying Forward

101       Price Fixing Hedge; Buying Forward, Backwardation Market

103       Price Fixing Hedge; Buying Forward, Backwardation Flips to Contango

104       Price Fixing Hedge; Buying Forward, Contango Market

105       Short Hedge-Selling Forward

105       Price Fixing Hedge; Selling Forward, Contango Market

106       Price Fixing Hedge; Selling Forward, Contango Flips to Backwardation

107       Price Fixing Hedge; Selling Forward, Backwardation Market

109       Summary

111       Chapter 8 Commodity Swaps

112       Swaps Overview

112       Swap Definition

113       Swap Features

114       Swap Pricing

115       Swap Mechanics

116       Exchange from the Perspective of a Swap Buyer

118       Exchange from the Perspective of a Swap Seller

122       Summary

 

124       PART 2 BASIC FEATURES AND STRATEGIES OF OPTIONS

125       Chapter 9 Introduction To Options

126       Options Basics

129       3 Ways to Liquidate an Option Contract

129       Exercising

129       Offsetting

130       Abandoning

131       Summary

133       Chapter 10 Basic Directional Strategies Using Options

134       Introduction

136       Buying Call-Long Call

136       Scenario I: Price Rise; In-the-money

137       Scenario II: Price Fall; Out-of-the-money

139       Buying Put-Long Put

139       Scenario I: Price Fall; In-the-money

140       Scenario II: Price Rise; Out-of-the-money

142       Selling Calls; Naked Call Writing

142       Scenario I: Price Rise; In-the-money

143       Scenario II: Price Fall; Out-of-the-money

145       Selling Puts-Naked Put Writing

145       Scenario I: Price Fall; In-the-money

145       Scenario II: Price Rise; Out-of-the-money

148       Options One Page Lesson: The Diamond Graph

149       Summary

151       Chapter 11 Hedge Patterns with Options

152       Hedging Positions Created with a Single Option

154       Futures vs. Futures Options

154       Payoffs and Profits at Expiration

158       Hedge Patterns with Options

160       Synthetic Long Put Option Strategy

Hedging Against Price Rise by Purchasing Call

162       Scenario I: Futures Price Rises to $915; ITM

163       Scenario II: Futures Price Falls to $855; OTM

167       Synthetic Long Put Hedge —Three Strategies Final Comments

169       Synthetic Short Put Option Strategy

Hedging Against Price Fall by Writing Call

170       Scenario I: Futures Price Rises to $915; ITM

171       Scenario II: Futures Price Falls to $855; OTM

173       Synthetic Long Call Option Strategy

Hedging Against Price Fall by Purchasing a Put

174       Scenario I: Futures Price Falls to $855; ITM

175       Scenario II: Futures Price Rises to $915; OTM

178       Synthetic Long Call Hedge —Three Strategies Final Comments

179       Synthetic Short Call Option Strategy

Hedging Against Price Rise by Writing a Put

180       Scenario I: Futures Price Falls to $855; ITM

181       Scenario II: Futures Price Rises to $915; OTM

184       3 Basic Order Types on Options Contracts

184       1. Market Order

184       2. Limit Order

184       3. Stop Order

185       Summary

187       Chapter 12 Typical Equity Hedging Strategies

188       Covered Call Writing

189       Scenario I: Underlying Stock Price Rises to $80; ITM

189       Scenario II: Underlying Stock Price Falls to $60; OTM

192       Covered Put Writing

193       Scenario I: Underlying Stock Price Rises to $80; ITM

193       Scenario II: Underlying Stock Price Falls to $60; OTM

196       Summary

 

197       PART 3 OPTIONS PRICING MODELS

199       Chapter 13 Determinants of Options Value

200       Main Factors Influencing Option Premium

201       Exercise Price vs. Option Premium

202       In-the -money options

202       At-the-money options

203       Out-of-the-money options

204       Underlying Instrument vs. Option Premium

208       Time Decay vs. Option Premium

208       Time Value

212       Volatility vs. Option Premium

213       Historic Volatility

213       Expected Volatility

214       Implied Volatility

216       Summary

219       Chapter 14 European Call & Put Pricing Bounds

220       European Call and Put Pricing Bounds

220       European Call Pricing Bounds

221       European Put Pricing Bounds

223       Summary

225       Chapter 15 Black-Scholes Pricing Model

226       Black-Scholes Pricing Model

227       Black-Scholes Model: An Illustration

229       Options Greeks

229       Delta

231       1. Hedge Ratio

232       2. Delta Neutral Concept

233       Gamma

234       Vega

234       Theta

235       Rho

236       Summary

237       Chapter 16 Binomial Options Pricing Model

238       Binomial Options Pricing Model

239       Properties of the Tree

240       Binomial Valuation

241       I. Riskless Hedge Model

241       Find a Replicating Portfolio

246       Creating the Performance of Risk-free Hedging

248       Verification of No-Arbitrage Principle

250       Multiple Binomial Tree

254       II. Risk Neutral Hedge Model

254       Pascal’s Triangle

256       Computing Risk-Neutral Probabilities

257       Constructing the Multi-Binomial Tree

259       Dynamic Hedge Primer; A Random Walk

Through the Binomial Tree

262       Summary

263       Chapter 17 Parity Relations

264       Parity Relations Between Options and Underlying Assets

268       Put Call Parity

270       Position Diagrams

275       Put-Call Parity Theorem Proofs

275       I. Fiduciary Call = Protective Put

276       II. Synthetic Long Underlying = Leveraged Equity

279       Arbitrage Opportunities

279       I. Fiduciary Call # Protective Put

281       II. Synthetic Long Underlying # Leveraged Equity

284       Summary

 

286       Part 4 ADVANCED HEDGING STRATEGIES

287       Chapter 18 Hedging Long Underlying with a

Bear Call Spread

288       Introduction

290       Hedging Long Underlying with a Bear Call Spread

290       Strategy Configuration; Case I

292       Strategy Configuration; Case II

294       Summary

295       Chapter 19 Hedging Short Underlying with a

Bull Call Spread

296       Hedging Short Underlying with a Bull Call Spread

296       Strategy Configuration; Case I

298       Strategy Configuration; Case II

300       Summary

301       Chapter 20 Collars & Fences

302       Introduction

303       Collar Strategy

303       Collar Strategy Configuration

306       Put Spread Collar

308       Fence Strategy

308       Fence Strategy Configuration

311       Summary

313       Chapter 21 Conversions & Reversals

314       Introduction

315       Conversions and Reversals—Multiple case Examples

317       Conversion Strategy

317       Conversion Strategy Configuration

319       Reversal Strategy

319       Reversal Strategy Configuration

321       Summary

323       `Chapter 22 Covered Short Straddles & Strangles

324       Covered Short Straddle

326       Covered Short Straddle Portfolio Key Features

328       Covered Short Strangle

330       Covered Short Strangle Portfolio Key Features

331       Summary

333       Chapter 23 Accrued Profits Protection

334       Accrued Profits Protection

334       I. Hedge  with a Short Futures

335       II. Protective Put Hedge

336       III. Covered Call Hedge

337       IV. Short Combo Hedge

337       V. Short Split Combo Protection (Short Semi-

Futures)

338       Summary

 

339       Part 5 OPTION SPREADS AND COMBINATIONS

341       Chapter 24 Options Spread Strategies

342       Introduction

344       Bull Call Spread

344       Strategy Key Features

346       Bull Put Spread

346       Strategy Key Features

348       Bear Call Spread

348       Strategy Key Features

350       Bear Put Spread

350       Strategy Key Features

353       Long Call Butterfly

354       Strategy Key Features

355       Iron Butterfly

356       Short Call Butterfly

356       Strategy Key Features

358       Long Call Condor

359       Strategy Key Features

360       Iron Condor

361       Short Call Condor

361       Strategy Key Features

363       Summary

365       Chapter 25 Call Ratio Spreads

366       Call (Bull) Ratio Spread

368       Bull (Call) ratio spreads (Credit)

371       Bull (Call) ratio spread (Even Money)

372       Bull (Call) ratio spread (Debit)

374       4. Call ratio backspreads

375       4.1 Call ratio backspread (Credit) – Sell 1 ITM Call, Buy 2 OTM Calls

378       Summary

379       Chapter 26 Put Ratio Spreads

380       Put (Bear) Ratio Spreads

381       1. Put (Bear) Ratio Spread (Credit)

383       2. Put (Bear) Ratio Spread (Even Money)

385       3. Put (Bear) Ratio Spread (Debit)

386       4. Put Ratio Backspreads

387       4.1 Put ratio backspread (Credit) – Sell 1 ITM Put, Buy 2 OTM Puts

390       Ratio Spreads Resume and Disambiguation

391       Summary

393       Chapter 27 Option Combinations

394       Long Straddle

394       Long Straddle Configuration

395       Bullish Long Straddle

397       Bearish Long Straddle

399       Short Straddle

399       Short Straddle Configuration

400       Bullish Short Straddle

401       Bearish Short Straddle

403       Long and Short Synthetic Straddles

403       Options Flexibility

406       Strip & Strap Strategies

406       Long Strip Strategy

406       Long Strap Strategy

409       Long Strangle

409       Long Strangle Configuration

411       Short Strangle

411       Short Strangle Configuration

415       Summary

417       Chapter 28 Synthetic Instruments

418       Synthetics Created Between Options and Underlying

Instruments

419       Synthetics Created Between Only Options

419       Long/Short Combos: Same Strikes

420       Long/Short Combos: Split Strikes

423       Synthetics Excluding Options

425       Summary

INDEX