Trading Strategies Used by a Commodity Trader - Case Study Example

Name: ___________ Course ID: _______ Student ID: _______ Trading Strategies used by a commodity trader For commodities I cover the energy markets (Crude Oil, Gasoline, Heating Oil, and Natural Gas); the metals (Gold, Silver, Copper, Platinum, etc.); grains and oilseeds (Corn, Wheat, Soybeans, etc.) and livestock (Cattle, Hogs, Pork Bellies, etc.); In this respect, I have observed that energy futures contracts are used by large integrated oil companies to provide accessibility and visibility of market prices for the purchase and sale of physical oil. Liquidity in the futures markets ensures that specific hedging strategies can be successfully processed. Production can set forward sales prices. Refining operations can be hedged using crack spreads to set profit margins by fixing differentials between crude oil and product prices. In addition, margins on the distribution of petroleum products can be set. The advent of options on underlying crude and heating oil futures contracts has introduced the concept of the ‘managed hedge’ at a known cost that is, the premium. Options provide the ability to hedge crude and heating oil cash and futures positions against adverse price movements without forgoing all the benefits of favorable price movements. Options also allow a company to fine-tune a hedge by allowing a choice of hedging insurance at different levels, costs, and degrees of protection. Let me give you an example of Mayfair Petroleum Company in which I worked as a commodity trader, is active in petroleum exploration and production on a worldwide basis with petroleum refining and marketing operations in the United States. As operations trading managers I had become more familiar with the hedging tools available and the appropriate risk strategies to implement, participation in the futures and options markets increased. The company entered the market in order to maintain a competitive edge as oil markets were deregulated and as volatility became more visible. Mayfair found that the futures markets provided an index for price discovery and immediate market information. Liquidity in the NYMEX markets provided the company with the necessary flexibility and ease of entry and exit in order to process specific hedging transactions. The company hedges crude and heating oil cash and futures positions against adverse price changes without forgoing all the benefits of favorable price movements. Options provide insurance at a limited known cost. The company’s current hedges include: (a) refinery supply crude prices, (b) purchase/sales for supply, and (c) inventories in tankage. Mayfairs continues to formally segregate trading operations. Formal strategy meetings, however, held twice a week with supply, refining, and marketing personnel to discuss open positions and proposed hedging strategies. At the same time, frequent informal contacts between traders and supply/marketing staff were maintained. In order to maintain the appropriate operational and accounting controls for its futures and options hedging program, my trading department reported directly to the vice president of supply and transportation. In most hedging strategies, the hedge is designed to protect profits or asset values, or establish costs or revenues at favorable price levels. The subsequent market action affects cash flow, not final costs. In a ‘fully hedged’ approach, the objectives are set, the hedge ratio calculated, and the position implemented. Only when the cash transaction is executed is the offsetting hedge lifted. The use of futures permits the attainment of objectives not always available in the physical market, and the introduction of option strategies broadens considerably the range of goals achievable within either the physicals or futures markets. I designed an options-related strategy in Mayfairs, in which I consider and resolved three major issues: What is the objective of the risk manager (hedger)? What is the hedger’s opinion or forecast for the related market during the hedging period? What has been the volatility of the underlying futures market, and what is it expected to be during the hedging term? Based on these considerations, the hedging objectives were set. On the producer side, these objectives may include: Locking in favorable prices for forward periods Protecting the value of existing inventories or future production at current values; Setting a minimum price for future sales, yet participating if prices rise; Enhancing revenue by collecting a premium for accepting the obligation to sell a product above the current market price. The first two objectives can be achieved using physicals or futures, but the last two require options techniques. On the consumer side, the objectives of hedging may include: Locking in favorable costs for forward periods; Protecting the value of raw materials purchased, goods-in-process, or finished goods at current values; Setting a maximum price for forward purchases, while benefiting if prices fall; Developing the potential to buy below the current market price and collecting a premium in so doing. Again, the last two objectives incorporated option strategies rather than futures alone. Although the use of futures strategies may not demand a market forecast, the choice of an appropriate options strategy requires some appraisal of likely market ranges over the hedge period. To illustrate: A strongly bullish forecast would suggest buying futures, buying calls, or writing (selling) puts. A strongly bearish forecast would suggest selling futures, buying puts, or writing (selling) calls. A moderately bullish strategy would suggest buying calls. An expectation of a narrow trading range with declining volatility might suggest writing both puts and calls. A directionless forecast with rising volatility might suggest buying puts and calls. Trading Strategies Options Bullish Trading Strategies Option Spread Strategy Description Reason to use When to use Buy a Call Strongest bullish option position. Loss limited to premium paid. Undervalued option with volatility increasing. Sell a Put Neutral bullish option position. Profit limited to premium received. High volatility, bullish trending market. Buy Vertical Bull Call Spread Buy Call & sell Call of higher strike price. Loss limited to debit. Small debit, bullish market. Sell Vertical Bear Put Spread Sell Put & buy Put of lower strike price. Loss limited to strike price difference less premium received. Large credit, bullish market. Bearish Trading Strategies Option Spread Strategy Description Reason to use When to use Buy a Put Strongest bearish option position. Loss limited to premium paid. Undervalued option with increasing volatility. Sell a Call Neutral bearish option position. Profit limited to premium received. Option overvalued, market flat to bearish. Buy Vertical Bear Put Spread Buy at the money Put & sell out of the money Put. Loss limited to debit. Small debit, bearish market. Sell Vertical Bull Call Spread Sell Call & buy Call of higher strike price. Loss limited to strike price difference minus credit. Large credit, bearish market. Neutral Trading Strategies Option Spread Strategy Description Reason to use When to use Strangle Sell out of the money Put & Call. Maximum use of time value decay. Trading range market with volatility peaking. Arbitrage Buy & sell similar options simultaneously. Profit certain if done at credit. Any time credit received. Calendar Sell near month, buy far month, same strike price. Near month time value decays faster. Small debit, trading range market. Butterfly Buy at the money Call (Put) & sell 2 out of the money Calls(Puts) & buy out of the money Call (Put). Profit certain if done at credit. Any time credit received. Guts Sell in the money Put & Call. Receive large premium. Options have time premium & market in trading range. Box Sell Calls & Puts same strike price. Profit certain if done at credit. Any time credit received. Ratio Call Buy Call & sell Calls of higher strike price. Neutral, slightly bullish. Large credit & difference between strike price of option bought & sold. Conversion Buy futures & buy at the money Put & sell out of the money Call. Profit certain if done at credit. Any time credit received. With the available futures and options instruments, I designed a wide range of hedging strategies. The following cases are a few examples of certain strategies that I pursued on the production/distribution side, as well as on the consumption side. An example of the use of options on the supply side is as follows. On October 1, a heating oil distributor finalized a contract with a municipality to deliver heating oil at a guaranteed maximum price of $0.48 per gallon. The deliveries occured in January 1989. If prices raise between October and January, the distributor, if unhedged, had been forced to absorb the higher costs. The distributor, however, would be reluctant to simply buy calls to protect against a rising market (a buyer of a call option has the right but not the obligation to buy futures at a specific price during the life of the option). Although the risk of a long call position was limited to its purchase price, this cost might seem excessive to the distributor should prices drop. One strategy to reduce this initial cost is a three-part options spread designed to accommodate the distributor’s forecast range of heating oil prices through the early winter. The approach calls for combining the buying and selling of February options at three different strike prices such that the net cost of the option spread is near zero. Specifically, the distributor could Sell a put at a strike price near the bottom of the expected trading range. Buy a call at a strike price near current futures price levels. Sell a call at a strike price near the top of the expected trading range. It should be noted that the seller of a put expects the market not to fall below the strike price of the put option; the seller of a call expects the market not to trade above the strike price of the call option. If these forecasts prove valid, the seller of these options simply earns the premium originally collected. The assumptions underlying the example are as follows: On October 1, February heating oil futures equal $0.47 per gallon. Distributor’s market view: heating oil prices could fluctuate between $0.42 and $0.50 per gallon through early January. Heating oil cash and futures prices move in tandem. The strategy is as follows: Buy February $0.48 call at $0.0200 per gallon. Sell February $0.50 call at $0.0135 per gallon. Sell February $0.42 put at $0.0065 per gallon. Net cost = zero It should be noted that with this hedge strategy, the distributor has significant flexibility. If the cash price falls, he has the ability to offer low prices to his customers, down to $0.42 per gallon without losing money on his hedge. Below $0.42, the short $0.42 put behaves like a long futures position, losing value tick for tick as heating oil prices fall. In this situation, the distributor will need to offset the loss on his hedge by maintaining his sales prices in the physical market. If prices rally, the distributor will earn a profit on his long $0.48 call position up to $0.50 per gallon. Should prices continue to rally above $0.50 per gallon, the distributor’s profit on his hedge is fixed, since the gain from the long $0.48 call will be offset by the loss from the $0.50 call. If the distributor believes, however, that $0.50 per gallon will be the maximum price during the winter, he is likely to realize full profit participation from the call spread. An example of hedging on the demand side is as follows. An end user needs to hedge against possible increases in the price of heating oil by the time he will need to purchase and consume the oil. He can buy heating oil futures contracts at $0.45 per gallon. If he uses the futures market for hedging, a net price of $0.45 will be received regardless of how dramatically prices change. With options, however, he would have a different risk-reward profile (buy call strategies provide protection against an upward move in prices but allow participation in a downward price move). For example, the end user buys a December $0.46 call option for $0.0240 per gallon. The call option has established a maximum purchase price at $0.4840 per gallon, because the long call conveys the right to buy futures at $0.46 with a cost of $0.0240 ($0.4600 + 0.0240 = $0.4840). If prices rally above $0.46, the end user can exercise the call option. The flexibility of the long call strategy is illustrated when prices decline. If prices fall to $0.42 per gallon, the end user has a net purchase price of $0.4440 after accounting for the cost of the hedge ($0.0240). Because the cost of the hedge is fixed at $0.0240 (the premium), the end user is able to participate in market declines. Compared with the futures hedge, the buy call strategy is superior when prices decline. At $0.50, the futures hedge achieves a net purchase price of $0.4541, while the $0.46 call achieves a price of $0.4840. The futures hedge is superior if prices rally or if prices remain unchanged. If prices remain unchanged at $0.4541, the futures hedger pays $0.4541 for the oil; the options trader receives $0.4541 plus the premium paid ($0.0240), or $0.4781. Trading different strike prices also alters the risk-reward profile of the hedger. For example, the $0.46 call establishes a $0.4840 ceiling, lower than the $0.4975 ceiling established by the $0.48 call, and lower than the $0.5125 maximum purchase price established by the $0.50 call. However, the best protection against an upside move costs the most. The premium for the $0.46 is $0.0240, while the $0.48 and $0.50 calls cost $0.0175 and $0.012, respectively. The cost of the option determines how much the hedger participates in a downward move in prices. With prices at $0.38 at expiration, the hedger who has purchased the $0.46 call pays a price of $0.4040, which is higher than the $0.3975 and the $0.3925 for the hedger who purchased the $0.48 or $0.50 call, respectively. If an end user has the flexibility to withstand some increase in oil prices, a sell put strategy may be appropriate. By selling puts the oil company takes advantage of high premiums and expects sideways trading markets. The premium received from selling the puts acts a hedge against rising prices. Protection is, however, limited to the premium received. If prices decline, the company participates until prices reach the put’s strike price. Losses on the short put then begin to offset gains on the cash position. Fences are effective hedging strategies for oil companies that need to establish maximum purchase prices and yet would like to participate in a down market. Floors and ceilings can be adjusted to reflect the amount of downside protection needed, the level of upside participation, and the amount of cash paid or received up front. The fence allows the hedger to remove extreme volatility in price movements at low cost. An Approach to Risk Management As a commodity trader I would like to use the following approach while taking and managing risks: 1. Identify the risks faced by the firm: Here I would identify the potential risks faced by your firm. 2. Measure the potential effect of each risk: Some risks are so small as to be immaterial, whereas others have the potential for dooming the trading company. I would segregate the risks by potential effect and then as a commodity trader I would then focus on the most serious threats. 3. Decide how each relevant risk should be handled. In most situations, risk exposure can be reduced through one of the following techniques, depending upon the situation I would implement one or a combination of them: a. Transfer the risk to an insurance company: Depending upon the situation I would decide whether to self-insure or not. b. Purchase derivative contracts to reduce risk: As I have experienced as a commodity trader, firms use derivatives to hedge risks. Commodity derivatives can be used to reduce input risks. Similarly financial derivatives can be used to reduce risks that arise from changes in interest rates and exchange rates. c. Reduce the probability of occurrence of an adverse event: The expected loss arising from any risk is a function of both the probability of occurrence and the dollar loss if the adverse event occurs. Fire probability is the best example. d. Reduce the magnitude of the loss associated with an adverse event. Continuing with the fire risk example, the dollar cost associated with a fire can be reduced by such actions as installing sprinkler systems, designing facilities etc. e. Totally avoid the activity that gives rise to the risk. Hedging with Futures One of the most useful tools I have always used for reducing interest rate, exchange rate and commodity risk is to hedge in the future markets. Most financial and real asset transactions occur in what is known as the spot or cash market where the asset is delivered immediately. Futures or future contracts on the other hand call for the purchase or sale of an asset at some future date, but at a price, which is fixed today. Futures contracts are divided into commodity futures and financial futures. As a trader of gold and oil I usually deal and would prefer to use commodity futures. References Razavi Hossein, 1991. “Fundamentals of Petroleum Trading”: Praeger Publishers. Place of Publication: Westport, CT. Houston Brigham, 2001. “Fundamentals of Financial Management”. Ninth Edition. Read More