Hedging 301 – Part Four: Financial Options – Using “Put” Instead of “Call”
Flexible Tools to Manage Price Risk
Our prior Hedging 301 posts have:
- Defined financial options (Part One)
- Identified the basic building blocks of financial options (Part Two)
- Provided an example of how financial options can be used in a fuel distributor’s business (Part Three)
However, we need more than one example to show the overall flexibility of financial options.
Using a Financial Put Option
In the previous post in this series, we discussed how a financial call option could be integrated into a fuel supply portfolio to provide additional margin. In this post, we will show that a financial put option can be used in a supply portfolio for the same purpose.
As a reminder, a financial put option allows the owner the right to sell a commodity at a fixed price, referred to as the strike price. For our example, we will use the same set of parameters that were defined in Hedging 301 – Part Three.
| Strike Price | $1.10/gallon |
| Delivery Costs | $ .35/gallon |
| Premium for Option | $ .10/gallon |
Financial Options in Action: Another Example
However, for this example we need to add one additional piece to the puzzle – a hedge. The fuel distributor buys a financial hedge (Hedging 101 Parts Three, Four, Six, Seven) for $1.10/gallon. When everything is purchased, the total cost for the fuel distributor looks the same as in Hedging 301 – Part Three:
Total delivered cost of $1.55/gallon
($1.10/gallon strike price + $.35/gallon delivery + $.10/gallon option premium)
The Difference in This Example
Here is where our example will start to look different from the call option in our previous post.
- The actual hub price, which determines the physical product cost, comes in at $.90/gallon.
- The physical cost to get supply to the retail fuel distributor is $.35/gallon above the hub price. This makes the cost of goods sold $1.25/gallon.
- Adding the option premium of $.10/gallon means that the distributor has a total cost of $1.35/gallon.
But does the fuel distributor really have that cost?
Looking at our example, we see that the fuel distributor purchased a financial hedge for $1.10/gallon. The actual hub price for the physical product came in at $.90/gallon. This means that the fuel distributor would have incurred a financial loss of ($.20/gallon) – the $1.10/gallon financial purchase less the actual market price of $.90/gallon.
If we were to add that loss onto the total cost scenario, they would be at $1.55/gallon, which is exactly what we estimated originally.
But again. . . did they really achieve that cost?
A Financial Put Option in This Example
The owner of a financial put option is allowed to “sell” a commodity at a certain price OR receive a financial payout if the commodity price goes below the strike price.
In our example, the strike price is $1.10/gallon, and the realized hub value is $.90/gallon. This implies that the owner of the put option would receive a cash payout of $.20/gallon – the difference between the $1.10/gallon strike price and the actual hub price.
Integrating this put option payout to our example, we see that the fuel distributor’s total cost equals:
| Total Cost: Supply and Delivery | $1.35/gallon |
| Loss from Financial Hedge | ($ .20/gallon) |
| Gain from Financial Option | $ .20/gallon |
| Fuel Distributor’s Total Cost: | $ 1.35/gallon |
Both of our examples – the one from Hedging 301 – Part Three with just the call option purchased and the one today with the financial hedge PLUS the financial put option – work to achieve the same cost profile. In today’s example the cost profile ends up being lower than our original budgeted cost.
Some of you might be asking, “What happens if prices go higher instead of lower?” Then, in both scenarios, the purchased call and financial hedge/put option purchased, the fuel distributor will achieve the budgeted price of $1.55/gallon.
Conclusion
In the last two posts we have explored how each option type – call and put – can be integrated into a supply portfolio to protect against both downward and upward price movements. However, there are many more ways to utilize these tools!
As we close our Hedging 301 series, we will summarize a few more strategies to utilize financial options to effectively manage risk and reach your business goals. Keep watching over the next few weeks for the final post in this series.
For more information about risk, hub prices, and foundational hedging terms and concepts, check out our previous series, Hedging 101 and Hedging 201.
For expert information on how your business can integrate these strategies into your supply portfolio, contact a Westlark Advisors team member today!
Hedging 301: Financial Options – Using “Put” Instead of “Call”
By JD Buss
