I always hesitate to write about options, because explanations on paper can be hard to follow.
It is only when one strategy – buying a call, for example – is worked through from beginning to end that its benefit becomes clear.
If you are tendering for a contract to build a bridge and know that your requirement will be for 10,000 tonnes of copper, you want to include a copper price that is both competitive and realistic.
You may win the tender by using today’s price, but you may then have to buy expensive copper in the market and sustain a loss as a result.
On the other hand, if you build in too large a safety margin, you may end up using too high a price and lose the tender.
Even if you do build in a large margin for error, there’s no guarantee it will be enough to protect you from rising prices.
In increasingly volatile markets, many companies tendering for contracts look to terminal markets for a solution.
Futures are not usually suitable; a long position may protect the company from rising prices, but if it loses the tender, the long position will be unnecessary and may have to be closed out at a loss.
An option is the next port of call. A call option gives the buyer the right to have a long futures position if he wants it, but if he does not win the tender, he does not have to have it; if he is unsuccessful, he simply abandons the option and pays no penalty.
In fact, he can make a windfall profit if he loses the tender but finds that the market has risen – he simply sells the option and banks the profit.
Call options can seem to be an ideal solution, but they have one major drawback – the cost.
Paying a substantial premium for an option, without knowing what the chances are of winning the tender, can be daunting. And since some tenders take many months to be awarded, premiums can be very high indeed.
A solution to this dilemma is to add yet another layer onto the hedging process.
A compound option is an option which allows the buyer to have a normal option if he wants it (because he’s won the tender) but not if he doesn’t.
The entire chain of transactions now looks like this: A compound option will default into a normal option if you declare it; a normal option will default into a future if you declare it; a future will default into a warrant if you want it to and a warrant will entitle you to metal in an LME registered warehouse.
They are all linked to each other, and each decision to declare or abandon is based on how the contract price compares to the prevailing market price.
At any point in the chain, the company can benefit from falling prices by abandoning the entire process and buying cheaper physical copper in the market.
But if the price rises, it knows from the outset what the maximum price will be – the strike of the normal option, plus the two premiums.
This is what a typical transaction would look like for a company involved in a tender:
The underlying asset (the normal option) is an LME traded option for 1000 tonnes per month between March and December with a strike price of $1000.
These are the months the company will need the physical copper if it wins the tender.
Today, this option would cost $100 per tonne. The company wants to be able to have that option and the protection it affords from rising prices, but doesn’t want to pay such a high premium in case it loses.
It buys a call on a call, or a compound option, and pays a premium of $15.
If it wins the tender and the price has risen to $1500, it declares the compound option and takes the normal option.
This option continues to give protection from rising prices but still offers the chance to do better.
If the company buys physical metal at $800, it simply abandons the normal option. If it buys the physical metal at $1500, it receives $500 from the option (but has to factor in the two premiums.)
Using a compound option, the company knows from the outset that it will never pay more than $1115 (the strike price plus the two premiums).
If it wins the tender, it can either take metal at this price, or lower if the market falls.
It seems like a long process, but what it means is a company tendering can buy price protection for a much smaller outlay.
The disadvantage is that if it does win the tender and declares the underlying option, the combined premiums would be higher than it would have paid if it had simply bought the underlying one.
Compared to the alternatives, it often seems worth that extra cost.
If you have a question for Lesley, you can email her on lesleycampbell@icuknet.co.uk and she’ll answer in this column – without using any names.
