It may have been considered wise to sell your copper forward at $US7000 a tonne when that’s where the market was, but who’s going to defend the hedging manager’s actions when the market rises to $9000/t?

It’s a situation most hedgers are only too familiar with - you're either a hero or a fool.

The decision is made to protect the company from adverse price movement, but if the market fails to oblige and forges ahead, it is easily forgotten that there was a tradeoff – you’ll never do any worse than the price you've sold your futures at, but you won’t do any better either.

Risk managers are often accused of selecting an inappropriate strategy, when the real disappointment is that they failed to forecast price trends – a very different issue.

If a simulation is run before the strategy is put in place, the board and shareholders will never be surprised by the outcome and the unfortunate risk manager should never be called upon to defend what appears to have been an unsuccessful program. But lost opportunity can still be galling, even if you always knew it was a possibility.



Because of the increasing volatility of markets and, as a result, the increased chances that a hedger will look mistaken, more and more risk management teams look for participation. That way they get the insurance they need if the price goes the ‘wrong’ way, but they also acquire a share of the benefit if the market goes the ‘right’ way.

For a producer or a company with a physical long position, this means getting protection from falling prices but also being able to benefit from rising prices. For a consumer, it means doing better if prices fall.

Traditionally, producers wanting to be able to benefit from rising prices bought put options. If the market was $6000 and the option had a strike price of $6000, the option would be abandoned if the market rose to $7000, for example. The disadvantage is that this flexibility comes at a cost.

Another way to achieve both protection and participation is to add an option onto an existing futures position.

Say a producer has sold forward at $7000 and is concerned that the market will rise making his decision to sell look premature. At any point, he can buy a call option. This option will not interfere in any way with the efficacy of his short futures position. If the market falls, the call will simply be abandoned and there will be no penalty.

If the market rises, however, the loss on his short position will be offset by the rise in value of his physical metal and the call option will pay out.

For a consumer who has bought futures, the purchase of a put option achieves the same thing – protection plus participation.

Ideally, the option should be bought when its cost is low. For the producer this means buying the call when the price is low and there seems to be little need for it. The put option should be considered by a consumer when the price is high.

The min/max option strategy involves the purchase of a put option to protect the producer against lower prices, with the sale of a call option above the market to generate enough premium to cover the put purchase and to allow a little participation if the price were to rise.

The trouble, as many producers have seen in recent times, is that the market may move substantially higher than the limit set by the call option sale and can expose the producer to variation margin calls.

The solution can be to buy another call option. If a no-cost or low-cost min/max strategy is put in place, the producer will never achieve any more than the strike price of the first call he has sold. If another call option is bought above this level, it can be a relatively cheap way to allow some benefit of higher prices to be enjoyed.

The three tier strategy becomes: buy a put, sell a call, buy a call. This is the beauty of options in a situation like this – they offer participation but do not interfere with the efficacy of the downside protection. Again, the call should be bought when prices are low.

There is an almost infinite variety of participation structures, with greater or smaller payouts if the market moves.

Barrier options have a pre-specified trigger level, at which point one of two things will happen – the options will terminate (known as a knockout feature) or the option will activate (known as a knock-in).

A copper knock-in call option with a strike price of $2,500 might have a barrier at $3,000. If the price moves above the $3,000 barrier during the life of the option, it is activated; if the market does not reach the $3,000 barrier level during the life of the option, the option expires worthless.

This has an application for copper producers who have a min/max in place. If the market moves up beyond the level of the call option the producer has granted, the call option comes into play and offers upside participation. The advantage of this kind of option over a conventional call is that it is usually cheaper.

Chooser options give the buyer the right to choose if the option is a call or a put after an initial period. These options are more expensive than normal puts and calls, but are usually cheaper than buying both and do offer a great degree of flexibility. A producer anticipating higher prices but fearful of lower prices might consider chooser options.

Hybrid strategies, using a combination of futures and options, can be designed and implemented from the start, or new layers can be added on as the market moves.

Falling prices for a producer may be a vindication of the decision to hedge, but they can also offer a way to buy cheap upside participation and can help avoid the situation where senior management kick themselves – or, more likely, kick the hedging manager – for having hedged too soon.



London-based Lesley Campbell is retained by a number of industrial companies to advise on commodity, foreign exchange and investment risk, and writes regular technical analysis reports for business analysis and consultancy group CRU.