Introduction
In the world of metals trading, particularly in aluminium, hedging strategies play a crucial role in risk management. One such approach involves using put options. But what exactly is a put option, and how does it compare to selling futures? In this episode of Hedging with Jorge, we dive deep into the mechanics of put options and explore why traders might choose them over futures contracts.
What is a put option?
A put option grants the holder the right, but not the obligation, to sell a commodity at a predetermined price within a specific period. In our market, this means having the right to sell aluminium at a future date. Unlike selling futures, where the trader directly commits to selling, buying a put option requires paying a premium for this right.
Selling futures vs. Buying a put
When you sell aluminium futures, you are immediately short on the market at the agreed price. If the price declines, you benefit. However, there’s an alternative buying the right to sell at a predetermined price. Here’s how they compare:
Selling futures: No upfront premium payment; the trader is obligated to sell at the contract price.
Buying a put option: Requires paying a premium but provides flexibility, allowing the trader to exercise the option only if it is beneficial.
Example in action
Let’s assume aluminium is currently priced at $2,600 per tonne. If you sell futures at this price, you lock in that rate for a future sale. However, if prices fall further, your profit potential increases.
Alternatively, you could buy a put option at the same $2,600 level. This secures your right to sell at that price in the future. If the market drops below $2,600, you can exercise the put and limit your losses. The catch? You must pay a premium for this right, which can be costly.
Why pay a premium?
One key question arises that why would a trader choose to pay a premium for a put option instead of directly selling futures? The answer lies in risk management. A put option acts as an insurance policy, it caps potential losses while allowing for upside benefits if prices rebound.
Conclusion
While both selling futures and buying put options serve the same fundamental purpose- gaining from a price decline, the choice depends on a trader’s risk appetite and strategy. Selling futures provides direct exposure, while a put option offers downside protection at the cost of a premium.
Stay tuned for our next blog, where we’ll delve further into strategic decision-making in the futures market!