In the world of aluminium trading, understanding your strategic choices as a speculator is crucial. One of the key tools available to traders is the put option, a financial instrument that offers the right to sell, but not the obligation. In this blog of “Hedging with Jorge,” we delve into the fundamental dynamics of a put option and its application as an alternative to selling futures outright.

Let’s start with a basic scenario. Suppose the current price of aluminium is $2,400 per metric tonne. As a speculator expecting prices to fall, your first option is to go short in the futures market by selling a contract for the third Wednesday of May at that same price. If the market moves against you and rises to $2,500, you incur a $100 loss. If it drops to $2,300, you earn $100.

Now, instead of entering a short futures position, you choose to buy a put option with a strike price of $2,400. This option gives you the right to sell at $2,400, regardless of the market price. However, acquiring this right comes at a cost, a premium. In our example, the premium is $70.

So what happens next? If the price of aluminium rises to $2,500, exercising your put option would make no sense. You wouldn’t want to sell at $2,400 when the market is higher. In this case, you simply abandon the option. The only loss you incur is the premium of $70. This is your maximum loss, offering a clear advantage over a direct short futures position.

Let’s consider another outcome. Suppose on the expiration date, the futures price for the third Wednesday of May drops to $2,200. You would then exercise your put option, going short at $2,400. You could then close the short position by buying at $2,200, securing a gross profit of $200. After deducting the $70 premium, your net profit stands at $130.

This flexibility is what makes put options attractive. They allow speculators to participate in downward movements while limiting potential losses. Even if the market doesn’t move in your favour, the most you can lose is the premium paid.

Understanding how a put works sets the foundation for more complex hedging strategies. While this episode focuses on speculative use, the next session will examine how a hedger can use put options for risk management.

Stay tuned as we continue to demystify financial instruments in the aluminium market.