In this episode of Hedging with Jorge, we revisit the concept of short hedging and dive into a more flexible risk management tool: put options. Jorge uses a simple and relatable analogy, car insurance, to help us understand how a put option works when you’re dealing with aluminium price volatility.

Let’s begin with a refresher. Imagine you’re a trader who buys aluminium and hedges it. If the market price falls, your hedge at the LME (London Metal Exchange) yields a gain. Why? Because you sold aluminium at a higher price and now buy it back at a lower one, offsetting the loss in your invoice price.

Now consider another case: you hedge aluminium, but the prices go up instead. While your invoice reflects a higher selling price (a good thing), your LME hedge shows a loss, since you sold low and now must buy high. Still, your goal wasn’t to profit from market swings, it was to lock in economics, irrespective of the direction of the price.

But what if you didn’t want to miss out on potential price increases? That’s where put options come into play.

A put option gives you the right, but not the obligation, to sell at a predetermined price. Jorge compares it to car insurance: you pay a premium, and if there’s an accident (in this case, a price drop), the insurance (put) compensates you. If there’s no accident, if prices rise, you’re happy you didn’t need to use it.

Let’s break this down with an example. Say you’re buying aluminium at $2,500. Instead of entering a short futures position, you buy a put option at $2,500. This protects you in case prices fall. Suppose they drop to $2,000, your put option kicks in, and you get compensated for the $500 loss in market value. You’ve essentially insured your aluminium.

However, unlike a futures hedge, this protection isn’t free. You pay a premium for the put. So why bother?

The answer lies in flexibility.

If prices rise to $2,700, you don’t use your put. You abandon it and benefit from the higher market price, potentially offsetting the premium you paid. This is what distinguishes a hedger from a speculator. A speculator buys a put expecting prices to fall and profits if they do. A hedger buys a put to protect against downside but hopes never to use it.

Of course, there’s complexity in the mechanics, expiry dates, broker approvals, and premium costs. But the fundamental principle is clear: a put option is like an insurance policy for your aluminium. You don’t want to crash, but you’re glad you’re covered just in case.