Hedging crude oil with options – a detailed example

By , CEO of Volcube.

A typical introductory text on options will contain payoff graphs that relate to ‘long put’ or ‘long call’ positions. Hedging is often described as simply a case of ‘buying puts’ for downside protection or ‘buying calls’ for upside security. But the details of the actual executable trade are frequently glossed over. Here we are going to look at a more detailed example to illustrate a more realistic reflection of the hedging process.

Let’s assume a trader has a certain exposure to crude oil. Specifically, let’s say he is long $1 million dollars of crude whose shortest dated future is trading at say $100. This could be because he is part of a small energy company holding physical inventory. Or perhaps he is part of a speculative trading team on an Energy dealing desk. Whatever the reason, let’s suppose the trader wishes to fully hedge his position from this price and lower, but he still wishes to benefit from any subsequent rally in the price of crude. In this case, his wishes are not really compatible with a simple futures strategy; selling futures equivalent to his entire exposure would fully hedge the downside risk but would not allow the trader to profit from any upside rally. In this case, buying put options makes more sense to fulfil the objective. So let’s work through the rough calculations required in our hypothetical case.

Firstly, the trader needs to figure out his equivalent exposure in terms of futures contracts; (available on the relevant derivatives exchange website; for example cmegroup.com). Looking at the futures contract specifications for crude oil shows that each future has a contract unit of 1000 barrels. In other words, each future relates to 1000 barrels of oil. So at a price of $100, the futures contract is worth $100,000. Therefore, a 1 million dollar exposure is equivalent to 10 futures contracts. Now let’s turn to the options market. The first point to note is the option contract multiplier. This tells the trader to how many contracts of the underlying (in this case a futures contract) each option relates. The simplest case (and most common in the case of futures options) is for the option contract multiplier to equal 1. Each options relates to a single futures contract. Other common multipliers are 10, 50, 100 or even 1000 lots of the underlying. It is vital to be sure on the correct multiplier, otherwise the hedge may be anything from 1000 times too small to 1000 times too large!

Let’s assume the multiplier in this case is 1. Here then the trader needs to buy 10 at-the-money put options to fully hedge his position to the downside. If the crude futures drop in value, he can exercise his put options and sell 10 crude futures at the previous price, which neutralises his profit and loss. If the crude futures price rallies, his puts will expire worthless; the loss is the price paid multiplied by the quantity bought multiplied by the contract size. This is the cost of the hedge; if the puts cost say $3 each, the loss would be $3 * 10 * 1000 = $30,000. However if the crude price rallies, the trader’s original exposure has been maintained, so he will gain on this leg of the portfolio. The break-even is at $103; here the cost of the hedge has been met by the profit from the original exposure.

To summarise, the hedging trader must :

  • calculate a total $ exposure
  • convert this into an equivalent number of lots of the underlying/futures market
  • convert this into a requisite number of options contracts for hedging purposes

When a trader is hedging in a new market for the first time, it is certainly advisable to return to first principles and calculate the payoff from each element of the portfolio in dollars and cents, at various prices in the underlying. The most common error is to over or under hedge by a factor (usually relating to either the contract size or the option multiplier). Since these can involve several zeroes, double checking is a must.

Have a question for the author? Happy to help! Email [email protected].

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This article is for educational purposes only. It is not a recommendation to trade or invest in particular futures and options.

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