Managing Price Risk

Most of us are risk-averse: we prefer certainty to risk and are willing to pay a bit to avoid risks.  You would probably be unwilling to wager $1,000 on a double-or-nothing flip of a fair coin: the disutility of losing would be greater than the utility of winning.

But some people are more risk-averse than others, and people with low risk-aversion are likelier to be speculators.  A speculator bets on price movements.  The conventional wisdom in business is to "buy low and sell high," taking a "long" position in some market and hope the price goes up.  But the reverse strategy can also be profitable: sell high, then buy it back low, taking a "short" position and hoping the price goes down.  How can you sell something you don't own?  Just borrow it!

Lay-people tend to disapprove of speculators: they don't appear to produce anything, they just get rich off of other peoples' losses.  But successful speculators serve a valuable function by stabilizing market prices.  In periods of surplus when prices are low and nobody else is buying, the speculator absorbs the surplus and prevents the price from falling lower.  In periods of shortage when prices are high and nobody else is selling, the speculator eases the shortage and keeps the price from going higher.

All businesses face risk.  Fortunately there are various mechanisms by which businesses can "hedge" or manage these risks.

Forward contracting and futures markets

The basic mechanisms that are used to manage future price risk in today's resource markets evolved from 19th century agricultural commodities markets, where short-term market demands are often highly inelastic.  Midwest farmers would deliver trainloads of corn or wheat to Chicago for export via the Great Lakes.  While the early-arriving grains might command a premium price, there might be no demand at all for late-arriving grain.  There are stories of entire trainloads of grain simply being dumped into Lake Michigan for lack of buyers.  Over time, speculators figured out how to profit from this price volatility by writing advance contracts for sales and purchases of future deliveries. Here's a hypothetical example, explained from the farmer's perspective.

Suppose a farmer in central Iowa plants her corn crop in May and wants to hedge against the risk of a big drop in corn prices by September, when she intends to harvest and sell her corn.  She might enter into a forward contract with the local grain elevator, specifying a set price and minimum delivery quantity.  The farmer avoids the risk of a price decline; the elevator avoids the risk of a price increase.  Obviously the farmer also gives up the chance of a bigger profit if prices rise, and the elevator gives up the chance of a bigger profit if prices fall.

Direct forward contracting is the simplest type of hedging, but like barter, it typically requires direct negotiation between the two parties with complementary (opposite) risks.  And forward contracting may involve significant risk of non-performance.  For example, there might be a drought, so that the farmer can't deliver the corn, or a bumper crop that reduces prices, so the elevator is unwilling to pay the higher price they had agreed on.

So instead of forward-contracting with the local grain elevator, our farmer could call up her broker in May and have him sell some September corn futures contracts on the Chicago Mercantile Exchange (CME) for her.  Since prices of corn futures will move pretty much in parallel with the local cash prices for corn, taking a "short" position now in September-delivery corn futures would complement her "long" position in her corn crop and offset her price risk.  Before the futures contracts expire in September, she harvests and sells her corn (probably to the local grain elevator) and buys back the futures contracts, effectively canceling them.  Here's how this hedge strategy would protect her from a price drop:

  May (now)September gain/loss
cash position: plant at $4.25/bu sell at $3.72/bu -$0.53/bu
futures position: sell (short) at $4.15/bu buy back $3.60/bu +$0.55/bu
net result: $4.27/bu

The price difference between the local cash market and the Chicago futures market is called the local "basis." When the CME and local prices don't move exactly in parallel, the basis changes. In this example, the basis rose two cents, in favor of our farmer. She was trying to lock in a price of about $4.25/bu and realized a price of $4.27/bu in September (minus some trading commissions paid to her broker).

Short vs. long

Before getting into the details of futures markets, we need to explain short-selling a bit more.  Short-selling involves selling a "borrowed" asset with the expectation of buying it back later at a lower price.  A short position profits from a price decline, just as a long position profits from a price increase.

Most investors in the stock market are bullish "longs" who buy stocks, betting that their prices will rise.  If you buy 100 shares of Megabux Inc. (MBUX) at $50/share, there is no limit on the upside: it could possibly go to $115,000/share like Berkshire-Hathaway (Warren Buffet's investment company) and your $5,000 initial investment would now be worth $11.5 million.  And your downside risk is limited: the worst that can happen is MBUX goes to zero and you lose your $5,000.

In contrast, a "short" is bearish on the stock, and bets that its price will fall.  If you thought MBUX was going to tank, you could short 100 shares at $50/share through your brokerage. The broker borrows some other investor's shares, sells them for you, and holds the proceeds for you.  The upside of this position is limited: the best outcome for you would be if MBUX goes to zero, and the $5,000 from the short sale is all yours; the unknown long whose shares you borrowed is out $5,000.  But your downside risk is theoretically unlimited: if MBUX suddenly soared to $80,000/share, you would be on the hook for the additional $7,995,000 needed to buy back those shares!

In practice, your broker will require you to maintain a "margin" account with sufficient assets to cover any losses in your short position.  As your losses approach what's in your margin account, your broker gives you a "margin call" requiring you to put up more money; otherwise the broker will use your margin account to close out your short position, buying back the shorted shares at the higher price.  Margin requirements minimize the credit risk in short-selling.

Short-sellers are often viewed with suspicion: they want companies to fail!  In the movie Casino Royale the evil dude took a huge short position on a jet manufacturer, and then tried to make their new jet crash so their stock price would tank.  (Fortunately James Bond saved the jet and the company's stock price too, so the evil dude organized the poker tournament to try to win back the money he'd lost in his margin account, etc., etc.)

Michael Lewis's book The Big Short explains how a handful of guys made millions shorting mortgage-backed securities when the speculative bubble in the US housing market burst in 2008.  During the bubble, with rising housing prices, even people with lousy credit could buy homes with zero down.  Banks were eager to give them mortgages, assuming the collateral home values would keep appreciating.  Investment banks bought huge portfolios of these "sub-prime" mortgages (aka "liar loans" because many borrowers' incomes and credit histories were never even documented), and converted them into multi-tiered bonds.  The top tier or "senior tranche" would get the first payments from the mortgage portfolio, then the next-highest tranche gets paid, etc.  If some mortgages stopped paying, the bottom or "mezzanine" tranche would default first, then the successively higher tranches.  Amazingly, the bond rating agencies (Moody's, S&P) gave these "collateralized debt obligations" (CDO's) top ratings--even the riskiest tranches!

Investors who bought these CDO's could also buy insurance against their default.  AIG (a mis-managed investment bank disguised as an insurance company) sold "credit default swaps" on about $450 billion in various CDO's, basically taking a portion of a CDO's revenue streams as an insurance premium, and guaranteeing to pay off the entire CDO if the payments are interrupted. 

What makes this interesting is that anybody can buy a credit default swap!  It's like buying homeowner's insurance on other peoples' houses--potentially very profitable (especially for arsonists).  So that's what these guy did: they bought credit default swaps betting that other investors' over-rated mezzanine-level CDO's, constructed from the very worst home mortgages, would default.

And it only took a hiccup in the US housing market to trigger some mortgage defaults, which triggered CDO defaults, which triggered huge payouts on the credit default swaps backing those CDO's.  The cascading defaults caused credit markets to seize up all over the world.  But while Washington Mutual, AIG, Merrill-Lynch, Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, Salomon Brothers, and hundreds of commercial banks were collapsing, a handful of smart guys made fortunes!

More on futures markets

While futures markets just look like legalized gambling to many lay people, they serve a valuable economic function by transferring risk from hedgers to speculators. In the bad old days, farmers shouldered all the price risk themselves.  As we noted above, they would all harvest their crops at pretty much the same time, and as their shipments flooded the Chicago markets, commodity prices would plummet. 

But the price movements were predictable enough that speculators could bet on them.  So the Chicago Board of Trade (CBT) began in 1848 as an official venue for forward-contracting agricultural commodities.  These forward contracts became standardized.  (For example, a corn contract became standardized as 5,000 bushels of #2 yellow corn of a specified cleanness and dryness to be delivered at a standard place and time of month.) And once the contracts were standardized they evolved into futures contracts that anyone could trade. 

(The Chicago Mercantile Exchange (CME) started as a spin-off of the CBT in 1898.  The CBT and CME merged in 2007, and the combined CME Group merged with the New York Mercantile Exchange in 2008.)

A futures contract is "created" when any buyer (long) and any seller (short) agree on an initial price.  The initial buyer and seller may both be speculators betting against each other.  The "open interest" in a futures market represents the number of active contracts.  A contract is "destroyed" whenever corresponding long and short positions are closed out.

Futures trading was traditionally conducted by open outcry in one of the trading "pits" (like little round amphitheaters) on the exchange floor.  Traders would signal their agreed quantities and price and send out matched buy and sell order slips for resolution.  The trading pits are now replaced by computerized trading.

To take a short or long position in a futures market, you simply establish a margin account with a brokerage that handles trading in those contracts, and then send in your buy and sell orders.  Each trade costs you a small brokerage commission which is deducted from your account.  Since futures speculation is highly leveraged and prices are often volatile, the potential gains and losses are large. 

For example, suppose contracts for light sweet crude oil (WTI) for delivery six months from now are currently selling at $100 per barrel.  Each contract represents 1,000 barrels.  Suppose you have $50,000 in your brokerage account, and you buy 10 of these contracts, taking a ride on a million dollars worth of oil.  Each one-penny move in the price per barrel means a $100 profit or loss for you.  The price per barrel could jump $5 in a single day, and you would have made $50,000--doubling your money.  Or it could drop $5 per barrel, and you would be wiped out.

Most of the players in commodity futures markets are speculators, taking on risk with the expectation of profit. But our Iowa corn farmer isn't gambling with corn futures, she's hedging. For her, facing the price risk without the offsetting short futures position would be a much bigger gamble.

Note that it doesn't matter that she's not growing the type of corn the CBT contract specifies, or that she has no intention of delivering her corn to Chicago. Most futures contracts are simply canceled out rather than executed. She will harvest and sell her corn locally, and close out her short futures position before the contracts expire. What does matter is that the price of the futures contract moves in parallel with her local market price for corn.

In the example above, the hedge strategy paid off handsomely; without it, she would have received $3.72/bu instead of $4.27.  On a farm with 500 acres of cropland yielding 160 bushels/acre, or 80,000 bushels total, that's $44,000 of revenue achieved by shorting 16 contracts.

On the other hand, suppose local corn prices rose to, say, $4.75/bu between May and September, while the futures price rises in parallel from $4.15/bu to $4.65/bu. Closing out the short futures position costs her the extra revenue she gained in the cash market, e.g.:

  May (now)September gain/loss
cash position: plant at $4.25/bu sell at $4.75/bu +$0.50/bu
futures position: short at $4.15/bu buy back $4.65/bu -$0.50/bu
net result:  $4.25/bu

So the futures position effectively locks in her price either way. She got $4.25, which is what she wanted at the outset, but she may envy neighboring farmers who didn't hedge and got 50 cents more per bushel.  Fortunately there is another hedging strategy that would guarantee her $4.25/bu if the cash price falls without sacrificing the profitability of a price increase.  Instead of shorting corn futures, she could buy a "put" option on corn futures.

Options markets

A futures contract is a "derivative" of the actual commodity market.  Commodity options are derivatives of the commodity futures market.  There are two types of options--puts and calls--and two parties in any options market--the writer (seller) of the option, and the buyer of the option.

The buyer of a "call" option acquires the right, but not the obligation, to buy the underlying asset from the option writer (seller) at a specified "strike price" on or before a specified expiration date.

The buyer of a "put" option acquires the right, but not the obligation, to sell the underlying asset to the option writer (seller) at a specified "strike price" on or before the specified expiration date of the option.

Our farmer could buy put options on September corn futures (one option per futures contract) at a $4.20/bu strike price.  She would pay the writer of these options a "premium" to compensate him for assuming her price risk.

Here's how the farmer's option strategy performs under price increase and decrease scenarios:

Price falls:May (now)September gain/loss
cash position: plant at $4.25/bu sell at $3.72/bu -$0.53/bu
put options: buy puts at $4.20 strike price
for $0.10/bu premium
exercise puts: short futures at $4.20;
close out position at $3.60
+$0.50/bu
(net of premium)
net result: $4.22/bu
 
Price rises:May (now)September gain/loss
cash position: plant at $4.25/bu sell at $4.75/bu +$0.50/bu
put options: buy puts at $4.20 strike price
for $0.10/bu premium
let puts expire -$0.10/bu
(lost premium)
net result: $4.65/bu!

Since the current (May) cash price is $4.25/bu, a September put option with a $4.20/bu strike price is "out of the money" because it has no intrinsic value.  You wouldn't exercise an option to sell for less than the current market price, neither would you exercise an option to buy for more than the current market price. 

Our farmer could buy "in-the-money" September puts with a $4.40 strike price.  These puts would have $0.15/bu "intrinsic value" (the current price minus the strike price) which would be included in the premium paid to the option-writer.

An in-the-money call option has a strike price lower than the current cash price, and its premium will include its current intrinsic value plus the seller's expected risk cost.  An out-of-the-money call has a strike price higher than the current price, and has zero intrinsic value, so it's premium is just the expected risk cost, which is based on estimated probabilities that the cash price will exceed the strike price before the contract expires.

In contrast, an in-the-money put has a strike price higher than the current cash price, and a correspondingly higher premium, while an out-of-the-money put has a strike price lower than the cash price, zero intrinsic value, and a premium reflecting just its expected risk cost to the seller.

Options strategies

As the term "premium" suggests, options are basically insurance policies against adverse price movements, but they are also highly leveraged speculative instruments.  The maximum potential profit from buying a put is the full strike price, realized if price of the underlying asset falls to zero; the maximum loss is the premium.  The maximum potential profit from selling a put is the premium received; the maximum loss is the full strike price if the underlying asset price goes to zero. 

The maximum potential profit from buying a call is theoretically unlimited, and a small premium payment could conceivably earn the buyer a big multiple of the strike price!  The maximum buyer loss is the premium paid.  The maximum potential profit from selling a call is just the premium received; the maximum potential loss is theoretically unlimited.

Before you get excited about the enormous potential profits you could make from buying options, consider this: the vast majority of options expire unused, with the option writers pocketing the premiums.  Option writers are typically expert traders with highly diversified risks and very large margin accounts to cushion occasional big payouts, and just like big insurance companies (and casinos!), they win in the long run.

Suppose you get some reliable insider information that Megabux Inc. is about to announce that it will be bought out for double its current stock price.  You might buy $1000 worth of MBUX and double your money.  Better yet, you could put up your $1000 for a margin purchase of $2000 worth, and quadruple your money.  Or better still, you could spend $1000 to buy a lot of out-of-the-money (cheap premium) calls. Say MBUX is currently trading at $50/share, and you pay a $1/share premium to buy cheap, out-of-the-money short-term calls on 1,000 shares at a $60 strike price.  Then when MBUX goes to $100, your calls are worth $40,000!  (Of course insider trading is illegal, and a small-time player hitting an options jackpot like this would almost certainly attract the attention of the SEC.)

Brokerages sometimes let ordinary customers write "covered" call options on shares of widely-traded stocks in their portfolios.  For example, you might own 100 shares of Megabux, currently trading at $50/share, and sell a July call option on them at a $60/share strike price, collecting a premium of $2/share, or $200.  You would not be able to sell the shares until the option was exercised or expired, or you bought back an equivalent call. 

MBUX might fall to $30/share, but you'd still be $2/share ahead of other MBUX shareholders.  MBUX might soar to $100, and your option buyer would exercise his option, taking your shares for the $60/share strike price and selling them for $40/share profit, but you'd have received a total of $62/share, the first $10 of the price increase plus the option premium.

Creative combinations

Apart from writing covered calls, option-writing is for sophisticated, large-scale traders.  Like insurance companies, successful option writers diversify their risks by writing large numbers of different options so that the total revenue from premiums typically exceeds the cost of settling the minority of options that get exercised.

Traders have develolped all sorts of creative options strategies for exploiting specific expectations regarding price direction and volatility.  Suppose MBUX shares are currently trading at $50.  Here are some examples;

To bet on a price decline you might try...

  • a bear call spread: sell an in-the-money $40 call for $12/share premium and cap your potential loss by buying an out-of-the-money $60 call for $1/share premium.  Max profit is the net premium $12 - $1 = +$11 when MBUX falls below $40; break even at $51; max loss is above $60 with both calls exercised: $12 sell premium - $1 buy premium - $20 loss (sold $40 put minus bought $60 put) = -$9.
  • a bear put spread: sell an out-of-the-money $40 put for $2, and buy an in-the-money $60 put for $13.  This spread has a max profit of +$2 - $13 + $20 = +$9 at $40 or below with both options exercised, and a max loss of +2 - $13 = -$11 with neither option exercised.

To bet on a price increase, you might try...

  • a bull call spread: buy an at-the-money $50 call for $5 and sell an out-of-the-money $60 call for $2, for a net premium cost of $3.  A price increase to $53 earns this back.  A price increase to $60 or higher earns you $7.
  • a bull put spread: buy an out-of-the-money $40 put for $2 and sell an in-the-money $60 put for $13 for a net premium received of $9.  Your maximum profit is when the price rises to $60 or higher and both puts expire.

To profit from high price volatility either way, you might try a long straddle, buying both puts and calls at the same strike price.  The most you lose is both premiums if the price remains flat. 

To profit from low price volatility, you might try a short straddle, selling both puts and calls at the same strike price.  Now your maximum profit is the two premiums, but a big price move can cost you a lot.

There are many other complex strategies such as butterflies, condors, collars, strangles, etc. that you can research on your own time.