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What is Optionality and why do Commodity Traders love it?

Updated: Jul 3, 2019

Optionality is not a word you hear very often outside the trading world. Use it when talking about life decisions and quite frankly you come across as pretentious. But it's an important concept to understand and is at the core of many trades, particularly in physical commodities. If you're interviewing with a physical firm, showing that you're aware of this concept will go a long way to show you have the right commercial mindset.

If something has Optionality, we mean it looks like a financial Option. Recall that an Option is the right, but not obligation, to buy or sell a particular future/stock/bond/currency at some point in the future. Options to buy are called Call Options ("calls"), and options to sell are Put Options ("puts").We pay a fixed price for the option now, but in theory no limit to our upside. This has the effect of being able to control our risk very carefully, and make convex returns.

While obviously we could just buy calls on flat price and stop there, Optionality extends to a number of types of trades in the physical world. It's used to describe any situation where you can make more profit than you can lose. I'll discuss a few of these scenarios below.

1) Cash and Carry

If calendar spreads are in a contango, we can buy spot, and sell forward, locking in a spread. The market very rarely provides a large profit opportunity from doing this alone, but this structure can provide some upside relative to the cost.

Let's imagine our 6-month spread is -$90 - so prices are $90 higher in 3 months time than now. If we have the following monthly cost structure per contract:

Storage: $20

Financing : $10

Insurance: $1

Exchange Fees: $2

Total: $33

This means that our cost for storing our material for the 3 months would be $99, offset by $90 by locking in the spread - so a $9 loss overall. but this isn't the whole picture. While we could see this as one hedged trade, it's actually a risk position in a couple of areas.

a) Spreads: We own exchange-deliverable material in the front, so this is equivalent to a front month future. We've sold futures in the back, so we really have a long spread position. We stand to profit if enough people get the same idea as us and send the spread higher. If this happens we can sell spreads, deliver against our short in the front and close out our deferred position.

b) Premium/basis: As we've discussed previously, commodities are often transacted at premium/discount/basis to futures depending on location or quality. By owning material of a certain quality in a certain location, we are taking a position in that premium. If the market is in contango, it's rare (but not impossible) that taking delivery from the exchange and selling to consumers in the region is profitable. However, dynamics can quickly change when supplies get tight and consumer need to get hold of material. We might want to look into where we want to store our material to have the best chance of this outcome - spreads can stay flat if the global market is well-supplied, and all our profits could come from premium if we've picked the right location.

For a more detailed explanation and example of the carry trade see here.

2) Pricing Period Option

Some traders will pay to have the option in which months their shipments are priced. If the month of shipment is M, we could ask to have M, M+1 optionality. This means that in the month before the shipment, we declare to our counterpart in which month we want to price. This allows us to position ourselves to pocket the spread between calendar months,

If the market is in contango, we will declare our purchases M, and our sales M+1, thereby buying with a lower reference price than our sales. Similarly we will want our sales ahead of purchases if the market is in backwardation.

That seems straightforward, but how does this provide optionality? The value of this option comes into play when the market flips from contango to backwardation. If you don't have any optionality in your book, the shipments you have already arranged basis a contango market no longer have a spread gain. If you've hedged your spread exposure of course this doesn't affect you, but your PnL is locked and there's nothing more you can do. However with the option of months to declare, you can switch your pricing months and pocket the backwardation. If you've hedged, your hedge will also be profitable - you can unwind it and lock in the PnL on both the physical and futures side of the deal.

This doesn't come free. Calendar spread options are tricky to price, so it's more about funding customers that are flexible enough to give you these terms, and making sure you're not overpaying for them.

3) Exchange Arbitrage

For similar products traded on different exchanges, we can price the cost of buying and selling simultaneously across the exchanges, taking delivery and shipping between them. This gives us a theoretical lower bound to our loss for the trade. Like the cash and carry trade above, we can use this to extract profit by buying lower than the delivery cost and executing, or use that as our worst case scenario. If it costs $100 to deliver an arbitrage and the spread is trading at $95, we know that if we buy the spread and it continues to widen, our loss would only be $5. If we expect the spread to rally $15 before expiry this gives us a very favourable risk/reward ratio.

Sometimes physical options contain clauses allowing traders to switch the futures reference price. Not only does this allow the trader to pick the best deal for them, but also they can switch hedges when they want to lock in a certain margin, and unwind this profitably if the market moves in the other direction.

4) Physical Assets

There has been a recent trend for large physical trading houses to own assets related to storage, production and processing of commodities. Some senior executives have even suggested that the pure trading business model has been in decline for a long time, and all the margin now is in owning and operating assets as efficiently as possible.

The simplest asset to own would be some kind of storage - either a warehouse or terminal. There is an obvious advantage to this in the energy markets, as we know that storage can fill up very quickly in times when the market is oversupplied. Owning these assets gives you the option to sell storage at a higher price than usual, or use it yourself to lock in favorable contango when the rest of the market is struggling to find a place to put their cargoes.

Another common type of asset would be a processing plant. Not only does this somewhat legitimize your relationship with both producers of the raw material and consumers of the end product, but it gives you a number of possibilities to trade around your "crush margin" position.

While usually seen as risky bets, traders have also been known to purchase production assets such as mines. If the asset has control over its costs then this can also be good trade that pays off handsomely if prices rise, and having units to sell to third parties directly can also give the trader a better insight into the market.

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