Hedging 301 – Part Three: Financial Options – How to Use Them

Flexible Tools to Manage Price Risk

With any tool, we need to understand how it works in order to get the best results from it.  In our last Hedging 301 post we identified the major building blocks that make up a financial option.

These blocks are:

  1. Underlying Commodity
  2. Option Type
  3. Strike Price
  4. Expiration Date
  5. Premium Value

Now that we recognize the building blocks of financial options, we want to look at how using them helps a fuel distributor manage fixed price risk.

The building blocks of financial options can help a fuel distributor manage fixed price risks.

building blocks; Hedging 101; Hedging 301 - building blocks of options

Financial Options and Fixed Price Risk

The most traditional place where fixed price risk presents itself comes when a fuel distributor chooses to offer their customer product at a set price.  In this situation, the distributor has a desired margin that they would like, and which they budget around, to achieve.

A look back at Hedging 101 will reveal financial hedges and swaps that could be used to achieve the distributor’s desired margin.  However, we can use the building blocks above to provide the exact same protection.

A financial call option provides a cash payout if prices increase.

white fuel truck on road; Hedging 301 - financial options - how to use them

Financial Options in Action: An Example

To show the building blocks in action, let’s look at this real-life example.

  • A propane fuel distributor has chosen to offer their customers a fixed price of $2.50/gallon and desires to earn a minimum of $1.00/gallon margin.
  • They are aware that the costs to move product into their area are usually $.35/gallon above the industry hub price.
  • Industry hub price for the future delivery periods average $1.10/gallon

While this distributor could purchase a financial hedge or swap, they also have a financial call option available for them to purchase.  They would want to purchase a call option because that is a product that provides a cash payout IF prices increase.  Currently, the call option could be purchased with a strike price equal to the hub price of $1.10/gallon and would cost the distributor $.10/gallon.

If the distributor makes the decision to purchase the financial call option, this is their cost to calculate their desired margin.

Strike Price $1.10/gallon
Delivery Costs $  .35/gallon
Premium for Option $  .10/gallon
Total Cost $1.55/gallon

Why Use Financial Options?

Going back to our example, we see that this result does not meet the desired target of $1.00/gallon margin on the sale to their customers.  So why would a fuel distributor consider this strategy?

Benefits of Using Financial Options vs. Hedge or Swap

A financial call option only provides a cash payout if prices rise.  If prices fall though, they do not require the owner of the option to make any financial payment. However, this is not the case with a financial hedge or swap.  A fuel distributor may be willing to take a margin that is slightly less than what they budgeted in exchange for these two possible benefits:

  1. No future cash payments
  2. Ability to increase their margin IF prices move lower

Benefits of Financial Options:
1.No future cash payments
2.Ability to increase their margin IF prices fall

blocks stacked in descending order like stair steps; the words cost descending stairs on the blocks with red arrows pointing down; Hedging 301 - Financial options - how they are used

How This Would Look in Our Example

To better understand the potential benefits to a distributor if prices move lower, let’s review the following scenario:

  • Actual hub price that determines physical product cost comes in at $.90/gallon.
  • The physical cost to get supply to the retailer is $.35/gallon above the hub price, so this results in a cost of goods sold of $1.25/gallon.
  • Adding on the option premium of $.10/gallon means that the distributor has a total cost of $1.35/gallon.

In this final situation the distributor can achieve an actual margin of $1.15/gallon.  This scenario would not have been available with a financial hedge or swap.

By using a financial option, fuel distributors can increase their margins IF the prices fall.

blocks with the letters - margin - on them and stacks of coins of increasing levels on top of the blocks; Hedging 301 - Financial Options - how we use them

Conclusion

In our example we used the building blocks of financial options to demonstrate how a call option can manage a distributor’s fixed price and margin risk. Additionally, we reviewed how that same financial call option could potentially expand a distributor’s margin in a declining market.

Future Hedging 301 posts will explore other ways to utilize the building blocks of financial options in effective ways to manage risk and reach the results you want for your business.

For more information about risk, financial swaps, and foundational hedging terms and concepts, check out our previous series, Hedging 101 and Hedging 201.

Keep watching over the coming weeks as we demonstrate other ways financial options can be used to reach the outcome you want for your business.

Hedging 301: Financial Options – How to Use Them

By JD Buss