How Options are Used for Managing Risk

We can use our illustration of the producer of crude oil and the user of crude oil to explain how buying options can be used. Suppose that there are options on crude oil. Management of the producer of crude oil wants to set a minimum price it will have to pay for crude oil two months from now. It does so by buying a put option on crude oil. The exercise price for the put option is the price that management can sell crude oil. Suppose the exercise price for a put option on crude oil that expires in two months is $19. Then if two months from now crude oil falls below $19, say to $17, then management will exercise the put option and sell the crude oil to the writer of the put option for $19. What is the effective minimum price that management will be selling crude oil? It is not the exercise price of $19. Rather, that price must be reduced by the cost of the put option (i.e., option price).

To appreciate the difference between a futures contract and an option, consider the scenario wherein two months from now the price of crude oil is $20 per barrel. In that case, management will not exercise the put option. Instead, it can sell the crude oil for $20 per barrel in the market to benefit from the higher price. The effective price it sold the crude oil for is $20 less the option price. So, with a put option management has set a minimum price for how much it will sell crude oil two months from now (exercise price less the option price) but has maintained the opportunity to benefit from a price that is higher than the exercise price. In contrast, with a futures contract on crude oil that has a futures price of $19 per barrel, management has fixed a price and cannot benefit from a higher price for crude oil two months from now.

Now let's consider the user of crude oil. Management wants to set a maximum price for crude oil two months from now. It can do so by buying a call option. For example, suppose that the exercise price for a call option that expires in two months is $19 per barrel. Then if the price of crude oil two months from now is higher than $19 per barrel, management will exercise the call option and buy crude oil for $19 per barrel. The effective maximum price it will buy crude oil for is the exercise price plus the price of the call option.

Again, let's see the difference between buying a call option and buying a futures contract. If the price of crude oil two months from now is $17 per barrel (a price that is less than the exercise price), management will not exercise the call option and, instead, buy crude oil in the market for $17. The effective purchase price is equal to $17 plus the option price. In contrast, with a futures contract to buy crude oil, management has locked in a futures price of $19 per barrel and has given up the opportunity to buy crude oil at a lower price.

Optimum Options

Optimum Options

Get All The Support And Guidance You Need To Be A Success At Options Trading. This Book Is One Of The Most Valuable Resources In The World When It Comes To How To Come Out A Winner In Options Trading.

Get My Free Ebook


Post a comment