Hedging using commodity futures options with a focus on energy products - theoretical research

Abstract

Because of correlation between derivatives prices and underlying commodity
prices in the spot market, it is possible to be used to reduce or increase a price
risk of spot commodities. For example, buy a spot commodity and sell call
reduces an investor\'s risk. If a commodity price has fallen, option price would
fall also Thus, the investor can buy back low- price option and make a profit to
compensate at least partially for a spot commodity loss. As is well known , the
investors have different risk preferences, some of them more risk tolerant than
others. But with that all investors are willing to maintain their investment at an
acceptable level of risk. And derivative markets enable those who wish to reduce
their risks of transfer or convert them to those who wish to increase it. Because
these markets are very active in reallocation of risk between the traders, there is
no one need to take the level of uncomfortable of risk. Hedgers are the party that
produce or deal with the spot commodity or instrument for the underlying
futures contract. These are looking for protection against price fluctuations by
taking positions in options opposite to their spot position. As a result, they are
struggling to manage the risk of unfavorable changes in commodity prices. This
is no different a lot from buying other forms of insurance, but in fact there is no
insurance company covering price risk. Because if prices moved against the
insurance company, all the customers will be creditors, so the futures options
market performs this important function which is represented by facilitating
convert of a price risk from hedgers to speculators. Thus, this research seeks to
achieve four goals , a clarify nature and importance of the hedging steps with
commodity futures options , and analytical discussion of its types, and explore a
mechanism to identify the optimum hedge ratio of spot commodity\'s price risk
by using the commodity futures options , as well as exploring the mechanism of
determining the number of commodity futures options contracts needed to hedge
a price risk of spot market position. The research has reached a number of
conclusions , the most important of them that traders prefer hedging by futures
options over hedging by futures as long as the broader state is uncertainty state
about a future price movement trend of commodity, in general, and energy and
crude oil, in specific. And the other preference reason is the large amount of
hedging strategies offered by futures options compared with the limited
strategies offered by Futures, also a trader could builds artificial futures
positions using futures options while he could not build artificial options
positions using futures alone. Hedging by futures options enable hedgers
everywhere in the production and marketing series to be work with narrower
margins lead to increase the free competition of the market, and this ends with
large cost savings for consumers. This research has reached to number of
recommendations, the most important of them that a need to adopt hedge
strategies of futures options contracts ( with the exception of synthetic strategies
which has similar characteristics to the futures strategies ) instead of hedge
strategies of futures contracts in the high volatility market as a market of crude
oil.