Short-Term Options in Commodities: Potential Benefits and Applications Part 2
Short-terms options are flexible tools for tactical trading strategies to mitigate specific event risks or make a directional bet on price movement in the short term. The trading volume of these types of options in commodities has grown tremendously in recent years because they appeal to different types of traders regardless of their time horizon or thesis. This article, which is Part 2 of a two-part series explains the macro and idiosyncratic (commodity-specific) market events and their applications using short-term options in commodities.
Commodity prices are determined based on a confluence of macro and idiosyncratic factors. As such, commodity price fluctuations are largely driven by fundamental (supply/demand) and cyclical factors (macro) tied to the business cycle and the economic activity, in addition to other exogenous market events such as geopolitical risk and weather events. These various factors can sometimes morph into a jump risk (tail risk), especially if the market event is significant enough and unanticipated. The short duration of these options offers more flexibility to target a specific market event.
Examples of economic data releases:
- ISM manufacturing index
- Central bank announcements
- GDP growth
- Unemployment rate
- Consumer Price Index, Producer Price Index
- Consumer confidence, etc.
Example 1: Using Crude Oil Weekly options for directional trade on the ISM
A trader expects oil prices to rise in response to the release of the ISM Manufacturing index which measures the activity of the manufacturing sector. This leading indicator is important and closely watched by the market because it is used as a proxy for the overall state of the U.S. economy. A level of 50 and above reflects economic expansion while below 50 signals a contraction. The ISM tends to move in tandem with oil prices in the long run as the result of their linkage from the demand side. Chart 1 depicts the intertwined relationship between ISM index and price changes of oil. The YoY oil prices changes are used to remove the cyclicality variations. An increase in ISM indicates a rise in manufacturing activity that requires more oil as input which would consequently lead to an increase in oil demand and prices. Additionally, this long-term linkage gives insight into the underlying momentum of the economy and oil markets and their projected trajectories. Though, this relationship can sometimes be decoupled in the short term due to other factors that affect oil prices such supply shocks (OPEC meeting, geopolitical event etc.)
Chart 1: Strong relationship between the ISM and Crude Oil
Strategy: Bull call spread
A trader expects oil prices to increase moderately based on the market consensus that the manufacturing sector is robust. He anticipates that the ISM index will be higher than 50, and he capitalizes on this short-term view with a cost efficient tool. He will long a call at a lower strike and short another call with similar expiry but at higher strike. This strategy caps the loss and reduces the cost of premium.
- Buy 10 WTI Friday Weekly call options with a strike of $71 and premium of $0.75/bbl. The total cost is $0.75*1000bbl*10=$7500
- Selling 10 WTI Friday Weekly call options with a strike of $74 at a premium of $0.20 /bbl. Cash received $2000
Current WTI Crude Oil futures price: $70/bbl
Long call option strike: $71/bbl
Long call option premium: $0.75 /bbl
Short call option strike: $74/bbl
Short call option premium: $0.20 /bbl
Expiry: two weeks
Cost: ($0.75-$0.20) x 1000 x 10=$5,500
After the bullish ISM release
Current WTI Crude Oil futures price: $73/bbl
Intrinsic value of long option: max (($73-$71, 0)) x 1000 x 10=$ 20,000
The out-of money call option is worthless.
P/L: $20,000-$5500= $14,500
In this example, the trader capitalized on a moderate price increase in WTI Crude Oil prices while limiting the potential loss.
Commodity-specific events: idiosyncratic factors
Commodity prices are determined by inelastic supply and demand which make them largely prone to short-term price shocks. Inelasticity means that the quantity demanded or supplied cannot adjust quickly. Short-term options can be used around key demand and supply report releases. These reports include inventory report, productions data, etc.
Examples of commodity-specific events:
- Energy: EIA weekly inventory report, OPEC Monthly Oil Market report, production reports, weekly rigs count, weather forecasts
- Agriculture: USDA reports, weather forecasts
- Industrial Metals: ICSG Copper Market Report, IAI Aluminum Market Report, World Steel Association data report
Example 2: Using Weekly Copper options to hedge the release of ICSG Copper Market Report
A macro hedge fund manager (PM) has an existing long position in 10 futures (25,000 pounds of Copper) based on his/her long-term directional bet (secular trend) on the growth of copper demand for electric vehicles and renewable energy. However, the PM is interested in hedging against a potentially bearish ICSG Copper Market Report release. This report provides insights into the global demand and supply balance with possible bearish sentiment.
Strategy: Long protective put
- Long 10 protective put options with a strike close to current futures price.
Current Copper futures price: $4.50 per pound
Put option strike: $4.40 per pound
Put option premium: $0.05 per pound.
Contract size: 25,000 pounds
Expiry: two weeks
Cost: $0.05 x 25,000*10= $12,500
After the bearish release of ICSG Copper Market Report
New Copper futures price: $3.80 per pound
Intrinsic value of put option: max (0, $4.40-$3.80)) x 10*25,000=$150,000
P/L: $150,000-$12,500=$137,500
In this example, the PM hedge his protecting the downside risk.
External (exogenous) market events
Commodity prices are sometimes affected by external market events that are outside the typical underlying demand and supply factors.
Examples of external market events:
War, geopolitical events, tariffs announcement, policy changes etc.
Example 3: Using Wheat Weekly option to hedge a geopolitical event
A trader who currently holds a short position of KC HRW Wheat futures equivalent to 10,000 bushels. The Ukraine-Russian war erupted, and the trader is concerned that the war will disrupt global supply of wheat which will lead to rise in wheat prices.
Strategy: Long call
- Long weekly call option on KC HRW Wheat futures
Current KC HRW Wheat futures price: $5.50 per bushel
Long call option strike: $5.60 per bushel
Long call option premium: $0.05 per bushel
Cost: $0.05 x 10,000 =$ 500
After the war escalates
New KC HRW Wheat futures price $6.00 per bushel
Intrinsic value of long call: max(($6 -$5.6), 0) x 10,000 =$ 4,000
P/L of options: $4,000-$500= $3500
P/L of futures : $5.50 -$6.00 X 10,000 = -$5,000
Net P&L = $-1,500
In this example, the trader hedges against potential price increase due to geopolitical risk offsetting a $5,000 loss to only $1,500
Conclusion
Short-term options are agile tools to adjust to precisely manage risk or capitalize on price movements driven by macroeconomic, commodity-specific and exogenous market events.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.