How lithium and cobalt option contracts can help producers and consumers with hedging strategies

This week, the Chicago Mercantile Exchange (CME) launched option contracts on lithium hydroxide, which are cash-settled and differ from many of the CME commodity options on futures

This week, the Chicago Mercantile Exchange (CME) launched option contracts on lithium hydroxide and cobalt metal. The options contracts are average-priced options (aka Asian Options) that are financially settled versus the average monthly price of Fastmarkets lithium hydroxide monohydrate 56.5% LiOH.H2O min, battery grade, spot price CIF China, Japan & Korea, $/kg and cobalt standard grade, in-whs Rotterdam, $/lb.

These option settlements are cash-settled and differ from many of the CME commodity options on futures that provide the right but not the obligation to purchase a futures contract.

Several strategies can be employed by producers and end-users who engage in commodity hedging, which take advantage of the flexibility offered by option contracts. Before we dive into some of the hedging strategies that can be used, we will touch on some option contract basics.

What is an option on futures contract?

There are a few different types of options offered by the CME. An option on a futures contract is a financial derivative that combines options and futures trading. It allows traders to have the right, but not the obligation, to buy or sell a futures contract at a specific price (known as the strike price) on or before a predetermined date (known as the expiration or exercise date). To purchase an option, the buyer pays the seller a premium.

Unlike futures contracts, options on futures provide flexibility and can have limited risk for traders and procurement managers. A call option gives the holder the right, but not the obligation, to buy the underlying futures contract at a specific price. In contrast, a put option gives the holder the right to sell the underlying futures contract at a predefined price.

Traders and procurement managers can use these options to hedge against potential losses, limit their exposure to market volatility, or speculate on lithium price movements. The most money the option buyer can lose is the premium that is paid to purchase the call or put option. Unlike the buyer, the seller can have unlimited risk.

What is an average-priced option contract on lithium hydroxide and cobalt metal?

The new lithium and cobalt option contracts that are listed are average-priced. An averaged-priced option is a type of financial security that derives its value based on the average price of an underlying asset over a specific period. The CME contracts use the average price calculated by Fastmarkets for a calendar month. These lithium and cobalt option contracts are cash-settled.

Instead of the option buyer having the right to buy or sell lithium futures or cobalt futures contracts, the buyer receives a cash payment for the difference between the strike and settlement price. An option strike price refers to the predetermined price at which an option can be exercised. No cash payment is made if the option settles out-of-the-money.

“Out of the money” for a call option means the option’s strike price is higher than the current market price of the underlying asset. Similarly, for a put option, it means the strike price is lower than the current market price. When an average-priced option settles out-of-the-money, the option seller keeps the premium, and the buyer does not receive a payout.

With an averaged-priced option, the payoff is determined by the average price of the underlying asset over the specified period. This averaging mechanism helps reduce the impact of short-term price fluctuations and can be helpful in situations where the underlying asset’s price is volatile.

The averaging can be suitable for hedging regular cash flows. The average-priced lithium options contracts settle like the lithium futures contracts. The difference is the option contract buyer’s loss is limited to the premium paid for the option.

Since the payoff of the options equals the under-average price, the effective historical volatility is lower. Daily spikes or drops in a commodity price generally occur more often than spikes or drops in a monthly calendar average. Therefore, average-priced options usually cost less than European or American-style options that expire simultaneously and have similar lengths of time remaining before a financial contract expires.

What option strategies can be used to hedge lithium or cobalt?

Asian option contracts on lithium hydroxide and cobalt offer traders and corporate hedgers several ways to mitigate their exposure to changing lithium prices and cobalt prices.

For example, a producer might consider purchasing a put option. The producer attains the right to sell lithium hydroxide at a specific strike price. The most the producer can lose on the hedge is the premium of the options.

The payout profile of a $20 strike put option shows that the producer will receive a payout for any price below $20 minus the premium paid for the put option. The producer will lose the premium paid for the options at expiration if the price of lithium hydroxide remains above $20.

Another example could be that an electric vehicle OEM exposed to lithium hydroxide might consider buying a call option. In this scenario, the OEM will pay an option’s premium, and the most they could lose is the premium paid for the option. The payout profile of a $30 strike call option shows that the OEM will receive a payout for any price above $30 plus the premium paid for the call option. A loss will occur at expiration, which is limited to the premium, if the price of LIOH remains below $30.

What if you don’t want to pay a premium?

If volatility rises, the premiums on lithium options could also increase, making call options and put option contracts more expensive. An alternative to purchasing a call or put option might be to combine one with another, where the producer or consumer sells one type of option and simultaneously buys another.

A costless collar is a hedging strategy that can be used to hedge lithium exposure where the producer or consumer does not have to pay a premium. For example, an OEM might purchase a $28 call option and sell a $20 put option where the premium from the sold put option offsets the premium from the call option purchase.

The payout profile of a purchase of a $28 strike call option combined with the sale of a $20 put option shows that a loss will occur at expiration if the price of LIOH remains below $30. The OEM will receive a payout for any price above $30. If the average price of lithium hydroxide is below $28 and above $20, there will be no exchange of cash. If the average price is below $20, the OEM will pay the difference between the average settlement price and $20. 

For example, if the average price of lithium for a calendar month settles at $30, the OEM will receive $2 = $30 – $28. No cash will be exchanged if the average price settles at $25. If the average price settles at $18, the OEM must pay $2 = $20 – $18.

The bottom line

The upshot is that there are several different option strategy combinations that a producer or consumer can use to hedge their lithium hydroxide or cobalt metal exposure. The benefit of using options is that they provide more flexibility than a futures contract. What is essential to understand is several components are used to generate the premium of an averaged-price option.

In addition to the price of lithium hydroxide and cobalt metal, the implied volatility, the strike price, current interest rates, and the time to maturity play a critical role in determining the premium of an option contract.

Additionally, when financial option contracts initially launch, success can sometimes be attributed to finding options sellers. 

For example, a producer might want to sell a call option since they already own the physical underlying commodity. An OEM might want to sell embedded options, which are listed in their physical offtake contracts. These are sometimes called ceilings or caps, look-back pricing, or escalators. These types of options can be monetized by potentially selling them to a financial institution.

Don’t hesitate to contact our risk solutions team if you would like some insight into how to hedge your lithium hydroxide/carbonate or cobalt metal risk using option contracts.

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