Average priced option: A risk manager’s guide based on a soybean oil volatility case study
Why Asian options are commonly used for commodity hedging
The commodity markets can be volatile and escalated historical and implied volatility comes at a price.
The historical volatility of the Fastmarkets RBD Soybean Oil price spiked higher in July 2022, hitting the highest level of the year and surpassing the levels seen at the Russian-Ukrainian war breakout.
Soybean oil, commonly used as a feedstock in the biofuel process, saw higher volatility as demand for protection from adverse market conditions accelerated. When volatility spikes, it creates uncertainty and makes hedging products like options more expensive.
What might mitigate the pain of higher volatility?
Financial engineering can help mitigate issues related to spikes in volatility like the one recently experienced for those involved in market risk commodity trading. Using average-priced options (aka Asian options), you can help reduce implied volatility levels, which mitigates the premium cost.
What is the timing of your physical commodity contracts?
Commercial players in the commodity space can benefit substantially from an average-priced option (APO) hedge. A goal might be to match your physical purchase and sales with a monthly APO strike price, which allows you to fix your costs against a monthly index (such as Fastmarkets RBD Soybean Oil benchmark).
What is implied volatility?
One of the critical drivers of the price of an option is the variable that controls the likelihood of an option contract settling in the money. The component that describes this possibility is called implied volatility. Implied volatility is a market input representing the market’s view of the future daily movements of an underlying asset.
What is an average priced option?
During the 1980s, two Bankers Trust employees introduced average-priced options (APO). They called these exotic options Asian option contracts since they developed the concept while in Tokyo.
An APO differs from a European-style option contract as the value is based on the predicted mean of the underlying commodity during the determination period.
The price of an asset during the determination period is used to calculate the floating price of the option. The floating price is then compared to the strike price to arrive at the payout of the options.
Call Value = Floating Price - Strike Price
What are the benefits of average priced options?
One benefit of an APO is it reduces the risk of market manipulation of the underlying asset as the option approaches maturity. Statistically, it is more likely that the price of an investment will spike on any particular day or week as opposed to the average price spiking for an entire month.
You can see the difference in the spikes and drops between the weekly RBD Soybean Oil prices and the monthly average of the RBD Soybean Oil prices.
Another advantage of APO contracts is their costs relative to European-style options. Since an APO’s payout is the average price of an asset over a certain period, the implied volatility used to price an APO has an averaging feature. Therefore, an APO mitigates an option’s volatility, making them less expensive than an option that settles on one day like a European-style option.
One of the difficulties in determining the premium of an APO is that it depends on the underlying path. Since the option’s premium needs to estimate the average, it needs to evaluate the direction the price will take to arrive at an estimated mean.
What is the payout of an average priced option?
The most common type of APO is a fixed strike option. The payout for a call option is the average price during the period minus the strike price.
For example, if the average soybean oil price during June is $0.9875 and the strike price is $0.85, the buyer would receive the difference of $0.1375 multiplied by the number of pounds the option represents.
The payout profile of the long-call APO is shaped like a classic hockey stick. The option buyer is underwater until the breakeven price. The breakeven price is calculated by adding the premium to the strike price.
What should you do when implied volatility is elevated?
An APO will help smooth implied volatility. If implied volatility is elevated, you can consider selling a call spread or put spread to reduce premium costs.
A Bull Call spread is a strategy to purchase a call option and sell a further out-of-the-money call spread. For example, if you buy a $0.85 RBD Soybean Oil call, you might also sell a $1.00 RBD Soybean Call to lower your net premium. In this situation, you would forego any gains in the price of RBD Soybean oil above $1.0.
The payout profile of RBD Soybean Oil shows the option payout underwater until the breakeven price and then capping out at the higher strike price (sold call option).
If you were to buy a bearish put spread, you would buy a put option and sell an out-of-the-money put to offset your premium cost.
The bottom line
The upshot is that APO is a financial tool that can help hedge against adverse price changes and mitigate volatility.
As mentioned, implied volatility is critical to determining an option’s premium. The mechanism used to price an APO smooths the volatility used to calculate the options contract value and, therefore, can reduce your premium. Remember, although there is a smoothing component, higher implied volatility for a European option generates higher volatility on an APO. You might consider purchasing a call spread or put spread option contract to reduce elevated levels of implied volatility.
If you’d like to know more about commodity risk management, contact our risk solutions team.