You wouldn’t use a hammer for a job that requires a screwdriver would you? Think about your risk management in the same way. Modern hedging portfolio trends combine different tools and actions to help manage the risk in a portfolio and protect against unpredictable market scenarios. The following graph shows how different market moves create positive or negative outcomes and how a combined portfolio works through the lens of a commodities consumer.
Using different tools makes sense from other aspects as well – cost, availability of credit, impact on working capital, cost/benefit, etc. The table below provides a quick overview.
You can learn more about building a diversified hedging portfolio in and the benefits of diversifying in another article we have posted, so we won’t go into detail on that here.
For this discussion, we are looking at when to use leverage in hedging strategies.
The principle shown in the graph above seems logical. It follows the standard “buy low, sell high” strategy. Now, here are the questions: What is high? What is low? Commodities markets have seen wide extremes in volatility due to the financial crisis, commodity cycles, trade wars and other major economic events.
Currently, volatility in commodities is perceived to be low versus those historical measures, so the next graph (source Bloomberg) attempts to start making sense of how to be alert of different measures that should be part of your consideration set when setting your risk management strategy.
Source: Bloomberg; volatility graph as of September 26, 2019
- Three Month Implied Volatility: Derived volatility from current options prices.
- Three Month Realized Volatility: Actual three-month realized volatility in the underlying contract
- Volatility Average: Average Range observed.
- High / Low: Extremes observed during a period of time.
Observing the following should give us a good sense if we should buy options, sell them or use them with measure to design hedging solutions.
- Where is each commodity’s volatility now?
- How is it priced on the ask of options prices?
- What has the actual behavior been in the last three months?
- How do current levels compare versus a period average?
This article is not recommending a specific strategy of either buying or selling options. Instead, the idea is to build on what we know from previous articles and add to that the observations from above. Here are some things to think about:
- Tool selection and mix in a hedging portfolio should not be static. This should be a dynamic exercise.
- As volatility changes, the allocation of percentages of what tools to use should also change.
- As volatility and prices are reduced, analysis should include considering tools buying optionality.
- As volatility and price of options increase, analysis should include considering using the value of options to take advantage in a balanced portfolio (in moderation and with limits).
- Past strategy mix selection success will not guarantee future success when volatility changes.
- Cyclicality should be taken in consideration, since some commodities are subject to seasonal changes in volatility (i.e. agriculture during crop season).
If you have questions about this topic or would like to learn more about leverage in hedging, Cargill Risk Management is here to help!