Question

Suppose that a manufacturer has an ongoing need for silver as a raw material in the production process, and is concerned about the risk of the price of silver going up. The firm is considering two hedging choices: futures contracts and option contracts.

(i) Suppose that the firm decides to hedge using futures contracts. Should it buy or sell futures contracts? Explain.

(ii) Suppose that the firm decides to hedge using option contracts. Should it use call or put options? Should it buy or sell these options? Explain.

Lastly, briefly discuss the advantages and disadvantages of hedging using options as compared to futures contracts.

Answer 1

Answer:

i)Since the manufacturer has an ongoing need for silver as a raw material in the production, and he is concerned about the risk of price of silver going up, the manufacturer must enter into a long position i.e he must buy future contract so that he can lock in the price.

ii) A call is an option contract giving the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time. Therefore the manufacturer must enter into a call option and he must buy it. It will give him the right to buy the commodity at the future date.

Advantages of using option contracts:

• Leverage. Options allow you to employ considerable leverage. This is an advantage to disciplined traders who know how to use leverage.
  
• Risk/reward ratio. Some strategies, like buying options, allows you to have unlimited upside with limited downside.
  
• Unique Strategies. Options allow you to create unique strategies to take advantage of different characteristics of the market - like volatility and time decay.
  
• Low capital requirements. Options allow you to take a position with very low capital requirements. Someone can do a lot in the options market with $1,000 but not so much with $1,000 in the stock market.

Disadvantages of using option contracts:

• Lower liquidity. Many individual stock options don't have much volume at all. The fact that each optionable stock will have options trading at different strike prices and expirations means that the particular option you are trading will be very low volume unless it is one of the most popular stocks or stock indexes. This lower liquidity won't matter much to a small trader that is trading just 10 contracts though.
  
• Higher spreads. Options tend to have higher spreads because of the lack of liquidity. This means it will cost you more in indirect costs when doing an option trade because you will be giving up the spread when you trade.
  
• Higher commissions. Options trades will cost you more in commission per dollar invested. These commissions may be even higher for spreads where you have to pay commissions for both sides of the spread.
  
• Complicated. Options are very complicated to beginners. Most beginners, and even some advanced investors, think they understand them when they don't.
  
• Time Decay. When buying options you lose the time value of the options as you hold them. There are no exceptions to this rule.
  
• Less information. Options can be a pain when it is harder to get quotes or other standard analytical information like the implied volatility.
  
• Options not available for all stocks. Although options are available on a good number of stocks, this still limits the number of possibilities available to you.