Question

You work for a gold mining company and you want to hedge the risk of a large drop in gold prices over the coming year. Explain one possible strategy to implement this hedge using options. Provide an example to demonstrate your strategy. What are the advantages and disadvantages of using options for this hedge as opposed to a forward contract?

Answer 1

I will be trying to hedge the risk of large drop in gold prices over the coming year by taking the position through put options in the derivatives market because put options will be providing me with ample opportunity to gain upon any fall in the prices of gold because when the prices of gold will be following the prices of put options are going to go up and hence, I will be gaining on the put option and my overall loss will be eliminated to certain extent.

for example if I have taken the put option of 1700 of gold and if the gold prices are going to fall for $200 then the option will be getting executed and I will be gaining on the option where as I will be losing on my underlying asset and hence the overall loss will be mitigated to certain extent.

Advantage related to such strategy is that I will be trying to eliminate my loss and I will also have a right not an obligation and I will also try to increase my profit.

The disadvantages related to such positions are that these are highly speculative positions and they can also lapse and there will be cost of the options which can be ultimately loading down my overall profits.

Advantages of option contract will be related to having a right not an obligation and it will also provide me with higher degree of transparency and no counterparty risk whereas forward contract will have higher counterparty risk and it will also have obligation to execute the contract.

Option contract are never customised in nature so it is one of the disadvantages related to option contract whereas forward contract will always offer with the customisation of exposure.