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Options – the next frontier

Mike Reardon explains why options are an increasingly smart choice in a volatile economy

The extreme volatility found in ocean bulk shipping calls for smart risk management. Though forward freight agreements (FFAs) can be used to minimize the effects of wild rate swings, the use of freight options is also becoming a popular tool for those seeking to smooth out the steeper peaks and valleys; options volumes traded with Imarex in March were up 165% from a year earlier. Options can be used as stand-alone instruments or in conjunction with the more basic FFA, or even with shipping equities.

The difference between options and FFAs

An FFA is a financial instrument where one can hedge an existing position in the physical market or speculate about the direction of the market without having any offsetting physical position. It is a zero sum game where every penny made by one trader is a penny lost by the other. When the FFA gains in value, the long position makes money and the short position loses that exact same amount of money. Understanding the contract details is of course important but the underlying premise is fairly simple. Options, on the other hand, can become a little more complicated in that the long position and short position do not have a symmetrical risk/reward profile. The buyer of an option has potentially unlimited upside with limited and known downside, while the seller of the option has limited and known upside with potentially unlimited downside. It is because of this profit/loss structure that many are turning to options to hedge their freight exposure as well as put on directional trades.

Options – the basics

The purchase of an option provides you with the right, but not the obligation, to buy (or sell) an asset at a future date. Understanding that definition is important. What it means is that if the trade goes your way, you have the right to cash in on the profitable trade. However, if the trade goes against you, you are not obligated to act – and are therefore not obligated to absorb any losses on that trade. Because you are dealing with an option, and not an FFA, you simply walk away, having only paid your premium.

Simply viewed, these instruments give you the option of deciding, at a later date, which trades you want to keep and which trades you don’t. There are two kinds of options, calls and puts. Buying a call option gives you the right (but not the obligation) to buy an asset at a future date an agreed price. It is a bullish instrument in that you profit when the price of the underlying asset moves up. Buying a put option gives you the same right – but in this case, to sell an asset at a future date at an agreed upon price. This is a bearish instrument in that you profit when the value of the underlying asset falls.

This is not a free lunch, however. In order to be allowed this beneficial risk/reward profile, you have to pay a premium. Similar to buying insurance, you pay the premium to the other party (the seller) – whereby the seller agrees to pay you the money earned on a successful trade, but only asks for that premium in return. Once you have paid that premium, you have no further downside with buying an option.

There are a few factors that have made options more attractive to some market participants than the more basic FFA. The primary reason that freight traders use options is that they allow you to enjoy the full upside to a successful trade while limiting how much downside you will have to endure should the trade work against you. Once again, this is similar to buying an insurance policy.

The other reason that traders use options is that they are relatively cheap. A call option on PM4TC for 90 days of Q3 costs about $2,000 at time of writing, assuming a strike price of $11,500. The total amount you would pay is therefore $180,000 ($2000/day for 90 days). As explained above, this represents your maximum downside. However, the alternative would be to buy the underlying FFA for PM4TC at $11,500. The money you would need to put up for this contract would be about $259,000, which represents about 25% of the $1.035 million notional value of the contract.

One thing to keep in mind, however, is that if the trade goes your way, the straight FFA trade would be more profitable. This is because you have not paid any premium on the straight FFA. So while a long FFA position and a call option may indeed move the same way to provide for a good return, you need to subtract the premium from any profits on your options trade.

How options are used

With tanker rates currently at low levels, we are seeing refiners looking to hedge their forward freight exposure through the use of options. The concern of refiners is that a freight spike would increase their costs and therefore hurt their already weak margins. In order to hedge against this possibility, the refiner could buy a call option that would pay off if freight rates rose to a certain level. A more specific example would involve a refiner in the Far East who has known deliveries of crude in Q4. In today’s market, he could buy a Q4 call option at a strike price of Worldscale 55 for 4 Worldscale points. This amounts to about 13 cents per barrel. So, for the refiner, it is a very cheap way to protect against a major freight surge.

Another example would be that of a shipowner who buys a put option against his own ship that operates in the spot market. Using the PM4TC example above, we’ll assume the owner wants to hedge against a downturn in Q3 and buys the put option for $2,000/day (remember a put option increases in value when the underlying asset decreases in value). If the spot market ends up at an average of about $11,500 – or actually goes higher, the option expires “out of the money” and the owner’s loss is the $180,000 he paid in premium. You need to remember, however, this is a hedged position and you have to account for both the paper trade as well as the owner’s physical position. Since the spot market has gone up, the owner’s spot vessel will make more money on his physical asset.

In a situation where the spot market does fall, the owner’s option will pay off. As the market falls below $11,500, the owner begins to recoup the premium he paid. If the market falls to $9,500 the owner is effectively even. He has paid $2,000/day and has earned back $2,000/day ($11,500 – $9,500). If the market falls below that $9,500/day level the owner begins to profit.

Using this same example, let’s view the other side of the trade, which in this case could very well have been a charterer. This means that the charterer would have “written” or “sold” the put option, which means that the charterer is looking to profit if the cost of freight goes up (or effectively stays the same). Remember if freight rises, the charterer’s costs go up – so he is looking to make money when this occurs, in order to offset his higher physical shipping costs. But there is a key difference regarding the extent of the obligations, ie liabilities, of the two parties.

Recall that the owner bought the put option. His downside is limited to the premium paid, though his upside can be substantial. The entity that wrote the option, the charterer, is the party that is liable to the owner. The charterer therefore collects the premium, which represents his maximum gain, but he is on the hook to pay out money to the winning side of the trade should the market indeed fall. You need to view the writer/seller of options in the same way as you view insurance companies. In a year where there are few claims against the insurance company, it collects more in premiums than it pays out in claims. Yet in other years, the insurance company may have to pay out more in claims than it collects in premiums.

Options can also be used in conjunction with shipping equities. An investor may feel that tanker rates for the balance of the year may fall off considerably, yet he does not want to sell his position in Frontline. Buying a put option can protect him if a collapse in spot rates brings about a collapse in the Frontline share price. If spot rates do fall, and the share price of Frontline falls as well, he will make money on the put option that he purchased.

If, however, both rates and the Frontline share price stay relatively strong, then he only loses the premium he paid for the option. Once again, the buyer of an option gets to enjoy the upside to a winning trade, while minimizing the downside.

There is an old trading maxim that advises one should “sell down to sleepability” if one is too nervous about the existing position. The use of options allows hedgers, speculators and all traders to limit their downside risk, while enjoying a large amount of upside and a good night’s sleep.

Trading strategies with options will be examined in depth in the Baltic Exchange’s Advanced Freight Modelling and `Trading course, which takes place in London (18-19 June) and Singapore (2nd-3rd July). See www.balticexchange.com/training www.balticexchange.com/training for further details.

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