I work at a company that produces natural gas. I had a simple idea but it looks so good I must be missing something. (No free lunch) . I am comfortable with option contracts and FOP's. NG is currently trading at about $ 3.42. At this price, we can make a profit. If I sold a call with a strike of $4.00 I there are only 2 possible outcomes. 1) The market price isn't above $4.00 by expiration and we keep the premium. (easy part) 2) The market price is above $4.00 at expiration. Assume it is $5.00. The trade will be a $1 loser but I am selling production at $5.00 to the market. I was happy to sell at $4.00 and now the market is $5.00 Will this trade act as if it was a covered call? I was thinking the 'extra profit' from selling gas at $5.00 would have to go back into the brokerage account to cover the loss. I think the result is I was simply a net seller at $4.00 Unlike a covered call, the stock doesn't simply get called away. What risk am I not seeing?
Thanks for the quick reply. Do you agree that it is equivalent to buying a stock at 3.42 and selling a call at 4.00?
You can tell your FCM you are a hedger. Selling the call only provides protection to the value of the call. Selling the future would provide full protection and lock in a price. You will want to unwind at the time of delivery of your product. Make sure the futures contract goes a little past that.
(( You *always* keep the premium...)) (( The trick here is that your commodity misses out on some revenue, but that is not part of this trade, it's lost opportunity.)) It seems like you're describing yourself as a commodity seller of NG, so let's assume your $3.42 is a BE with [commodity+trans+{hub}storage]. If you sell the $4 call for 40¢ and NG hits $4, you make $4.00-$3.42=58¢ + 40¢ = 98¢ on the trade. If you sell the $4 call for 40¢ and NG hits $4.40, you still make 98¢ {58¢+40¢} -- but the "lost" 40¢ from exercise at 40¢ under spot is just made up by the initial call premium. So you're still 98¢ ahead of where you started. You're just 40¢ under what the market alone would've paid. [But, that's not part of this trade, anyway.] If you sell the $4 call for 40¢ and NG goes {even just to} $4.45, things might taste a bit bitter. You're still 98¢ ahead for the trade, but if you hadn't sold the $4 call for 40¢, that chunk of NG could go for $4.45 on the market. And then, {$4.45-$3.42=$1.03} and you're a {lost} nickel ahead ["behind!"}. And more and more, for every penny beyond $4.40. Now, the question is... is it worth the risk?!?! This is, after all, the heart and soul of the options market: to smooth the commodity spot market for both buyers and sellers, by capitalizing risk into a separate market. "Welcome!"
What if spot NG drops to $2.50? There's your risk. You only get the small call premium to offset this. Robert Morse is correct - you are better off selling a futures contract with an expiration that is close to the date when you want to sell your gas. That will effectively lock in your sales price at the price of the futures contract. You can also do a "collar." Sell a call, then take the proceeds from selling the call and buy a put. That will lock the price into a range defined by the difference between the call strike and the put strike.
The other two issues are production risk and basis risk. Each contract is for 10,000 MMBtu. If you set up hedges for more than you can produce (because of operational issues) then you are on the hook for the difference. Also, you have basis risk, because spot natural gas prices vary widely across the country, and options and futures are FOB Henry Hub. Plus, futures might move $1.00, but your local spot price might not move at all (or go the other way). I'm sure you know your local market conditions 1000x more than me or anyone else on this board, but it's something to keep in mind.
@DR7 .... The hedge department does use collars. Good call! My idea is probably DOA. My pitch to the boss was while the price bounced around let's grab some premium. He didn't love it. Even though they are bullish the business sense has them purchasing puts too. They need to put in a 'floor' on pricing. Hence the collar. One last question then I will let this go... how does selling a future help? Wouldn't you be just locking in today's date plus some cost of carrying? Is the net effect that it would act like a 'tight' collar? Any chance it would cost less to construct?
Yes, locks in a price. I spoke to a guy once who bought large amounts of gold, silver, platinum and Palladium from retailers. He then smelted the product back down to bars and sold it to wholesale jewelers. After he bought the metals but before he made delivery he wanted to lock in a price and lock in his profit. This is the real purpose for commodity futures not speculation. If you’re running a business your purpose should not be speculation either but to lock in profits or cost.