Hedging the Iron Ore Downslide with Options

09/04/2015 8:00 am EST

Focus: OPTIONS

With iron ore prices cratering, iron ore options are one way to hedge against this commodity, so Poonkulali Thangavelu, at Investopedia.com, points out what has been the main culprit behind the downslide and highlights several ways to use iron ore options as a promising but risky trading strategy.

With iron ore prices on a downslide across the globe, industry players are looking for ways to hedge their exposures by using iron ore options. For one thing, iron ore producers want to lock in an acceptable price to sell products or buy raw materials and they want to avoid contending with ongoing market volatility. And even if you don’t have any actual exposure to the commodity, you can use iron ore options as a promising but risky trading strategy.

What’s Behind the Downslide?

Iron ore prices are in a downward spiral, mainly because there's too much of the product right now. Over the past year, global demand has slowed for the commodity, the main culprit being the ailing Chinese economy, a major importer of iron ore and steel products. With China slowing down, that's bad news for iron ore producers, who have come to rely on China's seemingly endless need for iron and steel to build up its infrastructure and housing sector. Having China as a large, seemingly guaranteed customer base meant that many iron ore producers upped their production rates in the past decade. Now, however, producers face large inventories and slowing prices. Goldman Sachs analysts expect that iron ore prices—which already have been falling—will drop further, from a predicted $49 a metric ton in the third quarter of 2015 to $44 a metric ton by the second quarter of 2016.

Making Money Off Iron Ore Options

One way to benefit from this situation is by writing a call option on iron ore. A call option buyer has the right, but not the obligation, to buy a certain quantity of a commodity at a price (called the strike price) before the option's expiration date. To purchase your call option, a buyer typically would pay you a premium. This buyer might be, in this case, a steel manufacturer that needs to secure iron ore as a raw material and wants to hedge against the possibility of rising iron ore prices, however unlikely that scenario seems in today’s market. The best-case scenario is that you collect the premium and hope that the buyer won't exercise the option to buy, considering that market prices keep falling and that the buyer could get a more favorable price on the open market.

NEXT PAGE: Are There More Ways to Play Iron Ore Options?

|pagebreak|

Another way to play iron ore options, although at a greater level of risk, is to write a put option on the commodity. This gives the buyer of the put option the right to sell you iron ore for a given strike price. So a producer of iron ore, for instance, might buy this sort of option to hedge against the possibility of iron ore prices falling further. By paying you a premium for the put option, the buyer could get a guaranteed floor price at which to sell its commodity holdings, regardless of future market conditions.

Yet another strategy is to take a call option on the stock of one or many iron ore companies, since that would also give you exposure to the falling iron ore prices. By writing a call option on these stocks, you could pocket the premium and anticipate that option won't be exercised.

Advantages and Risks

An advantage of gaining exposure to iron ore prices through the options market is that you don’t have to invest any money upfront except for your trading commissions. If your strategies perform as expected, you'll simply pocket your premium and won't hear any further from the option buyer.

There are also risks, however. If you're using options to hedge an existing exposure to actual iron ore assets, your risk is limited to the strike price you're prepared to pay. However, if you're using options to trade on the prospect of an iron ore price rise or decline, you may face a higher level of risk.

For one thing, if the buyer of the call option decides to exercise their option and buy the iron ore (or iron ore company stock) at the agreed strike price, you would have to buy the given amount on the current market to fulfill the agreement. This exposes you to having to buy the commodity or stock at a higher price than it was trading when you wrote the option or sell it at a lower one than it's currently trading. Similarly, if the buyer of the put option exercises their option, you'll have to buy the product at the agreed-upon strike price. If market prices are lower, you would face a loss if you were to subsequently sell the iron ore on the open market.

The Bottom Line

With iron ore prices cratering, iron ore options are one way to hedge against this commodity. While your initial outlay is limited when you play in options, you're also subject to the risk that the options will be exercised against you at a price that's unfavorable to you. You might have to buy or sell the iron ore at the going market prices. And by writing a call option on iron ore company stock, you're exposed to the volatility in the stock price.

By Poonkulali Thangavelu, Contributor, Investopedia.com

Related Articles on OPTIONS