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2.2.4 Seagulls / 3-Ways: Different options can be combined to match a hedge strategy to a market view. If a consumer wanted upside price protection but believed that the market price was unlikely to extend above $6000, they could buy the $5750 - $6000 Call Spread and sell the $5500 put in a strategy known as a 3-Way (or “Seagull”, due to the profile), at net zero premium cost.


By limiting the upside protection to $6000, the consumer can buy a lower call option and sell a lower put option, with a better outcome than the collar provided the market price remains below $6150


Chart 6


4. INITIAL MARGIN, VARIATION MARGIN AND LEVERAGE Trading derivatives requires the posting of Initial Margin and Variation Margin.


Variation Margin is the position “mark to market” at each day’s close of business, with valuation losses in excess of any credit line being called.


Initial Margin typically uses historical data to define an expected 2 day price buffer at 99% confidence, the logic being that if a counterpart is called for variation margin at the end of day 1, it could be the end of day 2 (or early day 3) before the client position is closed out if the call is not met. Volatile markets may trigger intra- day margin calls and increased Initial Margins.


Source: LME / Reuters / ADMISI


3. HEDGING FOR INTERMEDIARIES Smelters, refineries, crushers, and merchants who buy raw material, store, process and sell product operate on a margin (in contrast to the naturally long position of a miner), and have a price exposure determined by the terms of their purchase and sale contracts.


For example, in March 2020 a copper cable manufacturer receives a fixed price customer order for cable in August 2020.


The cable manufacturer sells the copper cable to their customer at a fixed price, basis the prevailing LME market price for August 2020 plus a premium (reflecting location, fabrication, quality and profit).


Basis a 2month fabrication time, they buy copper rod basis the unknown average LME price for June 2020, giving a fixed price physical sale in August and a floating price physical purchase basis June.


To hedge their short price exposure, they buy a Fixed Price Swap (LME “averaging trade”) from their LME broker basis average June 2020 prompt August 2020.


In practice, hedge books of cable manufacturers reflect their underlying mix of physical business priced on a fixed or floating price basis, and they hedge on a back to back basis.


Intermediaries benefit from contango curves, but backwardation curves erode their profit margin because they would buy raw material basis a higher nearby market price and sell basis a lower forward price. Therefore, some intermediaries may use a strategic hedge book to lock in beneficial contango curves.


Initial Margin also introduces “leverage” into a position, which helps explain why futures are popular with speculators. If a customer wanted to buy 1Mt of copper outright, they would pay the full cash price for the metal, say $5700/Mt. However, with the same amount of cash and basis an LME Initial Margin of $455/Mt, they could buy $5700 / $455 = 12.5Mt on Initial Margin, i.e. 12.5x the delta provided they could cover the Variation Margin requirements.


VARIATION MARGIN IS THE POSITION “MARK TO MARKET” AT EACH DAY’S CLOSE OF BUSINESS, WITH VALUATION LOSSES IN EXCESS OF ANY CREDIT LINE BEING CALLED.


17 | ADMISI - The Ghost In The Machine | Q1 Edition


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