This strategy may free up liquidity when it is needed most and allow you to participate if gold prices rise. It comes at a price.

It’s early August and jewelers are in the early part of the annual peak selling season. For most jewelers, this means carrying the highest inventory levels of the year. Careful estimates about expected customer volumes are made and supplier orders placed. Receivables from customers are expected to flow in faster in November, but that may seem like a long time away. For many jewelers credit lines are on the way to being drawn to their limits. There are still some looming supplier invoices still left to pay.

And then there is the question of the gold price. Sure, as a responsible business leader you’ve hedged against gold price moves with futures, or by leasing gold. But what about liquidity? A rising gold price can cut down your company’s liquidity at exactly the wrong time in your business cycle.

Companies using futures to hedge gold must keep sufficient cash or credit line availability to meet possible margin calls. It is difficult to project the amount of margin your company might need to post. The amount of cumulative margin calls can be significant, as many jewelers who operated through the 2007-2013 period can attest. Equally, there is no way to know how large these demands for additional margin can get.

Companies that lease gold are not wholly immune from this dynamic. As gold prices rise, borrowings rise closer to the credit limit, even if they don’t borrow any more gold.

The 2019 peak season is starting off with a “perfect storm” to constrain liquidity. Banks remain wary of the sector and are slow to offer credit limit increases. The gold price has risen from the $1,275 / oz level just three months ago to over $1,450 / oz.

So, what can be done to conserve liquidity when you need it most?

Hedging with options – the basics

Jewelry wholesalers and manufacturers sometimes hedge by buying put options as an alternative to shorting futures contracts. This strategy involves buying put options on gold futures contracts. Put options give the buyer the right, but not the obligation, to sell specific futures contracts at a “strike” price. This right lasts until the option’s expiry date.

Companies using this strategy aim to hedge downward movements in the gold price. Unlike selling futures, put options only offer hedge protection to the extent the price declines below the strike price.

A key potential benefit these companies are trying to capture is an upward movement in the price of gold. By using put options, the hedger enjoys the benefit if gold prices rise. Why? Because the put option hedger isn’t obligated to sell at the strike price. Rather, they can sell their inventory at the market price of gold to their customers, potentially capturing increased profit margins.

The gold hedger pays a premium, or option price, to buy the put option. This premium is generally paid in full when the hedger executes the trade. Since the premium is fully paid the hedger is not subject to additional margin calls. This is why hedging with options offers greater certainty on the amount of capital allocated to hedging compared to using futures.

For clarity, we are referring to a strategy where the hedger buys put options. Strategies that involve selling options have additional risks and considerations beyond the scope of this article. If you’d like to explore other futures or options related hedging strategies, please contact us.

How option prices are determined

The bids and offers made by market participants determine option prices. There are really four key factors that inform pricing decisions for options. 

Time value

Time is an important pricing consideration for options. Here we mean the expiration date of the option. If you bought a put option to protect against a gold price decline, wouldn’t it be better to have this protection for longer? Typically a buyer would pay more for an option that expires later than one expiring soon. The time value component of an option price typically declines as time passes and its’ expiry date approaches. This is often referred to as “decay”.

Intrinsic value

Intrinsic value reflects the amount an option is, or is expected to become “in the money” by the expiration date. In the money for a put option means the price of the underlying futures contract is lower than the strike price of the option. At expiration, the option’s price should approximate the amount by which the option is in the money. If the option is “out of the money” the option will typically expire worthless.

Volatility

Higher expected volatility in the underlying gold futures contract will increase the option price. This is because higher volatility increases the possibility that the option expires in the money. The impact of volatility on an option price is exaggerated by time. The greater the time to maturity, the more time volatility has to do its work.

Interest rates

This is really about the opportunity cost of money. If the money wasn’t invested in the options premium, what could it earn in interest over the same time period. Clearly at current interest rates, this is a pretty small factor.

An example of hedging with options

Coming into the season, the Sample Jewelry Co. has 3,800 oz of physical gold contained in its inventory. Of this amount, Sample has priced 400 oz with customers for delivery in the coming months. Sample is short 34 contracts of December gold futures to hedge its unpriced inventory.

Sample is already borrowing about 75% of its credit line and has made some large inventory purchases from its suppliers. Sample’s CFO wants to ensure the company has enough liquidity to pay its suppliers and operating costs. Consequently, she evaluates temporarily switching the company’s hedge position from futures to a put option strategy.

With gold trading at $1,470 / oz spot on August 5th, she looks at puts on the February gold contract. Puts with a strike of $1,450, expiring 28 January are offered at $36.30 / oz. If Sample executed at these levels, they would pay an option premium of $123,420 for 34 options contracts.

Assuming Sample decided to proceed, they would buy the 34 option contracts and buy back their 34 short December gold futures. In doing so, the company would free up the money posted as margin on the short December contracts. They would also have a degree of certainty about not having further demands for margin money on their put options hedge.

What if gold goes up?

Let’s look at a hypothetical $100 / oz rise in the price of gold by the option expiry date. In this scenario, the option would expire worthless. The $123,420 option price Sample paid has no further value beyond the expiry date. Equally, Sample’s unpriced gold inventory would now be worth $100 / oz more, or $340,000 for a net gain of $216,580.less commissions and fees.

And if the gold price declines?

Let’s look at the inverse, a hypothetical $100 / oz decline in the gold price by the options expiry date. Sample’s unpriced gold inventory is worth $100 / oz less, or $340,000. Sample has also paid the $123,420 option premium. At expiry the option has intrinsic value of $80 / oz. This reflects the strike price of $1,450 / oz minus the prompt gold price of $1370 (a $100 decline from the spot price when the trade was entered). Consequently, the put options Sample owns have an intrinsic value of $272,000, resulting in a net cost to Sample of $191,400. plus commissions and fees

The $191,400 reflects the approximate maximum exposure Sample is taking by hedging with put options strategy. Why? Because it reflects the full cost of the put options plus the decline in gold prices to or below the strike price.

Closing out the put option hedging strategy

As the options expiry date approaches, Sample can initiate a fresh futures hedging position by selling April gold futures. If the put options are in the money, Sample can sell them to capture this value. If the put options are out of the money, Sample can either sell them for whatever nominal value they have, or let them expire worthless.

Having selected put options with a January expiry, Sample is now re-initiating its futures hedge after peak season. Inventory levels are likely lower and accounts receivable are being collected quickly. Consequently, the company may have the excess liquidity to post margin on its futures hedge.

An additional liquidity consideration – borrowing base credit on your hedge account

Most companies don’t have unlimited liquidity. Consequently mid-market companies typically aim to have as much available liquidity under their credit lines as possible. This usually means negotiating the highest advance rates they can against assets like receivables and inventory. Some companies considering options or futures to hedge may not be aware that your hedge account can be pledged to your bank. Some banks will give hedgers borrowing base credit against the liquidation value of a company’s hedge account.

The futures industry has developed a standardized security agreement that may be used for this purpose. With this agreement in place, some banks give up to 100% borrowing base credit for hedge account liquidation value.

Hedging with options during the peak season – Conclusion:

Some jewelry manufacturers and wholesale companies hedge with put options during the peak season. This may help mitigate the risk of having to fund additional margin calls when company liquidity is stretched. It may also help improve cash forecasting compared to using Futures, where the amount of margin that will be required is difficult to predict. This strategy may allow companies to enjoy higher profit margins in periods where the gold price rises.

The strategy does have drawbacks. Options can, and often do, expire worthless. This strategy only provides hedge protection once the market price is below the option’s strike price. Consequently, hedging with options does not provide the same equal and offsetting hedge structure that hedging with futures does.

For these reasons, many companies rely primarily on futures to hedge their gold inventory. Hedging with options is potentially a useful additional strategy, to be employed at times when company liquidity is limited.

The concepts outlined here may be unfamiliar to some readers, but they are rather straightforward at their core. For additional training check out this precious metal futures course. If you would find it helpful to explore the usefulness of hedging with options for your company, let’s talk.

We hope you’ve found this a practical and useful guide to analyzing your hedging needs. Please let us know if you have any suggestions on how we can improve it, or any of our resources. If you would find it helpful to explore your company’s hedging requirements please contact us. We would be grateful for the chance to help.

---