Hedging with Jorge #Episode 67: Selling a put option

When we think about managing aluminium price risks, one of the most effective strategies available to consumers is the zero-cost collar. This strategy allows buyers to protect themselves from price volatility by combining two option positions: buying a call and selling a put. In today’s episode, let’s focus on the first leg of this strategy selling a put to build the foundation for understanding how a zero-cost collar works.

What is a put option?

A put option gives the buyer the right but not the obligation to sell a certain amount of aluminium at a pre-agreed price (the strike price) on or before a specific date (the expiry).

Think of it as an insurance policy:

• The accident = aluminium prices falling.
• The insurance coverage = the strike price.
• The premium = the cost of buying the put.

When you buy a put, you are paying for protection against the risk of falling prices. If prices drop below the strike price, you can exercise your right to sell at the higher, pre-agreed value, minimising your losses.

What happens when you sell a put?

Now, let’s flip the perspective. When you sell a put, you become the insurance provider.

• Your reward: You collect the premium upfront.
• Your obligation: If the market price falls below the strike price, the buyer of the put can sell aluminium to you at that higher strike price.

This means that when you sell a put, you are potentially long because if exercised, you will have to buy aluminium at the strike price, regardless of how low the market goes.

A practical example with aluminium

Let’s say:

• Strike price = $2,700/tonne
• Premium collected = $120
• Expiry = First wednesday of december

As the seller of the put, you pocket the $120 premium immediately. When expiry arrives, if the market price is below $2,700, the buyer will exercise the option and sell aluminium to you at $2,700. This leaves you long aluminium for the third wednesday of december.

If the market price is above $2,700, the buyer will let the option expire worthless, and you simply keep the premium.

Key Mechanics to Remember

• Options have structure: strike price, premium, expiry and underlying tonnage.
• Aluminium options typically expire on the first Wednesday of each month (unless they are Asian/average options).
• American options can technically be exercised anytime, but in practice, they are rarely exercised before expiry.

Selling a put is the first half of constructing a zero-cost collar. By collecting the premium, you finance the purchase of a call option, which we will explore in the next episode. Together, these positions create a strategy that limits your downside while also protecting you from the risk of rising aluminium prices.

Final Thoughts

Understanding the logic of selling a put is essential for building a strong hedging strategy. It’s about accepting a potential obligation today in exchange for collecting a premium that will later finance your upside protection.

Stay tuned for the next episode, where we will explore the second half of the strategy: buying a call option, which is conceptually simpler and completes the zero-cost collar structure.