Hedging power production with options

Short recap of the same problem: Green Hydro is a small German power producer. With its small hydro power plant located at the Bavarian Fischfreude Staudamm it is committed to produce 1 MW baseload in Q4-2024 to be delivered at Phelix price index. On 1 July 2023 when the production volumes were first budgeted the position was valued at 132 EUR/MWh worth 291 kEUR. On 1 March 2024 the value of the long position decreased to 166k EUR following continuous deterioration of power prices in the recent months.

Today is 1 March 2024 and Green Hydro's shareholders are concerned about Mark-to-Market loss and urging the CFO to work out a hedging strategy.

In a previous post we discussed CPPI, DPPI and Stop Loss hedging strategies. Today we turn to hedging with options. Without spending much time on boring hedging with put option which our shareholder won't like anyway (they say: "it only costs money!") let's look at implementing the following strategy:

• Write (sell) a call option with strike at 122 eur/mwh with expiry Sep 2024
• Buy a put option with strike at 50 eur/mwh with expiry Sep 2024
• Annualised volatility is currently at 40%
• The yield of 10Y German government bond is at 2.5%
• (remember current spot price is still 75 eur)

First we need to calculate options prices and deltas. On Day 1 both options are out of the money (having only extrinsic values): call is worth 0.68 €, put is at 0.65 €, call delta is 0.08 (we need to consider call delta with a minus because we are selling the call), put delta is -0.06.

If we sell 1 call and buy 1 put, then our total delta on Day 1 would be 0.86 compared to 1.0 without the hedge.

Now we are protected against severe deterioration of power price at zero cost: we are able to sell 1 MW at 50 €/mwh or higher. Zero cost is achieved through subsidising put option (our insurance against price drop below 50) with premium from selling a call option.

Since there is no free lunch in economics - what is the downside of this strategy? Obviously we onboarded a risk of call expiring deep in the money: if Q4 settles at price higher than strike price of the call option (122 €) then the loss is going to be (settlement price - 122 €) x contract size. However this risk can be controlled by actively risk managing call delta, e.g. reducing call delta as it goes into the money.

If you would like to know more about hedging commodities with options comment below or write me a message.