What are options and why are they relevant in steel trading?

An option is the right but not the obligation to buy or sell an underlying good or asset at an agreed price in the future. Options are used by a wide variety of steel market participants for their many advantages. The biggest draw to options is that they are incredibly ‘margin friendly’*. Only the seller of the option has to put down a margin. In turn, the buyer of the option pays the seller a premium* to use the option at a future given date. ?

Here are some essential options terms that you will need to understand first:?

Strike: a fixed price at which the option owner can buy or sell the underlying security or commodity

Call: to give the option buyer the right but not the obligation to buy

Put: to give the option buyer the right but not the obligation to sell

Break-even: the break-even point is the point at which the position is making money, i.e. the strike price +/- the premium

So what does this mean for you and the steel industry??

So far in 2023, we have seen record volumes go through the US HRC options space as we have already traded 186KT in the first quarter, which is half of last year’s volume (~375Kt)! So, we are on pace to hit ~750Kt traded this year! Most ‘open interest’ (or ‘OI’)* is currently in the first six months, from April to August 2023, with 7235 lots of OI/145Kt, 5690 lots* of that being Put OI/ ~114Kt. This is evidence that there is a range of market participants in the options market and it will definitely be relevant to understand the steel markets in the coming months and years. Additionally, from 2020 to 2022, the ‘call / put ratio’* was an average of ~85% – this has plummeted to ~45% in 2023 as investors are currently looking for protection from the ‘downside basis high prices’* in the market. ?

Becoming increasingly popular as a way to hedge against physical price risks, the options market has shown strong signs of growth. For example, SCs hold significant physical risk as part of their warehousing business. If prices for HRC fell and an SC had to sell its physical* at a lower price, they would realise a loss. To offset this negative opportunity cost*, the SC could purchase a put option. Assuming the SC bought HRC at $900, they could purchase a put option with a strike of $925 to lock in a sale price and $25 margin. Should HRC prices rise to $1000, the SC’s put options would expire as worthless and the SC would sell the physical at the higher price of $1000. If prices plummet to $800, the SC would be able to sell its physical at $800 but the put contract with a strike of $925 would have netted them a $125/mt profit, offsetting the loss and locking in a small profit from selling the paper* at a higher price than the market value. ?

To learn more about how options contracts can be beneficial to your business, feel free to contact our Steel Desk at [email protected]. @Joshua Stern would be happy to help!

*margin friendly = to have a beneficial profit margin ?

*premium = a sum added to an ordinary price or charge?

*open interest (or OI) = the number of contracts or commitments outstanding in futures and options trading on an official exchange at any one time.?

*lots = contracts?

*call / put ratio = the ratio of calls vs puts in the market?

*downside basis high prices = how much lower the high prices will go ?

*physical = physical asset ?

*opportunity cost = the downside of choosing one option instead of other alternatives ?

*paper = financial ?