Proper Hedging is Always a Winner
Septemeber 18, 2020
Dominick Paoloni, CIMA®
CIO & Founder
Portfolio Manager, IPSAX
Adjunct Professor, University of Denver
& University of Colorado
When the futures market in oil went negative due to Covid-19, I was surprised when one of my interns from Texas was talking about his family’s concern. He told me his family was receiving spot prices on the oil from the drillers extracting oil from their land. It was April 27, 2020, and the West Texas Crude spot just broke 13 dollars a barrel. I was surprised because as a major source of revenues for his family’s estate, I couldn’t believe their money manager wasn’t managing their oil price risk. I asked my intern, “Is this common that landowners don’t hedge their price risk?” He told me most people he knows do not.
As an adjunct professor at the University of Colorado and a portfolio risk manager for the past 30 years, I teach my students that the goal of hedging is putting yourself in a position to always win.
Hedging depends on whether you are long or short the commodity or any other asset be it real estate, investments, etc. My intern’s family is long the oil commodity. What that means is, there is a risk to his family’s cash flow if oil drops in value, conversely, his family benefits if the price of oil rises.
In speaking to my intern, he explained that most people do not hedge because they believe that oil is always in demand and although the price may fluctuate, the oil will be higher in the long run. Additionally, many landowners are pleased to be getting oil royalties and reinvest this capital as they see fit. If they hedge, they will be missing out on price appreciation, essentially locking in today’s price tomorrow.
Having Your Cake and Eat it Too
What if we can put on a hedge that benefits from the price of oil rising and from the price of oil falling? That would be too good to be true, wouldn’t it?
My mom, who was a 30-year high school math teacher always used to say, “the reason I love math is that it takes the uncertainty out of life”. So, why can’t we use math to take the uncertainty out of a family’s income derived from oil?
The basic setup would be to let 1/3rd of his family’s income float with the market. In other words, just receive spot price on 1/3rd of the family’s oil revenues. The next step is to tie 1/3rd of the family’s oil revenues to short oil futures contracts. The final step would be to tie 1/3rd of the revenue stream to purchasing put options on oil futures contracts. (see Chart)
This setup mathematically puts the party receiving oil incomes in a winning position no matter which direction oil moves.
Let’s break it down. If oil should drop his family will be making less on 1/3rd of their oil revenues which is floating with the market. That’s still much better than making less than 100% of the revenue stream.
Let’s examine what’s happening on 2/3rd of his family’s cash flow. Their short oil futures and the puts will be profitable, holding the value on most of the cash flow. (see Chart)
If oil should rise the situation looks even better. The floating portion of the cash flow will appreciate the market as will the portion tied to the put option on the futures contract. (just the premium on puts will expire worthless).
This strategy will put the cash flow positive on 2/3rds of the position with unlimited upside. The 1/3rd short futures contract position however will lock in the price oil was trading which is still much better than being short futures contracts on 100% of the cash flow, not benefiting from any price appreciation.
Obviously, where, and how the positions should be placed, and rolled is how a professional manager of money earns a living. The truth is, hedging is a profession that many advisors never learn and are rarely taught but, what every person that hangs a sign whether they call themselves a financial advisor, broker, account executive, etc. should understand that a true manager of money needs to raise the bar and learn that proper hedging is the future of money management.
If we can take the uncertainty out of our financial future, we can live a happier, less stressful life.
IPS Strategic Capital is a Quant firm that builds hedge solutions for corporations, endowments, pensions, advisors, and individual clients
Dominick Paoloni, CIMA is a member of the OIC Advisory Council and the TD Ameritrade Trading Panel. Mr.Paoloni guides future professionals as an Adjunct Professor at the University of Denver and the University of Colorado. He is a published author and is frequently quoted in financial journals and can be reached at firstname.lastname@example.org
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