- Market views, reflected through SGX Iron Ore forward curve, implies continued weakness in iron ore prices as the curve shifts towards contango.
- Stronger demand for protection against downside price risk is demonstrated through SGX volatility surface curve with higher implied volatilities for put options than call options with similar expiries.
- Hedging of downside price risk is possible with option strategies such as protective put and zero cost collar.
Weakening Chinese demand and oversupply amongst other factors have led to soft iron ore prices. Since the start of the year, front-month SGX Iron Ore daily settlement price (SGX DSP) declined 33% from USD133.38 on 2 Jan 2014 to a low of USD90.58 on 16 Jun 2014. The plummet slowed as prices hovered around USD95 in July 2014.
Front-Month SGX Iron Ore DSP
However, from historical front-month SGX DSP alone, it is unclear if price recovery is on the horizon or if price weakness will continue. This report turns to the SGX forward curve and SGX options volatility surface for more insights and presents practical hedging and trading strategies for market participants adversely affected by the low iron ore prices.
Market Expects Continued Weakness in Iron Ore Prices
Our last market update – The Nexus of Iron Ore Prices – looks at the forward curve as a reflection of market expectations. Generally, strong demand leads to higher prices in front months and results in backwardation; while weak demand leads to lower prices in front months and results in contango.
SGX Iron Ore Forward Curve
The V-shaped forward curve observed at the end of July 2014 suggests that despite some near term recovery (slight backwardation in front months), continued weakness in iron ore prices is expected in the longer term (contango in back months). Since then, the front-month SGX DSP has fallen further from USD96.05 on 31 July 2014 to USD92.96 on 22 August 2014. Furthermore, the shape of the forward curve is also gradually shifting from V-shaped to contango, reflecting further softening of market demand.
A similar sentiment is also apparent in the volatility surface (as of 15 August 2014) for SGX Iron Ore Options. Broadly, put options have a higher implied volatility than call options of the same expiry. This suggests that there is greater demand for protection from further downside risk.
SGX Iron Ore Options Volatility Surface
Furthermore, growing liquidity (both in terms of volume and open interest) along the entire SGX Iron Ore Options forward curve allows for effective hedging in most of the listed contract months.
Protecting Downside Risks with Options
For market participants such as miners whose top line is directly dependent on the price of iron ore, the softer prices mean lower revenues and a diminishing profit margin ceteris paribus. Some of the larger miners have chosen to produce and sell greater quantities to compensate for the lower profit margins – however this also adds to the current supply glut and further depresses iron ore prices. Meanwhile, other smaller miners with higher production costs are finding it difficult to continue producing iron ore profitably at such low prices.
SGX Iron Ore Options present an opportunity to manage such price risks. The following hedging examples illustrate how iron ore miners can use options to hedge their downside risk whilst retaining exposure to the potential upsides.
Hedging Example 1: Protective Put Strategy
On 22 August SGX, iron ore miners concerned about prices falling below their breakeven point of USD85 per metrtic ton can hedge his downside risk by buying a put option on SGX Iron Ore Swaps with a USD85 strike. The premium for this option is USD2.78.
Options Portfolio 1:
- Buy put option at USD85 strike at USD2.78 premium for Mar-15
In the event that the final settlement price of Mar-15 iron ore swaps (“FSP”) fall to USD80, the put option is In-The-Money and will be automatically exercised into short Mar-15 iron ore swaps at USD85 and cash settled against USD80. The miners will make a profit of USD2.22 per metric ton (USD85 – USD80 – USD2.78) on their options position to compensate for the loss in revenue from the lower physical iron ore sale price.
Conversely, if the FSP rises to USD100, the put option will not be exercised. The miners continue to enjoy unlimited upside of being able to sell their iron ore at higher price and their eventual price per metric ton for the physical iron ore will be USD100 – USD2.78 premium paid.
Hedging Example 2: “Zero Cost Collar” Strategy
If miners who while being concerned about downside price exposure, believe prices will not rise beyond a certain level can choose to reduce the cost (i.e. premium paid) of the abovementioned Protective Put strategy through a “Zero Cost Collar”. In addition to buying a put option, they can also sell a call option. Assuming miners sell a call option with a strike price of USD95 at a premium of USD2.78, their payoff is as follows:
Options Portfolio 2:
- Buy put option at USD85 strike at USD2.78 premium for Mar-15
- Sell call option at USD95 strike and USD2.78 premium for Mar-15
On the last business day of March 2015, the options will expire, and the following could happen:
*Final Settlement Price is the monthly daily average iron ore reference prices for the contract month. This is the price the options will be cash settled against.
By using this strategy, the miners have effectively set a floor of US$85 per metric ton for their iron ore sales without totally eliminating upside price potential. It also succeeded in establishing the hedge without incurring options premium.
Trading Iron Ore Prices with Options
Trading Example: Ratio Spread Strategy
Other than physical participants who use options to hedge their underlying exposure, financial traders who have views about the iron ore prices can also utilise options to take positions and earn premiums. If they expect iron ore prices will trade within a certain range, they can execute the following ratio spread trades.
Options Portfolio:
- Buy put option at USD85 strike at USD2.78 premium for Mar-15
- Sell call option at USD95 strike and USD2.78 premium for Mar-15
- Sell put option at USD80 strike and USD1.38 premium for Mar-15
On the last business day of March 2015, the options will expire, and the following could happen:
Options on Iron Ore Futures are now available for trading and clearing via SGX. Click here for more information.
For further details on SGX iron ore products, please contact our team or alternatively visit our website: http://www.sgx.com/asiaclear/ironore