CHAPTER 10 PRICE RISK MANAGEMENT: HEDGING 101
| Jurisdiction | United States |
(May 2005)
PRICE RISK MANAGEMENT: HEDGING 101
Kase and Company, Inc.
Cheyenne, Wyoming
Cynthia Kase, president of Kase and Company, one of the energy industry's premier boutique energy trading and hedging solutions firm, holds a B.S. and M.E. in Chemical Engineering and worked in that field for 10 years commencing in 1973. In 1980, she joined Chevron's engineering department and three years later, coincident with the introduction of crude oil futures, transferred into oil trading. After a short stint trading crude, she became Manager, Clean Products Trading in New York.
At the turn of the decade she joined Chemical Bank as their first commodity derivatives VP, responsible for the energy-trading book and for hedging swaps and options. In September 1991, she left the bank to consult on a one-year assignment with the Saudis as Director, Risk Management and Technical Analysis. The following year, Kase founded Kase and Company, Inc.
Uniquely qualified as cash market trader, market technician, risk manager and software developer, Kase now has a mature practice in providing natural gas, oil, products, and liquids trading and hedging advisory services to hundreds of client firms, offering forecasting, hedging strategies and software. She is winner of the Market Technicians Association's Best of the Best Award, 1997 and has received the Key Women in Energy Award twice, first in 2002 for Vision and in 2004 for Innovation and Creativity.
A
Abandonment
Permission given to interstate pipelines by FERC allowing for the discontinuation of sales, storage or transportation service along any portion of the pipeline system.
Acceleration Indicator
A type of momentum indicator, such as the KCD and MACD, which is a derivative of a velocity indicator, also called a second derivative indicator, that generates momentum divergence and zero crossover signals.
Example: S&P500 September 2000 w/ KCD Acceleration Indicator showing A: Bearish divergence B: Bullish Divergence
Access Session
After hours trading of computer matched trades in the NYMEX energy and metals markets.
Accordion Effect
The tendency of a mature bear market to compress price action into smaller and smaller choppy waves. This price activity then begins to look like an accordion, having little room to further compress, but capable of a substantial rally off the base as the accordion opens back up in expansion.
Accumulation Phase
A sideways pattern found at market bottoms. Characterized by the "smart money" starting to buy, or "accumulate" contracts. Occurs prior to the beginning of an uptrend.
ADP
Alternative Delivery Procedure. A provision of a futures contract that allows buyers and sellers to make or take delivery under terms or conditions that differ from those prescribed in the contract. An ADP may occur at any time during the delivery period, once long and short future positions have been matched for the purpose of delivery.
All-in Price
Also see Break Even Price.
Trader's jargon for "all included." The price of an instrument after all expenses. For calls, the strike price plus the premium. For puts, the strike price less the premium.
Alternation, Rule of
In Elliott wave theory, the two corrective waves, Wave Two and Wave Four, are said to alternate, where one wave is simple, either not breaking down into any subwaves, while the other breaks down into at least a three wave ABC formation, or where one breaks down into a simple ABC formation and the other is erratic and complex.
American Option
An option that can be exercised at any time during the life of the option.
An Actual
Term used to identify the security underlying an option.
Annuity, Cap or Floor
A cash market deal which includes an embedded option sale whereby the seller of the embedded option enjoys a better price relative to index in exchange for placing a ceiling on price as a seller or a floor on price as a buyer.
Arbitrage
The simultaneous purchase of one commodity against the sale of another in order to profit from fluctuations in the usual price relationships. Variations include the simultaneous purchase and sale of different delivery months of the same commodity; of the same delivery month, but different grades of the same commodity; and of different commodities.
Assignment
The process by which the seller of an option is notified of a buyer's intention to exercise the rights associated with the option.
Associated Person, AP
Any person who is associated in any of the following capacities with a futures commission merchant, introducing broker, commodity pool operator or commodity trading advisor (e.g. as a partner, officer or employee in any capacity which involves: (i) the solicitation or acceptance of customers' orders or (ii) the supervision of any person or persons so engaged or. (iii) providing advice through written publications or other media.
At the Market, also a Market Order
In futures trading, placement of an order immediately at the best available price on the trading floor.
At-the-Money
A condition where the underlying price equals the strike price of the option.
Average, Volume Weighted
In the context of hedging, when a portion of the total volume allocated for hedging was hedged at a series of prices (p%li%l), the overall resultant hedge price can be found by taking a volume weighted average of these prices.
The volume weighted average is calculated as follows: each percentage hedged (v%li%l for the volume) has a price (p%li%l) associated with it, therefore the volume weighted average is the sum of each price (p%li%l) times its volume (V%li%l %) divided by the sum of the volumes (V%li%l).
| (5% * $4.00 ± 10% * $4.23) | &pi08c4; p%li%lv%li%l | |||||
| Volume _ Weighted _ Average | = | %y | = | $4.15 | = | %y |
| (5% ± 10%) | &pi08c4; v%li%l |
The volume weighted average gives more importance to the prices with the most volume, whereas a simple average gives no regard to volume, i.e. every price would get the same weight. For the following, assume that 5% of the hedging volume was fixed at $4.00, while 10% was fixed at $4.23, the volume weighted average would be $4.15.
Average, Weighted
If each piece of data(x%li%l) is assigned a weight(w%li%l), then the weighted average is the sum of each data point times its weight divided by the sum of the weights.
| &pi08c4; w%li%lx%li%l | ||
| Weighied _ Average | = | %y |
| &pi08c4; w%li%l |
B
Backwardation
The market condition in which futures prices are progressively lower in the distant delivery months than in the nearer delivery months.
Bands
HedgeModel plots (lines) at which price protection strategies (buying options) are triggered. The Warning band is dark cyan, band 1 is dark blue, band 2 is green, and band 3 is dark green. (Bands are below the fix forward Scales for producers, above the fix forward Scales for consumers).
Bar Chart
A chart which displays vertical bars, the top and bottom of which denote the high and low price of a commodity for the period included in the bar, having a horizontal tick-mark to the right of the bar denoting the closing price, and often having a tick mark to the left denoting the open. Sometimes referred to as HLC (High Low Close) or OHLC (Open High Low Close) bars. Bar charts are based either on time, as a 5 minute or 1 day bar chart, or on ticks, as a 21 tick bar chart.
Basis
The differential that exists between the cash or spot price for a given commodity and the futures price for the same or related commodity. (spot minus futures). Someone who is "long the basis" has purchased spot goods and has sold futures. On the other hand, someone who is "short the basis" is selling spot or producing cash market goods and is long the futures.
Basket Option
Option on cash flow.
Bear, Bearish, Bear Market
One who anticipates a decline in price. A decreasing or falling market that is making new lows.
Best Efforts
Best efforts refers to an interruptible purchase and sale agreement which is based upon interruptible transportation service. Best efforts agreements rarely contain clauses defining performance requirements and as a result, are occasionally subject to interruption due to changes in day-to-day market economics.
Beta
The change in a specific instrument relative to the change in an overall market index.
Beta Version
An intermediate pre-release of software for debugging and use among a select group of test users.
Bid/Ask
Also known as Bid/Offer, is a measure of market I-quidity. The bid is the price level at which buyers bid to acquire the contract from sellers. The ask is the price level at which sellers offer to sell the contract to buyers. To be valid, bids and offers have to be made by open outcry, during the day session, by a qualified trader in a relevant trading pit. Bids and offers have to be better than or equal to the best bid or offer currently available.
Black Box Program
A computer program which generates buy and sell signals automatically, with no information given to the user of the program as to how or why the signals are generated.
Blow Off High
The final topping process on a bull run to a major top accompanied by a sharp rally after a long advance on increasing volume and decreasing open interest which is indicative of liquidation.
Book
The aggregate of all physical and derivative positions held by a trader or company. Also, the documentation relating to the current positions held by a trader or company.
Bottoming Out
A bear market which is either coming to an end before a reversal higher, or to a major stall area, before a correction higher.
Break Even Price
The price of the underlying futures contract at which an option does not have any loss. A call...
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