Aluminum Explainer: Options as a risk management tool

We are going to focus on the most conventional options in common use. I am happy to have an offline conversation with clients who want to learn more about some of the exotic options that exist, such as knock-in or knock-out options, accumulator options, and the like.

These exotic options are typically driven by a desire to lower option premium cost. They do work, but the trade-off is accepting different risk scenarios.

Aluminum options are insurance products

The easiest way to think about metal options is to consider them as a form of price insurance.

The purpose is to protect against unforeseen situations that could lead to loss. We take out coverage for various amounts and pay a premium for that coverage over a specified period of time.

Aluminum options incorporate all the same principles as conventional insurance. Metal options are designed to protect two things: volume and price.

Aluminum options: Basic definitions

Let’s start with basic terminology in option transactions:

Abandoned – The process of surrendering an option, whether a put or a call, without exercising it.

Asian Option – An option based on the average price of aluminum for a given month and financially settled at the end of the month.

At the Money – An option priced at the current market price.

Out of the Money – An option priced either above the current market price (in the case of a call option) or below the market price (in the case of a put option).

In the Money – An option that is profitable relative to the prevailing market.

Call Option – The right to buy aluminum.

Collar – An option strategy that entails a combination of put or calls.

Consumer Collar – The purchase of a call option and the sale of a put option. This protects the buyer of aluminum against upside price risk while giving up the opportunity to participate in prices below the strike price.

Producer Collar – The purchase of a put option and the sale of a call option. This protects the seller of aluminum against downside price risk while giving up the opportunity to participate in upside price movements above the strike price of the call.

Declaration – The date on which a European option must be exercised or abandoned.

European Option – An option based upon the LME aluminum price on the third Wednesday of the month for which the option is bought or sold.

Exercise – The process of declaring one’s intention to take the option: to buy metal in the case of a call option or to sell metal in the case of a put option.

Premium – The cost or value of the option, expressed in dollars per metric ton. Premiums are paid immediately upon purchase or sale of an option. This should not be confused with physical premiums for metal.

Put Option – The right to sell aluminum.

Strike Price – The trigger price of the option. For example, a $3,000 call option would be exercised if the aluminum price is at or above $3,000 per metric ton. The closer the strike price is to the market, the higher the cost or value of the option. The farther away it is, the lower the cost or value.

Time Value – The amount of time that the option is being held. The duration of the option has a major impact on its cost. An option taken for one month is substantially less expensive than one taken for one year.

Volatility Factor – The perceived rate of change in the underlying market against which the option is bought or sold. A market experiencing significant price movements is said to have high volatility. Conversely, a market that is relatively stable has low volatility. The higher the volatility, the more expensive – or valuable – an option becomes.

Scenarios and appropriate option choices

Options can be used to address a variety of price scenarios. Below are some common examples.

Consumer protection against higher prices for future unknown volume – A classic scenario where aluminum consumers know they will commit to sales but do not yet have firm volume. They may need to hold prices against a catalogue price and are concerned about rising prices. In this case, purchasing call options would be appropriate.

Producer protection against lower prices for future unknown sales volume – Another classic scenario in which an aluminum smelter has defined production (and cost) for future periods but does not yet have firm sales. They are concerned about prices falling. In this case, purchasing put options would be appropriate.

Consumer has metal bought on average price indices and wants upside price protection – A scenario where consumers have metal bought on average price indices month-prior-to-month-of-shipment and are selling their products during or after the month of shipment. They want to protection against higher prices during averaging period. In this case, purchasing Asian call options makes sense.

Producer has metal sold on average price indices and wants downside price protection – A scenario where producers have metal sold on average price indices month-prior-to-month-of-shipment or month-of-shipment. They are concerned that prices will fall during the averaging period and want protection against lower averages. In this case, purchasing Asian put options makes sense.

Consumer wants to bracket their price exposure in a fixed range – In this scenario, the consumer buys call options to cap upside price risk while selling put options to establish a floor price they are comfortable with. The cost of the call option is offset by the value of the put option sold.

Producer wants to bracket price exposure in a fixed range – In this scenario, the producer buys put options to establish a floor price while selling call options to cap upside participation. The cost of the put option is offset by the value of the call option sold.

Common mistakes in option trading

From years of experience, both through internal execution and client work, the following mistakes are common:

• Paying for more time value than you need – People often believe the need to protect against an entire future year (e.g., all of 2026) and therefore buy call options covering the full calendar year. In reality, prices are typically set month-prior-to-each-quarter (December, March, June, and September). This means the client may only need options through September, eliminating three months of unnecessary time value.
• Setting the strike prices too close to the prevailing market – There is a tendency to try to insure future prices at current levels, which makes options very expensive. It is often better to “own some of the risk” by setting strike prices out of the money, thereby reducing premium costs.
• Not applying the K.I.S.S. principle – Many participants try to jump into complex strategies before they are comfortable executing basic options. It is also important that your Chief Financial Office (CFO) be fully comfortable with the strategy. My personal acid test was always whether I could explain the option strategy to my spouse. If she understood it, it made sense to pursue with a client. If not, it needed to be simplified. This is not to suggest that CFOs cannot grasp complex derivatives, but rather that the easier a strategy is to explain, the better the chance of gaining approval to execute it.

Why This Matters

Options have developed a “bad rap” in the market due to high-profile financial failures where participants lost sight of their original objectives.

This is the same trap that can occur with outright price hedging. It is a slippery slope from hedging to pure speculation.

Options should be viewed as price insurance and accepted as the cost of doing business.

No one would operate a rolling mill without insuring it against catastrophic loss. The same principle applies to price risk.

No one should operate with completely unhedged exposure. Options are simply another tool in that process.