How to Value Equities Using Commodity Futures Options

Article excerpt


Individual companies' stock options and the commodities those companies trade provide a powerful context for analyzing hedge strategies and trades.

In mid-December 2011, the Organization of Petroleum Exporting Countries (OPEC) surprised the energy markets by deciding to increase oil production with a new output target of 30 million barrels a day. Bloomberg reported that crude oil for January declined $5.19, or 5.2%. On Dec. 14, March crude oil fell $5.1 1 to $95.37 - up from $76.53 on Sept. 4, but at the time on a short-term downtrend.

"March 2012 calls" (right) shows four energy futures: Crude oil, heating oil, natural gas and gasoline, along with March calls on Valero Energy Corp. On this chart, option prices and underlying futures and stock prices are standardized by dividing by the strike price. The comparison indicates diat die equity options of Valero are significantly more valuable in terms of future price volatility than options on the four energy futures. Crude oil and gasoline calls are bounded by the more volatile (in the option sense of the word) natural gas and the less volatile heating oil contracts.

Valero also is more valuable in terms of option pricing when compared with several energy equities (BP, Exxon Mobil and Chevron). The chart "Calls on energy equities" (right) again places Valero considerably higher than the other three call price curves as standardized by dividing the underlying stock and option prices by the strike price. The larger expected future price variability of Valero may be a function of its product mix, which includes ethanol and heating oil, or simply traders' assessment of future stock price trends.

A more complete comparison of option market forecasts for energy stocks futures is shown on "Delta hedge forecasts" (page 37). Heights of the call option price curves are measured at the point where the underlying futures or stock price is equal to the strike price. The height of an option price curve is determined by two prices for the underlying at expiration that will permit a hedged trade between futures or stock and corresponding options to break even, with neither profit nor loss. These are the upper and lower breakeven prices of a delta trade, in which delta is the slope of the option price curve - showing the price change for the option versus a change in the underlying price.

"Delta hedge forecasts" shows that Valero Energy has the highest option price curves and largest expiration breakeven price spread for January 2013 and March 2012. The options market does not pick a direction, thus the upper and lower expiration prices equally are likely. It is possible that either one or both prices will be achieved in the equities market well before the expiration date.

Commodity comparison

Of the four energy futures' - crude oil, heating oil, gasoline and natural gas - March contract, the most correlated with the Valero Energy stock price is heating oil

"Valero & heating oil" (right) contains the daily cumulative percent price changes for Valero stock and March heating oil futures from Sept. 1 through Dec. 16, 201 1.

Based on the previous charts and numerical table we expect Valero stock to be more volatile than heating oil futures, and this chart illustrates the difference between the two. Although the directions of price changes are similar, the price movements are larger for Valero, extending from slightly more than plus and minus 20% vs. plus and minus 10% for March heating oil futures.

By using the cumulative price change for heating oil as a guide, it may be possible to improve trades on Valero common stock. A similar trade could be based on variations in the cumulative percent price changes for March heating oil futures where the oscillation is around zero in the absence of a sustained uptrend or downtrend in the futures price.

Cumulative percent price changes for Valero stock and heating oil futures eliminates a problem in terms of differential price movements. …