Deploying options strategies to protect profitability in B2B marketplaces
On digital B2B marketplaces, buyers and sellers typically trade physical assets at spot (i.e. current prices), in a secure, auditable environment facilitated by a customised User Experience (UX) delivered via a secure internet connection, hosted in the cloud. Transactions are often enhanced by high quality visual data in the form of PDFs, satellite imagery or other downloadable items – especially useful for products with many differing attributes – allowing buyers to make more informed decisions. The products may be traded in a number of differing manners, including trading ‘at market’ (i.e. at a quoted price the buyer / seller displays), private negotiations (utilising for example on-line chat functionality), or auctions, where many bidders compete to ‘win’ the particular physical asset. Marketplace operators may decide to publish activity reports (e.g. number of buyers and sellers, volumes transacted, prices negotiated), or simply keep the data private.
Given that many physical marketplaces for high value B2B items will require time for delivery of the asset – sometimes running into multiple months - some marketplace owners have introduced the concept of forward or ‘futures’ pricing to allow both buyers and sellers to protect themselves against ‘quotation risk’. Quotation risk exists when the physical asset in question moves in price to such a point that the buyer or seller(depending on whether prices have risen or fallen) feel that the original deal struck is no longer as attractive or commercially viable upon delivery. In this case, the buyer of the asset will look to sell forwards or futures on the underlying asset – referenced to an agreed underlying benchmark (e.g. for petroleum products you may reference the WTI or Brent crude prices, whereas for Iron Ore you may choose to reference the Iron Ore 62% Fe CFR China price), to protect themselves against a sharp price increase in the underlying asset, whereas the seller will look to do the opposite. By this process of ‘hedging’ against adverse price movements, both buyers and sellers can at least partially off-set physical losses in the underlying asset by paper gains on a futures trade.
However, OTC trading of forwards or futures does come with its own challenges. Aside from the need to connect buyers and sellers to liquidity providers – i.e. specialist Brokers, Proprietary Trading Groups or other institutions that will quote forward prices – the underlying buyers and sellers are undertaking to exchange a legally binding futures contract. Each buyer and seller must therefore put aside budget to enter into these contracts, effectively paying the ‘spread’ (the difference between the bid and offer quoted by the liquidity provider) in order to enter into a futures hedging transaction. In addition, many liquidity providers are mandated by regulatory rules to warehouse futures trades in a recognised Clearing House – CME Clearing or ICE Clearing for example – which will incur additional costs in terms of initial margin and variation margin.
When taken alongside the difficulty of convincing senior management of the benefits of hedging in the first place, some physical buyers and sellers may decide that the costs outweigh the benefits, leaving them ‘speculating’ that the price of their physical materials will not move in an adverse fashion. Is there a better way?
The Benefits of using Options
Options give investors the right, but not the obligation, to purchase or sell an underlying asset at a future price and date. Whilst they have a somewhat unfair reputation for being a risky investment that only expert traders can understand, the fact is they are a very useful tool for reducing risk.
Firstly, purchasing options can be highly cost effective when compared to purchasing the underlying asset or a future / forward contract on that underlying asset.
In our example, our ‘investors’ are in fact physical buyers and sellers of an underlying asset, or commodity. Options protection against sharp price rises (buying ‘calls’) or sharp price falls (buying ‘puts’) offers a low cost alternative to futures – options premiums (the cost of buying an option) are calculated in relation to actual strike price (whether the option is ‘in or out of the money’) of the option being purchased in relation to the underlying asset, the length of time until the option expires, and how much the price of the underlying asset is likely to fluctuate.
For example, a buyer on our market buys a three month put option on crude oil at a strike price of $70, when the underlying market for crude oil is trading at $65. The option has an intrinsic value of $5, plus a moderate increase representing time value (since it is valid for 90 days), with a volatility factor for the likelihood that a future change in the price of crude oil could push the option further into the money (if the price of crude falls), or make the option worthless altogether (if the price of crude rises above $70).
In this way, users of B2B marketplaces may use options as a much lower cost way to hedge their exposure to sharp price movements in the physical assets they are buying or selling. Due to the relatively ‘cheap’ nature of buying options, users of B2B marketplaces may wish to combine options strategies to achieve even further protections. For example buying ‘call spreads’ or ‘put spreads’ (buying options at one strike price and selling the same amount at a higher one), or ‘long straddles’ (purchasing a call and a put on the same underlying asset at the same strike price).
Sourcing Liquidity – Continuous Updates or Request for Quote?
As we have shown, the benefits of using options markets to hedge your exposure to a shift in the price of an underlying asset, can represent a cheaper alternative to using futures or forwards markets. However there is a further challenge which needs to be addressed, and marketplace operators need to carefully consider their technology deployment to meet this specific challenge for sourcing liquidity.
If you think about the range of strike prices around the underlying asset, in combination with options strategies as described above, GUI ‘real estate’ can immediately become quite a serious issue. This is nicely illustrated by the below screenshot of a Trading Technologies options pricing dashboard, illustrating CME Crude Oil Options:
B2B marketplace providers are in the business of giving their customers a highly effective UX which allows them to easily source the materials they wish to buy and sell, and securely transact them via their platform. However B2B marketplace providers are not in the business of providing a fully functioning GUI for the execution of screen based futures and options trading. These marketplace structures are far better served by regulated exchanges and their software partners than OTC marketplace operators such as ourselves.
Indeed, the majority of Liquidity Providers (LPs) described above, are unlikely to wish to continuously update their options quotes as the underlying market moves, especially in an OTC environment, when pricing is often based on non-public data. In addition, such a continuous stream of options pricing updates would put a considerable overhead on the capacity and performance of the marketplace; in the example above there are many active quotes on CME Crude Oil Options. But would Liquidity Providers be willing to continuously quote more esoteric (but no less valuable) commodities such as other hydrocarbons, differing dairy products, base metals, rare earths and cattle?
For this reason, many options markets have developed Request for Quote (RFQ) functionality, allowing users of the marketplace to specifically ‘request’ the options they wish to trade, and await a direct response from a Liquidity Provider. This will allow the LP time to consult their options pricing models and other data which may be available in the marketplace, in order to accurately price the option. Using an RFQ system therefore does away with the need for an LP to continuously update their options pricing models, and publicly ‘autoquote’. The added benefit for the B2B marketplace operator is you have immediately removed two potential technical challenges – that of performance and capacity to deal with multiple LPs pumping out options pricing, and the challenge of representing this data on a GUI. Furthermore, an RFQ platform has the added benefit of allowing the Liquidity Provider to quote for ‘package trades’ or strategies, as one single price, significantly simplifying the client experience. Clients may also want to wait a specified time in order to compare quotes across multiple LPs, a further enhancement to the RFQ experience.
In the above example, a client has Requested for Quotes from multiple liquidity providers in Swap markets in Henry Hub (the benchmark seen in the screenshot above) and Put Options on ICE Brent. The efficiency of the RFQ platform lies in the fact that it allows the client to specify the exact term and tenor of their desired hedge position; meanwhile the platform provider (in this case NovaFori) has achieved a significant saving in screen real estate, capacity and performance. Here you can find an example of the interface and case study specifications.
About NovaFori Marketplace Solutions
At NovaFori, we have built digital marketplaces for the OTC trading of physical assets, enhanced by the ability to trade derivatives (swaps and options) on those assets to protect the profitability of client deals. All our marketplaces are delivered in a secure, cloud hosted environment meeting the highest standards of cybersecurity. If you would like to learn more, please get in touch with us.
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