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Speculative
3-Way Collars for Producers
Energy Derivatives Risk Management Series
As price volatility returns to energy and commodity markets worldwide, producers are starting to
ramp-up their hedging programmes. Some of the most widely used option combination structures
involve 2-way, 3-way and 4-way collars. In this piece, we discuss different types of 3-way collars, one
of the most widely used and misunderstood hedge instruments.
By Carlos Blanco
June 2013 83
A 3-WAY COLLAR is an extension of a standard collar,
but has a third option that effectively transforms a
relatively simple hedge structure into a considerably
riskier or more conservative one.
A standard collar is an option strategy that consists
of buying an option and financing its purchase with
the sale of another option. For example, producers
can buy put options for protection and finance their
purchase by giving away the price upside selling
call options. Many collars are structured so they are
costless at inception, because the premiums from the
options sold and bought are equal and therefore no
upfront payment is required.
There are two main alternatives for hedgers to
enter into 3-way collar structure. The first one is to
purchase and sell the individual options, and the
second one involves transacting it as an OTC structure
with a counterparty. Investment banks like to offer
3-way collars to producers and consumers, as it is
relatively easy to hide embedded fees inside the option
combination.
Speculative vs. Conservative 3-Way Collars
One of the key points to understand when analysing
3-way collars is the risk implications of adding the
third option to the structure to complement the simple
collar. In fact, the third option can turn the 3-way into
a highly speculative deal or a more conservative hedge
than the two-way collar.
If the third option is a purchased call deeper out
of the money (OTM) to cover the call option sold,
the option structure becomes considerably more
conservative. However, if the third option is a sold deep
OTM put, then the structure becomes substantially
more speculative.
Perhaps surprisingly, most firms that use 3-way collars
tend to choose the speculative type, even though we will
show it is not a good fit for most hedging programmes.
The reason why firms choose the speculative 3-way
is that there is an upfront premium received by the
hedger, but as we will see in an example, the structure
offers very limited protection against adverse moves
and also exposes the firm to potential large losses.
3-Way Collar Used By Natural Gas Producer
Let assume that on May 1
st
2013, a producer is looking
into hedging August 2013 expected revenues. The
NYMEX Henry Hub August 2013 Futures is currently
trading at 4.42.
The producer is interested in hedging with options.
The premiums of different calls and puts on the August
2013 contract are shown below.
An investment bank approaches the producer with
two alternative 3-way collar structures. We will assume
that the overall premium for the structure reflects
actual market prices, but in most cases, the banks are
able to charge embedded fees when they set up the
structure that could be minimized by hedgers if they
build their own.
Speculative vs Conservative 3-Way Collar
Overview of Simple Collar in the Structure
The first two options of the structure are the costless
collar not be confused with riskless collars, as many
hedgers have painfully learnt over time.
We can see that the premiums (Table 1) from the
$4.30 put and the $4.55 call are exactly the same, so
we could build a costless collar with those two options
and no premium exchange would be required. If the
producer did not add a third option into the structure,
Table 1: Option Premiums For
NYMEX Henry Hub August 2013 ($/MMBTU)
Strike Premium Strike Premium
4.20 Put 0.17 4.45 Call 0.26
4.30 Put 0.21 4.55 Call 0.21
4.40 Put 0.26 4.65 Call 0.17
4.90 Call 0.11
Table 2: Option Premiums For
NYMEX Henry Hub, August 2013
Aggressive Conservative
Buy $4.30 Put Buy $4.30 Put
Sell $4.55 Call Sell $4.55 Call
Sell $4.20 Put Buy $4.90 Call
June 2013
3-WAY COLLARS
we would be effectively setting a revenue floor of $4.30
and a revenue ceiling of $4.55 for the expected August
2013 production volume. Figure 1 above shows the
revenues for the producer before and after hedging for
a range of possible future price levels.
Now, we are going to study the impact of the
introduction of the third option on top of the collar.
Speculative 3-Way Collar
Lets start with the speculative 3-way. Lets assume
that the producer thinks that prices are going to trade
in a narrow range and it is very unlikely that gas
84
Figure 1: Revenues Before & After Hedging With Costless Collar ($4.30 floor & $4.55 ceiling)
Source: NQuantX
Figure 2: Speculative 3-Way Collar P&L
Source: NQuantX
... most firms that use 3-way collars tend to choose
the speculative type, even though we will show it is
not a good fit for most hedging programmes
Revenues Before Hedging Revenues After Hedging
Costless Collar Short Call @ 4.55 Long Put @ 4.3
3-Way Collar Short Call @ 4.55 Long Put @ 4.3 Short Put @ 4.2
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Gas Price ($/MMBTU)
Gas Price ($/MMBTU)
3-WAY COLLARS
prices will fall below $4.20, where they think there is a
technical support level. In addition to buying the $4.30
put and selling the $4.55 call, the producer decides to
sell the $4.20 put and collect $0.17 per MMBTU.
The payoff from the 3-way collar under different
settlement prices for the underlying is shown in
Figure 2 . If we analyse the different price regions and
the associated payoff of the 3-way collar we can see the
following: