Time-bomb in your book: risk in option-embedded trades

Last week, the oil price has plunged down to 2-year low. Soon we will be hearing stories about winners and losers, not only in their betting but also in managing risk – like this story, which I witnessed some years ago.

I was working with a metal trading company. It had a very conservative policy over trading activities – no speculation, no exotics, one-to-one hedge only. Curiously, they were allowed to do trades with ‘embedded’ options – for example trades with a price floor, cap and both, sometimes. The rationale was that these are part of price conditions like ‘price adjustment’ or ‘marketing rebate’, totally different from such speculative derivates like options (you can name it differently but it would not change its risk and final payoff!) Continue Reading