By Vinson Sensenig, Hedge Manager, AMERIgreen Energy
Risk tolerance is the amount of margin you’re willing to put at risk for profit potential.
A “quick and dirty” way to evaluate your risk tolerance is to ask, “How much margin am I willing to lose before I can cover my operating expenses?”
Let’s look at an example:
XYZ Oil Inc. delivers heating oil at a $.65/gallon margin. In order to pay insurance and make payroll, XYZ Oil needs to maintain a margin of $.20/gallon for the upcoming heating season. Conceptually, XYZ Oil can lose as much as $.45 of margin before it compromises the business.
In this scenario, XYZ Oil’s risk tolerance would be 45 cents. However, XYZ still needs to protect their inventory from anything beyond a $.45 drop. Since XYZ Oil knows that they have a 45-cent risk tolerance they can consider a range of hedging strategies to protect their inventory. They may decide to cover 70 percent of their inventory with put options (downside protection) and leave 30 percent of the inventory unhedged with the strategy that their margin can make up the difference if the market falls. XYZ Oil may also look at purchasing options that only pay out if the market falls by more than $.20. These options (out-of-the-money options) trade at a discount to traditional options.
Depending on XYZ Oil’s palate for risk, these two options may not make sense for them and they may want to consider strategies that offer a tighter level of risk protection. Being able to define risk tolerance can greatly improve a your ability to evaluate when and which types of hedging tools are most effective to protect your inventory, your margin and your business.
For more discussion about risk tolerance and margin preservation, visit our website and watch our risk management seminar, “When to Hedge”.