Pricing and Risk Management of Option Positions

Abstract

In the previous chapter we discussed the properties and characteristics of freight options. Freight options are becoming increasingly popular with practitioners and are used both for risk-management and speculation purposes. From the point of view of traders in the market and particularly for option sellers, there are two important considerations that have to be examined. The first is the issue of determining a fair option premium to charge when selling a freight option. This should reflect, among other things, the risks option sellers face in the market and should provide a fair level of compensation for those risks. The premium should be fair because if it is too high then the option will be overpriced; on the other hand, if the premium is too low then the premium will not provide an adequate level of compensation for the risks the seller is facing. The second important consideration is how to manage or hedge a short-option position. As was shown in the previous chapter, a short position in a call or put option that is exercised against its seller may lead to potentially very big losses and option sellers therefore need to have offsetting positions in either the FFA or the physical market in order to reduce their exposure.