We are running a week long series on the OTC commodity structure known as the Accumulator. The trade is simple, yet very complex. Understanding the trade, its risks and when to avoid it will be the focus of the five part series.
Part 3. Zero Cost
What does ‘Zero Cost’ really cost?
Today we are going to talk about the term ‘Zero Cost’. All of the various forms of Accumulators mentioned so far are marketed as Zero Cost. They are not Zero Cost.
In the case of the Producer, you are ‘granting’ two strips of calls and receiving one strip of puts. The calls are worth more than the puts so you are giving up value on trade date. The value given up is the “edge” that goes to the broker/dealer. Edge put value = call value. This is solved for ‘Zero Cost’ by adjusting the put/call strike and the knock out barrier.
Sugar producer - SBH18 = 14.00 cents/lb. 98 trading days, daily accumulator at 14.80, knock out at 13.40. Actually looks fairly reasonable. Volatility is 25% compared to yesterday’s corn example with volatility at 16%. (We’ll cover this later)
This trade is priced at ‘Zero Cost’ using parameters common to most OTC dealers. I solved for ‘Zero’ using the above formula...so there’s an edge factored in for the house. Let’s be clear, the OTC dealer has to make money to run risk and pay its overheads. The amount of edge charged will vary greatly. The better skilled the traders are, the less edge needs to be charged. The more efficient the operation is, again, less edge needs to be charged.
Where does this edge or markup go?
It’s actually a mark to market loss against the client. The market value of the short calls is greater than the value of the long puts. This sometimes will be reflected the next day or sometimes dribbled into the P/L over a period of days or weeks. If you are trading on a credit line this will show up as line usage. If you are being fully margined this will push you closer to your threshold.
Tomorrow we’ll cover what these markups look like and the market factors that govern them.
Part 4 of the Accumulator Series tomorrow...
Pack Creek Capital constructs and manages hedge portfolios for companies in the grains, softs and energy markets. Contact mbradbury@packcreekcapital.com for more information.
