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 4. How the ‘greeks’ and price environment impact the Accumulator
Yesterday we covered the subject of Zero Cost which led into a discussion of Broker/Dealer markups. So now that we know what the markup is, let’s discuss factors that govern the markup.
Hedging and managing Accumulators can be quite rewarding or a slow death. Why is this important to the commercial hedger? It has a direct effect on how much the dealer needs to markup to cover risk.
Generally, the same conditions in which the producer should not do accumulators is also a difficult period for dealers to retain the markup.
Without babbling on about option Greeks (to be covered in another series) for the rest of this blog, here’s why... from the dealer’s perspective, an Accumulator has positive Gamma, long Vega and negative Theta.
Positive Gamma - this is good when the market goes up, you get long and when the market goes down, you get short. However, you pay for this privilege.
Long Vega - you are long volatility. If vol goes up you make money. If vol goes down you lose money.
Negative Theta - you pay relatively large amounts of money for this position every day.
Hedgers and traders, what is wrong with this picture? If the market is not moving you cannot trade the Gamma to pay for the Theta. In addition, in a low price, low vol regime, you also run the risk of vol continuing lower and staying lower for many months.
When vol and price are high, the Accumulator works well. Dealers will grant higher accumulation levels. The risk is easier to run because there is plenty of intraday movement to scalp Gamma.
In summary, for producers, in low price, low vol environments, using Accumulators not such a great idea. Aside from the double up risk, your markups paid away will be proportionately higher. High prices, high vol lead to good levels to double up and better accumulation prices.
Part 5 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.
