JKM options traded volumes rise as LNG hedging strategies evolve

JKM LNG options trading volumes have reached record highs this year, driven by the influx of new market entrants and the increasing sophistication of risk management techniques, according to industry participants.

The development highlights the increased emphasis on optionality in physical contracts that form the underlying basis of hedging for most of these options trading.

A total of 23,460 lots were traded for JKM average price options in January-August 2024, more than the entire traded volume for 2023 at 14,660, according to data on the Intercontinental Exchange. The majority of volumes traded were concluded via brokers.

In 2020, the contract saw a record volume of 44,205 lots being traded. However, in the January-August period, the traded volume stood at 18,155 lots in that year as well, the data showed.

Market participants are bullish about the pickup in traded volumes and expect growth in these contracts as more buyers and sellers hedge their floating price exposures.

"Option hedging eventually will come into play once more players understand the concept of hedging, it happened to crude and now shall happen to gas," a Singapore-based derivatives trader said.

The JKM average price option expires into a corresponding JKM LNG futures contract at the expiry of the contract. If the option is not abandoned, it would be automatically exercised if they are in the money. Out-of-money or at the money options expire worthless, as per the product specifications on the Intercontinental Exchange website.

The trading of options involves premiums paid to the seller or buyer of the options to exercise the right to sell or purchase the underlying derivative.

Platts, part of S&P Global Commodity Insights, assessed JKM, the benchmark price for LNG cargoes delivered to Northeast Asia, at $13.593/MMBtu on Sept. 3.

In 2024 year-to-date, the average for JKM was at $10.97/MMBtu. The highest and lowest values were $14.366/MMBtu and $7.981/MMBtu this year so far, according to data by Commodity Insights.

Options could be a viable alternative to futures due to lower risks and more flexibility to the entity hedging its exposure, according to derivatives traders

A second Singapore-based trader noted that price risk was limited to the premium paid upfront, especially for buyers.

"The main value of options is that there are lower risks compared to trading futures, people can trade with limited downside," the trader said.

Moreover, trading options provide market participants additional opportunities to boost profit margins when prices eventually settle in favor of the physical LNG trading position, according to a third trader.

"If you are running a physical portfolio, you need to allocate a portion to options. That way there will be continued flexibility to play around and optimize your final profit," the trader said.

Another market source added that while futures contracts fix the hedge at a certain level, options allow the trader to be exposed to a range where they reckon to be safe.

If an entity purchases a call option and the JKM price falls, then the buyer can directly purchase the futures at the lower price instead of exercising the call option and the cost would be the premium paid. If the JKM price rises, the buyer has the right to exercise the option at the strike price, even though JKM is at a higher price, plus the cost paid out as a premium.

Similarly, if the entity purchases a put option can do vice versa. If the JKM prices rise, they can sell at the prevailing market price and the cost would be the premium paid out. If the JKM price falls, they can still sell at the strike price, giving the entity the opportunity to sell at a higher price.

Market sources said that there are various strategies to use a combination of options to cap and floor the floating price exposure for both buyers and sellers.

Furthermore, there are option combinations that could limit both upside and downside by purchasing put and call options at the same strike price.

Despite the flexibility and limitation on price exposure, the relatively low liquidity observed for the JKM options compared to the JKM futures has restricted the pool of market participants.

The LNG futures market's growth potential can be observed in the overall yearly increases in trade volumes and end-month open interest for the JKM futures.

As of Sept. 23, the traded volumes recorded from January to September 2024 totaled 680,717 lots, surpassing the total recorded in 2023 at 640,330 lots.

Moreover, the end-month open interest has been on an upward trajectory as the end-month open interest has breached 100,000 lots for eight consecutive months in 2024.

The previous time the LNG futures market saw the end-month open interest breach 100,000 lots was in February 2022.

Risks associated and costs incurred

However, market sources flagged certain risks of options trading. In particular, counterparties would still have to bear the cost of the option contract even if the favorable pricing scenario fails to materialize.

For example, buying and selling a call and put option may allow protection against swings in the floating price. However, if the price remains relatively unchanged, the counterparty will still have to pay the premium on the contract for purchased options.

Furthermore, the risk that a seller of an option holds can be potentially unlimited. If the JKM price rises, the seller of a JKM call option will need to buy at the prevailing JKM price and sell the option at the strike price.

The rise in traded volumes of JKM options reflects a significant evolution in the LNG market, driven by the need for flexibility and effective hedging strategies among market participants.

As more traders recognize the benefits of options—such as limited risk and enhanced pricing flexibility—adoption is likely to grow. However, understanding the associated risks and costs remains crucial for effective utilization.