Shipping as options trading
I wrote this small piece 7-8 years ago after thinking about the shipping industry and studying it for years.
Shipping as options trading
When purchasing an options contract, you pay a premium. When you invest in a ship, you pay the purchasing price for that ship. When buying that ship you stand to benefit from an increase in freights and an increase in the price of your ship, so you basically have a call option on those two variables.
If your shipping investment does not go well and your ship cannot be employed profitably you can scrap that ship for a value of (scrap price at that time * by the ship's lightweight tons). The scrapping component is like being long put an option on freight prices. The strike price is the level of freight rates where the ship is no longer profitable but the payoff when you exercise that option is the revenues from scrapping.
Basically, your total risk is the difference between the amount you pay to purchase ship and the amount you can scrap it for. If that amount is X but you stand to earn many times X from your shipping operations, you are antifragile. Make certain that X is not your total capital and you have more capital elsewhere, either to buy more ships or invested elsewhere. To be antifragile you must also be robust.
When you have a trade on, that is, when you own a ship and it is operational, there are certain dynamics at play. For example, when the difference between revenues and operating expenses is small, you are fragile because a small drop in freights will render you unprofitable. You can control/lock this parameter by fixing your ships for long periods at fixed rates / day (time charter).
After doing that you are only vulnerable to counter-party risk (charterer default) and an increase in your operating expenses (e.g. from inflation) that can decrease your bottom line or even render you loss making.
You stand to benefit from many call options at a time
Remember that not all ships (options) have the same sensitivity to changes in variables (freights). The amount of money you stand to make depends on the price you pay for the vessel.
If you buy a ship that is barely profitable, let’s say freights are at 11,000 and total operating expenses are 10,000. Ship makes 1,000 per day net profit or a net profit margin of 9%. If freights increase by 30% your expected net profit goes to 4,300 per day for an increase of 330%.
Which means that if you buy that ship at a price, which gives you a return of 10% on your capital. With the new freights you are yielding 43% on your capital. Therefore, the lesson to be learned is that the sensitivity of your options is dependent on the price you pay for those options and the potential scenarios of the payoff connected to that option.
Also, if you buy the option at a cheap price you stand to gain a lot from positive optionalities.
Clipping the downside, Opening the upside
By chartering a ship for a long period with profit sharing clauses you are convex to freight rates. The more leverage you employ the more convex you are. However, when you employ leverage you are also concave when the trade starts to lose money. How you can protect yourself from that downside?
When ship values go up, you are even more convex to ship values than freight rates (when you have profit sharing clauses) because your ship goes up with ship values but your income goes up only 50% when freights go up 100% (due to profit sharing of 50%).
If you sell the ships you have made multiples on your initial investment. By selling the ships at greatly overvalued prices you are locking yourself into a better position than you were before, that is the essence of optionality/antifragility. You first benefit from the option and then you exercise it.
When arranging your affairs as explained above, the function of freights will be convex because the average of the net income will be higher than the net income produced by the average freight rate!
Leverage and Fragility
By adding leverage to your shipping investment, you increase your potential upside but also increase your potential downside. For a given change in freight rates, the downside is bigger than the upside and so you are fragile. This dynamic is produced because by borrowing money, you must pay interest, and the interest is a fixed cost.
However, if you lock the freight rates and obtain upside clauses (e.g. profit sharing) then you change the shape of the chart to a convex shape. Because when freights drop you still get paid the fixed amount, when they go up you get paid more.
However, the above only stands for the time that the ship is chartered, when the charter expires the graph resets to a normal concave shape. The more levered, the more concave the shape.
This quote from George Procopiou explains how to invest in shipping, by stressing two important parts of playing the game very well. 1) Buying with conviction when prices are low and 2) accepting that you should focus on doing because focusing on knowing doesn’t work well.
3 years ago that I had problems, there were about 25 bankers in a meeting to see what is the best solution for me. One, in order to tease me, said “If I give you now 150 million what will do? [sic]”. I replied, “I will buy as many as can VLCCs, they all started laughing. [sic]” So, nobody knows, only continuation and dedication gives the result.
Starts at minute 18:00 below.