The situation
Green Hydro is a small German power producer. Its hydro plant at the Bavarian Fischalptraum dam is committed to deliver 1 MW baseload in Q4 2024 at the Phelix price index.
When production volumes were first budgeted on 1 July 2023, the forward price was 132 €/MWh, valuing the position at 291 k€. Following a sustained decline in power prices, the forward has since fallen to 75 €/MWh, reducing the mark-to-market value to 166 k€ — a loss of 125 k€ in eight months.
Green Hydro's shareholders are alarmed. They are pressing the CFO for a hedging strategy that stops the bleeding without simply locking in the current loss by selling forward.
In a previous article we covered CPPI, DPPI and Stop Loss strategies. Here we focus on hedging with options — specifically a zero-cost collar.
The strategy: zero-cost collar
Rather than paying for a plain put option (which shareholders dismiss as "it only costs money"), the CFO proposes a structure that finances downside protection by giving up some upside:
- Sell a call option — strike 122 €/MWh, expiry September 2024. Green Hydro receives premium for capping its upside above 122 €.
- Buy a put option — strike 50 €/MWh, expiry September 2024. Green Hydro pays premium for a floor at 50 €.
The two premiums are structured to offset each other, resulting in zero net cost. Green Hydro is now protected against any price collapse below 50 €/MWh without paying anything upfront.
Pricing the options
Both options are priced using Black-Scholes with the following market inputs on 1 March 2024:
| Parameter | Value |
|---|---|
| Current spot price | 75 €/MWh |
| Annualised volatility | 40% |
| Risk-free rate (10Y Bund) | 2.5% |
| Call strike | 122 €/MWh |
| Put strike | 50 €/MWh |
| Expiry | September 2024 |
On Day 1, both options are out of the money — they carry only extrinsic (time) value:
| Option | Price | Delta | Position | Effective delta |
|---|---|---|---|---|
| Call 122 € | 0.68 € | +0.08 | Short (sold) | −0.08 |
| Put 50 € | 0.65 € | −0.06 | Long (bought) | −0.06 |
The combined option delta is −0.14, reducing the overall portfolio delta from 1.0 (unhedged production) to 0.86. Green Hydro is slightly less exposed to price moves than before — a modest but immediate reduction in risk.
What protection does this provide?
The put option guarantees Green Hydro can sell at least 50 €/MWh regardless of where Q4 Phelix settles. If prices collapse to 20 €, the put kicks in and limits the loss. The collar creates an effective price band:
Ceiling: 122 €/MWh (call strike — upside participation is capped here)
Between 50 € and 122 €, Green Hydro participates fully in price movements. Below 50 €, the put provides full protection. Above 122 €, gains are surrendered to the call buyer.
The hidden cost: call risk
There is no free lunch. The call sold to finance the put introduces a new risk: if Q4 Phelix settles above 122 €/MWh, Green Hydro owes the difference to the call buyer.
This risk is not purely theoretical — power markets are volatile. At 40% annualised volatility, prices can move substantially over six months.
However, the call risk can be actively managed through delta hedging. As the price approaches and exceeds 122 €, the call moves into the money and its delta increases toward 1.0. A disciplined risk manager will progressively reduce the net short call exposure by purchasing forward contracts as the delta climbs — effectively converting the static collar into a dynamic hedge that limits the upside loss.
Summary
The zero-cost collar gives Green Hydro what its shareholders actually want: no further deterioration below 50 €, no upfront premium, and continued participation in any price recovery between 50 € and 122 €. The trade-off — surrendering gains above 122 € — is a manageable risk if the call delta is actively monitored.
The strategy works precisely because it reframes the question. Rather than asking "how much does it cost to hedge?", it asks "what upside am I willing to give up in exchange for downside protection?" For an asset-backed producer with cash constraints, that is often the right question.
If you would like to discuss hedging power production with options — including dynamic delta management, collar structuring, or volatility analysis for your portfolio — get in touch.