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Introduction to Power Options

Introduction to Power Options. Iris Mack Options Trading Desk X3-6711. Presentation Outline. Basic Options Definitions Options and Risk Management Intrinsic and Extrinsic Valuation Value of an Option Understanding Options Premium Components of the Option Premium

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Introduction to Power Options

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  1. Introduction to Power Options Iris Mack Options Trading Desk X3-6711

  2. Presentation Outline • Basic Options Definitions • Options and Risk Management • Intrinsic and Extrinsic Valuation • Value of an Option • Understanding Options Premium • Components of the Option Premium • Intrinsic Value of an Option • Measuring Intrinsic Value • Example: Intrinsic Value • Extrinsic (Time) Value of an Option • Measuring Extrinsic Value • Example: Extrinsic Value

  3. Presentation Outline, continued • Options Pricing Parameters • Pricing Parameters: Price Curve • Examples • Contango Curve and Put Premiums • Backwardated Curve and Put Premiums • European vs. American Style Options • Pricing Parameters: Strike (Exercise) Price • Definition of Strike Price • Classifications of the Strike Price

  4. Presentation Outline, continued • Pricing Parameters: Expiration Date • Maturity • Example: Increasing Time to Exercise • Time Decay • Time Value vs. Price Curve • Example: Time vs. Curve Value Affect on Premiums • Pricing Parameters: Interest Rate • Interest Rate • Discount Factor • Pricing Parameters: Volatility • Trading Volatility

  5. Basic OptionsDefinitions

  6. Basic Options Definitions • Options are of two basic types: • A call option gives its owner the right (but not the obligation) to take a long position in a given asset (typically a security, commodity, index, or futures contract) at a fixed price on or before a specified date. • A put option gives its owner the right to take a short position in a given asset.

  7. Optionsand Risk Management

  8. Options and Risk Management • Managing risk - a way for companies to create wealth. • A company’s liabilities may be framed, quantified and better understood via using financial engineering methodologies – such as options analysis. • Options analysis may be exploited to • generate managerial flexibility • help firms minimize risks and maximize revenues.

  9. Options and Risk Management Enron may assist its clients in the development of an “optimal” risk management strategy via: • Optimization Process 1: Identification (and perhaps in some cases, creation) of the client’s portfolio of embedded options. • Key Link: Diagnosis of the client’s risk exposure, as well as its “risk appetite”. This requires an appreciation for why certain risks pose problems for the client. • Optimization Process 2: Utilization of the Key Link to structure an optimal risk management tool via the utilization of energy derivatives (power options, gas options, weather derivatives, various customized cross-commodity structures, etc).

  10. Intrinsic and Extrinsic Valuation

  11. Value of an Option … the fair value price or premium that an option writer may charge for that option at a particular point in time.

  12. Understanding Option Premiums Two perspectives… Expected Cost/Earnings from Hedging – The premium is the expected cumulative cost (or income) from dynamically hedging the option. These costs are not the standard transaction costs (i.e., bid-offer spreads), but the hedging imperfections that are the consequence of price movements. The premium is the projected costs/earnings from these imperfections based on the projected fluctuations in prices. (Perspective of option traders.) Expected Payout – The premium is the statistical measure of the expected payout assuming a probability distribution of price movements. (Perspective of financial engineers and academicians.)

  13. Components of the Option Premium The option premium is composed of • Intrinsic Value • Extrinsic (Time) Value

  14. Intrinsic Value of an Option • Intrinsic value is the measure of the amount of guaranteed profits an option offers. • The guaranteed profit is the result of • the forward sale for a call (forward purchase for a put) and the execution of the option.

  15. Measuring Intrinsic Value Intrinsic value of a call option = Max(market value of commodity - exercise price, 0) Intrinsic value of a put option = Max(exercise price - market value of commodity, 0)

  16. Example: Intrinsic Value • A call on 2.0 MMBtu of natural gas at a strike of $4.00, with the market price at $4.20, has intrinsic value of Max($4.20-$4.00, 0) = $0.20. • This call will allow the buyer to buy July gas at $4.00 – a $0.20 profit (excluding premium) would be guaranteed. • If the market price were $3.90, the intrinsic value would be $0.

  17. Extrinsic (Time) Value of an Option Time value, or extrinsic value, is the measure of the “insurance value” of an option.

  18. Measuring Extrinsic Value Assuming the premium is known, the extrinsic value can be calculated as follows: Extrinsic value = Premium - Intrinsic Value

  19. Example: Extrinsic Value • A put option on 1.0 million MWh for March power has • a strike price of $39.50/MWh • a premium of $3.75/MWh (or total premium of $3,750,000). • Suppose the current market price is $38.00/MWh. Intrinsic value = (1.0 Million MWh)*Max($39.50 - $38, 0)/MWh = $1,500,000 or $1.50/MWh Extrinsic Value = Premium - Intrinsic Value = $3,750,000 - $1,500,000 = $2,250,000 or $2.25/MWh

  20. Example: Extrinsic Value, continued Guaranteed Profit • The put buyer can earn a profit (before premium) of the $1.50 of intrinsic value by immediately buying March power forward at $38.00. • The put will allow him to sell March for $39.50, assuring $1.50 in profit.

  21. Option Pricing Parameters

  22. Pricing Parameters: Price Curve Controlled Inputs:Market Inputs: Option Pricing Model Price Curve (known) Strike Price Interest Rate (known) Expiration Date Volatility (forecast) Output: Premium

  23. Price Curve • The relationship between the forward price(s) and the strike price indicates the degree of likelihood of the option requiring a payout. • The greater the likelihood of a payout, the greater the premium value.

  24. Example: Contango Curve and Put Premiums Let’s consider the following scenario • Spot price of power = $43/MWh • Strike price of power put option = $44. • The premium for this put option will depend upon the shape of the forward price curve. • Recall that a curve is contangowhen the forward price is above the expected spot price. • A contango curve implies that forward prices take the put option further out-of-the-money, so put option premiums will be relatively less expensive.

  25. Example: Contango Curve and Put Premiums Out of money

  26. Example: Backwardated Curve and Put Premiums Let’s consider the following scenario • Spot price of power = $45/MWh • Strike price of power put option = $44. • The premium for this put option will depend upon the shape of the forward price curve. • Recall that a curve is backwardatedwhen the forward price is below the expected spot price. • A backwardated curve implies that forward prices take the put option further into-the-money, so put option premiums will be relatively more expensive.

  27. Example: Backwardated Curve and Put Premiums In-the-money

  28. European vs. American Style Options • With European-style options the forward price at expiration is the sole determining price in valuing the option. • With (path-dependent) American-style optionsevery point on the price curve influences the premium since the option can be exercised at any point in time.

  29. Pricing Parameters: Strike (Exercise) Price Controlled Inputs:Market Inputs: Option Pricing Model Price Curve (known) Strike Price Interest Rate (known) Expiration Date Volatility (forecast) Output: Premium

  30. Definition of Strike Price • The exercise (strike) price is the price at which the underlying will be delivered should the holder of an option choose to exercise his right to buy or sell. • The setting of the strike (exercise) price level determines the relative likelihood of the option resulting in payout and hence is a determinant of the premium.

  31. Classifications of the Strike Price Call Strikes • The lower the setting of the strike prices for call options, the higher the call option premium. By giving the call to the buyer at lower strike prices, the option becomes more valuable. The probability of exercise increases, as does the expected payout. Put Strikes • The higher the setting of the strike prices, the higher the put option premium. By giving the put buyer the right to sell at higher prices, the option becomes more valuable.

  32. Pricing Parameters: Expiration Date Controlled Inputs:Market Inputs: Option Pricing Model Price Curve (known) Strike Price Interest Rate (known) Expiration Date Volatility (forecast) Output: Premium

  33. Maturity • The longer the term before the option expires - the more time to allow prices to move into-the-money. • General rule: greater potential for a larger payout for an option of longer term vs the same option of a shorter term. • Longer term options are described as having more Time Value.

  34. Example: Increasing Time to Exercise

  35. Time Decay • As an option approaches maturity and the time remaining for prices to move into-the-money shortens, the value of the option declines. • The rate of decline of time value is not constant. • For a given forward price, time value may decay at an accelerating rate.

  36. Time Decay Time Value Exercise Execute

  37. Time Value vs. Price Curve • The effect of maturity on premium is influenced by the shape of the price curve and by time value. • It’s possible that a shorter term option will have a higher premium than a similar option with a longer term. • If the price curve is such that a shorter term (European) option is more, or closer to being, ITM, the shorter term option could have the higher premium.

  38. Example: Time Value vs. Curve Affect on Premiums Compare the following: • 3 month (ITM) power put @ strike of $35 against • 6 month (OTM) power put @ strike of $35 with • contango curve

  39. Example: Time Value vs. Curve Affect on Premiums In-the-money

  40. Example: Time Value vs. Curve Affect on Premiums • In the 3rd month the forward price is ~$34.50 giving the 3 month put $0.50 of intrinsic value plus three months of time value. • The 6th month forward is ~$37, making that option $2.00 out-of-the-money with no intrinsic value. • Hence it’s likely that the shorter-term option will have a greater premium because of the price curve.

  41. Pricing Parameters: Interest Rate Controlled Inputs:Market Inputs: Option Pricing Model Price Curve (known) Strike Price Interest Rate (known) Expiration Date Volatility (forecast) Output: Premium

  42. Interest Rate • Changes in interest rates have a large influence on the option premium. • This is because the forward prices of these assets change directly with interest rates: • Higher interest rates increase cost of carry and result in higher forward prices.

  43. Discount Factor • In energy commodities, interest rates impact premium in the discounting of the future potential payouts of the option. • A rise in interest rate (i.e., the discount rate) reduces the present value of the future payout and so results in a lower premium. • Lower rates result in a higher premium.

  44. Pricing Parameters: Volatility Controlled Inputs:Market Inputs: Option Pricing Model Price Curve (known) Strike Price Interest Rate (known) Expiration Date Volatility (forecast) Output: Premium

  45. Volatility Volatility is the measure of the frequency and magnitude of price changes. • If price movements are small and infrequent, the likelihood of the option going ITM and/or going deep ITM is small and the premium would be relatively low. • If price movements are large and frequent, there would be a higher likelihood of a larger payout and hence a higher premium.

  46. Trading Volatility

  47. Trading Volatility • An option trader following the discipline of the option model is at risk to volatility. • All the other determinants of the premium are known. • The only unknown is volatility. • If volatility increases, the extrinsic (time) value of the option increases. • If volatility decreases, the extrinsic value of the option decreases.

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