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## Overview of Options – An Introduction

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Options Definition

- The right, but not the obligation, to enter into a transaction [buy or sell] at a pre-agreed price, quantity, time [by a specified date in the future], and terms.
- The option buyer typically pays the seller an upfront free (the premium) for the option rights.

Options Markets

- Over-The-Counter (OTC)
- And Physicals Market, Tailored
- Exchange Traded
- Standardized Terms
- Style
- Expiry Dates
- Strike Levels

Basic Options Structures

- Calls – Options acquired by a buyer (holder) and granted by a seller (writer) to buy at a fixed price
- Puts – Options acquired by a buyer and granted by a seller to sell at a fixed price

Basic Options Structures

- All option products & strategies are some combination of buying or selling of calls or puts

Basic Options Provisions

- Buy or Sell (Write)
- Long or Short
- Call or Put
- Underlying Asset
- Product, Security / Instrument
- Strike (Exercise) Price
- Premium
- Exercise Date and Style

Basic Options Provisions - Strike

- Strike Price – Fixed price to be paid if option exercised, as specified in the options agreement
- Set in intervals on exchange traded options
- At any preferred level OTC
- How would you set the strike?

Basic Options Provisions - Premium

- Premium – Price of the option that buyer pays and seller receives at the time of option transaction.
- Consideration paid for rights
- Non-Refundable

Option Exercise Provisions or “Style”

- American - Style
- European - Style
- Asian - Style
- Bermudan - Style
- What is the impact on option value?

American-style Exercise Provision

- Buyer (Holder) may exercise at any time prior to expiry
- Value factor related to dividends on equity options

European-style Exercise Provision

- Buyer (Holder) may exercise only on expiry date
- Valuation difference

Asian-style Exercise Provision

- Class of options which have payouts dependent on the history of the price (some averaging basis) of the underlying asset during a pre-defined time period.
- Average Price Options (APO’s)
- Path Dependency, Barriers, Look-Backs, KO’s
- Potentially more complex price modeling

Early Exercise Of Options

- Exercising an option prior to expiration date
- Would that be economically attractive?
- Provisions for automatic exercise of “In-the-Money Options”

Option Concepts

- Insurance Policy Analogy Commonly Cited
- Fee For Providing Financial Protection
- Transfer Of (Price) Risk
- Intuitive Pricing
- Real Estate Options To Buy, Extended By Property Owners

Volatility Factor

- Measure Of The Degree Of Change In The Value Of The Underlying Asset
- Historical Volatility
- “Implied” Volatility

The “Greeks” - Delta

- The Most Commonly Watched Factor Since Used In Delta Hedging
- The Degree Of Change In Option Value In Relation To A Change In The Value Of The Underlying Asset

The “Greeks” - Vega

- Measures Effect On Premium Of A Change In Perceptions Of Future Volatility
- Vega Also Referred To As Kappa
- The Degree Of Change In Option Value Relative To A Change In The Price Volatility Of The Underlying Asset

The “Greeks” - Vega

- Vega Is Closely Followed By Traders Since Trading Options Is Viewed As Trading Volatility

The “Greeks” - Gamma

- The Rate Of Change Of Delta
- An Indicator Of How Stable Delta Is
- If A Position Or Portfolio Has A High Gamma, What Might That Suggest?

The “Greeks” – Theta

- Measures Effect On Premium Of A Change In Time To Expiry
- The Degree Of Change In Option Value In Relation To A Change In The Time To Expiry
- BecomesMore Important

Closer To Expiry

The “Greeks” – Theta

- Time Value Decreases At A Faster Rate As Option Expiry Date Is Approached

The “Greeks” – Rho r

- The Degree Of Change In Option Value In Relation To A Change In Interest Rates
- Of More Importance In Very Long-Term Options

Delta Measurement Example

- If The Price Of Natural Gas Changes By 1 Unit
- And The Option Value (Current Premium) Changes By 0.4
- Then What Is The Option Delta Currently?
- So, What Does That Suggest?

Delta Concepts

- Delta Of An Option Approaches “0” As Option Moves Deep Out-Of-The-Money
- Delta Of An Option Approaches “1” As Option Moves Deep In-The-Money
- Option Begins To Behave Like The Underlying
- Why Is That?

Complex Options Structures

- Path Dependent Options
- Asians
- Combinations Of Options
- Or Combos Of Options & Other Instruments Such As Swaps
- Embedded Options
- Building Blocks

Examples Of Options Structures

- Extendables
- Expandables
- Double-Ups, Double-Downs
- Simplicity of structure for buyer
- A bit more complex for seller to price and trade
- Participation swaps

Decomposing A Participation Swap

- To Understand From A Pricing Standpoint
- And From A Trading / Hedging / Managing Standpoint
- A Swap With Option Embedded At Ratio To Produce Desired Participation & Pricing
- Components Hedged Separately By Trading Desk

When To Consider Using Options For Hedging

…rather than fixed price,

fixed volume commitments

- When Underlying Exposure Is Uncertain Or Contingent
- When Option Pricing Is Viewed As Attractive
- When Weak Credit Standing Precludes Use Of Fixed Price Swaps, Or Other Instruments

When To Consider Using Options For Hedging

- When Competitive Business Position Dictates Avoiding Locking-in Costs
- And Yet Price Protection Against Catastrophic Price Change Is Sought
- When Seeking To Monetize Embedded Optionality Of Existing Position [Physicals]

When To Consider Using Options For Hedging

- When Seeking A Tool To Reduce Or Transfer Risk
- When Selling Puts To Generate Income, At A Strike At Which Writer Is Happy To Own The Underlying Asset
- Ultimately, When Exposures Dictate Using Options

When Do Traders Typically Use Options In Their Portfolios

- When Pricing Is Viewed As Attractive
- When Seeking To Enhance Portfolio Income
- To Play The Market With Limited Risk (No More Than Premium Paid)
- When Attempting To Use Leverage To Increase Yield

When Do Traders Typically Use Options In Their Portfolios

- When Systems And Trading Expertise Provide Capability To Manage Complexity
- When Seeking To Generate Income On Holding Of Underlying Asset
- Covered Calls
- Ultimately, When Exposures, Market View, And Trading Strategy Dictate Using Options

Options Trading Strategies

- Secondary Trading In Options
- Rights Sold And Re-Sold
- Typically Not Just “Buy And Hold”
- Frequently Traders Will Exit Or Roll Positions Before Nearing Expiry
- IPE Sample Pricing
- Web Example

Options Trading Strategies

- Straddles, Strangles
- Butterfly Spreads, Bull Spreads, Bear Spreads, Box Spreads, Calendar Spreads
- Typically Used In Taking Speculative Views On Future Market Price Moves
- Not Usually Employed In Hedging Techniques
- Configures Payoff Profile Consistent With Trader’s Market View

Options Trading Strategies

- Straddles – Simultaneous Purchase And/Or Sale Of The Same Number Of Calls And Puts With Identical Strike Prices And Expiration Dates [Long or Short]
- Strangles – Simultaneous Purchase And/Or Sale Of Calls And Puts At Different Strike Prices

Options Trading Strategies

- Bull Spread – Simultaneous Purchase & Sale Of Calls Or Puts That Will Produce Maximum Profits When Value Of Underlying Asset Rises
- Bear Spreads – Purchase & Sale Of Calls Or Puts For Maximum Profits When Value Of Underlying Asset Falls

Options Trading Strategies

- Box Spread – Combination Of Bull & Bear Spreads Transacted Simultaneously
- Calendar Spreads – [Time Spreads] Purchase & Sale Of Calls Or Puts With Different Expiration Dates

Options Pricing

- Theoretically The Net Present Value Of All Potential Outcomes For The Option
- Various Methodologies For Determining
- Issues In Energy Options
- Price Distribution
- Price History
- Illiquidity

Options Pricing Theory

- Black-Scholes Formula
- Numerical Computational Techniques
- Monte Carlo
- Lattice Probability Tree Methods
- Bi-Nominal, Tri-Nominal Methods
- Assumes Price Follows Stochastic Process

Options Can Be Considered “Wasting Assets” That [Generally] Decline In Value Over Time. After Expiration Date, Becomes Worthless.

Black-ScholesOptions Pricing Model

- Developed by Fischer Black and Myron Scholes In 1973
- First Theoretical Options Pricing Model
- Quantified Value Of Key Variables (Primarily Underlying Asset Value & Price Volatility)
- Basis Of The Model Is To Estimate Probability That Option Will Finish In The Money

Black-ScholesOptions Pricing Model

- Derived From Observation Of Mathematics From Physical Phenomena (Heat-Exchange Equation)
- Widely Used, Extensively Studied

Black-ScholesOptions Pricing Model

- Assumes Price Of Option Related To Square Root Of Time
- Assumes Price Volatility Is At A Constant Level And Can Be Measured Through Standard Deviation Of Historical Prices
- Concentrated On European-style Options, Or No Dividends

Black-ScholesOptions Pricing Model

- Critical Assumption For Model
- Stochastic Price (Random Walk Theory)
- Underlying Asset Price Follows Lognormal Distribution
- Assumptions May Not Be Valid For Energy Markets

Adjusted Black-ScholesOptions Pricing Model

- Often Used Term, Also Referred To As Modified Black Model Or Extended Model
- Adjustment In Pricing Formula To Accommodate Alternative Assumptions
- Black Model For Options On Futures, Rather Than Stock
- Assumes Lognormal Distribution For Futures

Adjusted Black-ScholesOptions Pricing Model

- Adjustment In Pricing Formula To Accommodate Alternative Assumptions
- For Energy Presume Deterministic & Random Price Components
- Deterministic Component Follows Mean Reversion To Reflect Seasonality Feature
- Random Price Component As Lognormal

Monte Carlo Methodology

- Simulation Of Possible Outcomes
- Probability Assessment
- Various Methodologies
- Computer Resource Intensive

Options Price Simulation Based On Assumptions & Probabilities, Not A Clarivoyant Prediction…

Cox-Ross-Rubenstein Option Pricing Model

- Introduced Shortly After Black-Scholes
- A Binominal Model
- Constructs A Probability Tree
- Volatility Cones As Projections Of Volatility Into The Future

Considered Much The Same As Black-Scholes Model, Just A Different Methodology

Likely Factors Influencing Pricing Of Options

- Price Volatility Of Underlying Asset
- Duration Of The Option – Time To Expiration
- Strike Price Of The Option
- Value Of The Underlying Commodity [Or Financial Instrument]
- Risk Free Interest Rate

Likely Factors Influencing Pricing Of Options

- Terms And Conditions
- How Could One Impact The Price Of An Option Through Contract Provisions?

Physical Assets As Options

- In Terms Of Economic Valuation…
- A Way To View The Value Of A Production Facility
- Such As A Power Plant
- A Call On Capacity
- A Call Option
- Product Storage Facility
- Such As Natural Gas Or Fuel Storage

Writing Covered Calls

- Covered In Terms Of Owning The Underlying Asset To “Cover” Option Position If Call Is Exercised
- Obviously Less Risky Strategy
- But Commits Asset
- A Call On Production Capacity
- A Call On Product Stored Or Owned
- Such As Natural Gas Or Fuel Storage

Optimizing Options Value Realized For Generation

- Retail Sales Are The Sale Of The Plant’s [Or Portfolio’s] Option Value
- “Struck” At The O&M Cost
- Fuel As The Variable Cost
- Spark Spread

Price Distribution

- Lognormal [Bell Shaped Curve]
- Skew
- Event Risk
- Fat Tails
- Probability
- Degree Of Certainty

Option Pricing

- Various Theoretical Pricing Basis For Options
- Black-Scholes
- Merton Model
- Adjusted Black-Scholes
- Cox, Ross & Rubenstein
- Bi-Nominal, Tri-Nominal
- But Presumably Ultimate Market Price Determined By Supply & Demand

Option Pricing

- Theory Aside, The Practical Pricing Issues Can Sometimes Be A Bit Difficult

Option Pricing

- Valuation
- Price Discovery
- Timing
- Expertise
- Basis
- Risk Free Interest Rate

Option Pricing Factors

- Higher The Volatility, The More Expensive The Option
- Longer The Life Of The Option, The More Expensive The Option

Historical Volatility

- Historical Volatility Is Determined From Past Price Data
- Selection Of Appropriate Time Period
- Historical Volatility Can Be Estimated By Calculating The Square Root Of Variance

Implied Volatility

- Implied Volatility Is Determined Mathematically From Option Pricing Formulas When Premium Is Known
- Implied Volatility Is Closely Watched By Traders
- Reflects Market Perceptions Of Future Volatility, Not Necessarily Historical Levels

Average Price Options

- Averaging The Underlying Asset Price Smoothes The Volatility
- Highs & Lows Can Cancel Each Other Out
- So APO’s Tend To Be Cheaper Than Standard Options
- May Be A Better Match For Exposure Based On Daily Consumption Of A Commodity (NG)

Average Price Options

- Since APO’s Are Path Dependent, Option Writers May Use Monte Carlo Simulations To Estimate Value
- Computational Techniques May Improve The Accuracy Of These Simulations
- Delta Hedging APO’s May Require Frequent Adjustments Early In Option’s Life

Delta Hedging

- Dynamic Hedging – Using Futures To Hedge An Option Position
- Involves Frequently Buying And Selling Futures Contracts To “Re-Balance” Options Portfolio
- Widely Used Technique
- Transactions Costs Consideration

Delta Hedging

- Delta-Neutral – Maintaining A Risk Neutral Position (Hedging)
- Requires Continual Monitoring And Managing
- Trading Expertise

Option Value

- At-The-Money
- In-The-Money
- Out-Of-The-Money
- Option Price Can Be Viewed As Comprised Of Two Components
- Intrinsic Value
- Extrinsic Value, Time Value

Option Value - Intrinsic

- Intrinsic Value Of An Option Is Simply The Amount, If Any, By Which The Option Is In-The-Money
- Profit That Could Be Realized If Option Were Exercised Immediately
- Easy Valuation

Option Value - Extrinsic

- Extrinsic Value Reflects The Potential Future Value Of The Option, Influenced Primarily By The Time Remaining To Expiry And The Price Volatility Of The Underlying Asset
- The Hard Part To Value

Option Value

- Deep In-The-Money
- Deep Out-Of-The-Money

Selling Uncovered Calls

- Naked Option – Sold When The Option Seller Does Not Own The Underlying Asset
- Risk Factor

Selling Covered Calls

- Option Sold When The Seller Owns The Underlying Asset
- For Example, A Power Generator Selling Calls On Capacity
- Opportunity Cost

Options On Spreads

- Price Distribution Is Likely Not Lognormal
- Price Spread Can Be Negative
- Complex Pricing Issues
- Refinery “Crack Spreads”
- Power “Spark Spreads”

Financial Risk On Options

- For Buyers Of Options, Risk (Of Losses) Are Limited To Premium Paid For Option
- & Profits Are Potentially Unlimited, But…
- …Be Careful…
- A Very Deceiving Perspective: PCA Example
- Probability Assessment On Risk / Return Ratio

Financial Risk On Options

- As Writers Of Options,Financial Exposure Would Be Potentially Unlimited
- Profits Are Limited To Premium Received
- Is There a Situation Where One Would Write An Option?

Credit Risk On Options

- For Writer Of Options, Counter Party Credit Exposure Limited To Settlement Risk (On Premium Payment)
- Generally Considered Minimal
- But Counter Party (Buyer) May Require Substantial Credit Support Such As Margin/Collateral, LC

Credit Risk On Options

- For Option Buyers, Credit Exposure Is Similar To Fixed Price Instruments, Such As Swaps
- Level Of Counter PartyCredit Risk Depends On Market Price Risk, Which Is Theoretically Unlimited
- Know Your Customer / Counter Party

Using Options

- High Potential Opportunity In Energy Options
- …But Potentially Very Dangerous If A Blunder Made
- Numerous Areas Of Possible Risk

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