Car insurance is a good example of an option, specifically, a "call" option. A premium is paid and the insured has the right to “call” their insurance agent in the event of an accident. The “price” they will have to pay for the damages is limited to the amount of the deductible (“strike price”). The term is usually one year, and if no claim is made, the “option” expires worthless (i.e. – no payout is made by the insurance company since no claim was made). The insured’s maximum exposure is the deductible, thereby establishing a “ceiling price.” And, the premium is calculated using complicated mathematical models (actuarial tables, statistics & probabilities).
Energy options are very similar in nature. As with most financial derivatives, they can be used for hedging price risk or for outright trading. One key difference is that options represent the buyer’s right, but not the obligation, to buy or sell futures/forwards contracts. The options contracts themselves are not futures or forwards contracts but rather a right to buy or sell those contracts. They are traded on the exchange as well as over the counter. And, the buyer is under no obligation to purchase or sell the underlying commodity contracts if the pricing makes no sense.
Here are some common terms in option contracts:
Call: An option contract that gives the holder the right to buy the underlying security (futures) at a specified price for a certain fixed period of time.
Put: An option contract that gives the holder the right to sell the underlying security (futures) at a specified price for a certain fixed period of time.
Holder: The purchaser of an option.
Premium: The price of an option contract, determined in the competitive marketplace, which the buyer of the option pays to the option writer for the rights conveyed by the option contract.
Strike Price: The stated price which the underlying security (futures) may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.
Expiration date: The day on which an option contract becomes void.
Intrinsic value: The value of an option if it were to expire immediately with the underlying commodity at its current price; the amount by which an option is in-the-money. For call options, this is the difference between the underlying commodity price and the striking price, if that difference is a positive number, or zero otherwise. For put options, it is the difference between the striking price and the underlying commodity price, if that difference is positive, and zero otherwise.
In-the-money: A term describing any option that has intrinsic value. A call option is in-the-money if the underlying security (commodity) is higher than the striking price of the call. A put option is in-the-money if the security (commodity) is below the striking price.
Out-of-the-money: A call option is out-of-the-money if the strike price is greater than the market price of the underlying security (commodity). A put option is out-of-the-money if the strike price is less than the market price of the underlying security (commodity).
Time Value: The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option has in addition to its intrinsic value.
Key Learning Points for the Mini-Lecture: Options Contracts
While watching the following mini-lecture (16:13 minutes), keep in mind the following key points regarding energy risk hedging using options contracts:
- Options give the buyer the right but not the obligation to buy or sell financial energy contracts at some point in time in the future at a set volume and price. They are traded on both the exchange and over the counter markets.
- They are much cheaper than outright contracts or swaps in that premiums usually represent only a fraction of the face value of the underlying contracts.
- As a result, a substantial amount of contracts can be “controlled” relatively cheaply.
- Options contract components list the commodity, volume, date, price ("strike"), and premium to be paid.
- A “call” option gives the buyer the right to buy contracts at a fixed price, which creates a maximum, or “ceiling price.” These are mostly used by consumers of the energy commodity wishing to cap their price risk exposure.
- A “put” option gives the buyer the right to sell contracts at a fixed price, which creates a minimum or “floor price.” These are mostly used by producers of the energy commodity wishing to limit their downside price risk.
- Options values are calculated using algorithmic models.
- The most popular model is the Black-Scholes model.
Now watch the following two videos for more details. (9:20 and 6:50 minutes)