PrintCar 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)
The last advanced financial derivative we're going to talk about are options. And again, I've given you pretty extensive notes and some good examples of what options are and how they're utilized and how they're valued. So, these slides just represent pretty much an overview of the notes from the lesson content. Well actually, we'll talk about the definition, the types of options, some of the terminology, the benefits and risks of using options, what happens when options expire, how options are valued, and then we'll just have a summary of the key learning points.
Options are another type of financial instrument used to manage risk and/or to speculate. An option contract gives the holder the right but not the obligation to buy or sell futures contracts at a specified price at any time in the future prior to the expiration of the option contract. Now keep this in mind, this is an important point. If you're buying an option-- in other words, you're the holder of the option-- you have the right but not the obligation to either buy the underlying contracts or sell them. You do not have to.
Types of options contracts-- there are two types, the Call, and the Put. A Call is an option to buy. In other words within the option, you have a designated commodity and the number of contracts and a specified price. Your option position is long. So, once you buy a call option, since you have the right to buy the contracts, your option position is considered long.
So, many times the holder is short the underlying commodity. In other words, let's say a crude-oil refiner would want to buy a call option for crude-oil contracts, thus having the right to buy the crude-oil contracts at a certain price-- again, not the obligation. So. while their physical position is short, their options position is long.
On the flip side, we have the Put option. This is an option to sell the underlying contracts. Again, the option position here is short. Why? Because they have the right to sell. Many times the holder is long the underlying commodity.
So, for example, a crude-oil producer may want the right to sell their crude or to sell contracts in the financial marketplace at a predetermined price which is stated in their option. So, again, to the extent that they exercise, they have the right to sell. We consider their option position to be short because their physical commodity position is, in fact, long.
The most popular type of option is the Futures option or the Commodity option. It is an exchange-traded option calling for the delivery of futures contracts. However, options can be traded in the over-the-counter market and, at times, can call for physical delivery.
And then note my footnote. Having the options contract means you have the right-- you have contracts or can sell contracts. The Premium, this is the price of the option. The premium value reflects the risk of the underlying commodity, and its value is made up of two components. In other words, this is the price you'll have to pay. Just as in the lesson notes, I talked about car insurance and you have a premium. The premium is what it will cost you to have this type of risk insurance.
And there are two pieces, the Intrinsic and the Extrinsic. When you think of the intrinsic, think of the embedded value. As soon as you execute the option, you're going to have a strike price, and there's going to be a market price or what we call the asset price. So, it's the positive difference between the strike price and the price of the underlying commodity.
So, for example, if you, in your contract, you set a strike price of $52 and the current market is $50, the intrinsic value of that is $2.00. So, we know that the premium would be at least $2.00. At $2.00, the writer or seller of the option you're dealing with isn't going to make any money.
Part two of the premium then is what we call extrinsic, which is the time value of money. So, think about it this way. You enter into an options contract on a particular day, but that particular underlying contract won't expire until some point in time in the future. Well, every single day with market changes in price, volatility, and those types of things as well as the time that gets closer and closer to expiration, the value of that option changes. So, in other words, the premium that the writer of that option would then charge you is going to change every day, and this is reflected in what we know as the Greeks, the theoretical models that calculate the various differences in the extrinsic value.
So, when you have the premium and you know what the intrinsic is, all remaining value other than the intrinsic is the extrinsic, and it consists of the components that we talk about as the Greek values. So, for the example above, if the premium for this particular option of $52 was $2.50, we know, based on the fact that the intrinsic is $2.00, that the extrinsic part of the premium or the time value of that premium is $0.50.
The Strike Price, that's the buy or sell price as detailed in the options contract, also known as the exercise price. Expiration, which again, it's the date by which the outcome of the options contract, whether it's sold, exercised, or just abandoned, has to be determined. Now, the options expire typically one to three days prior to the expiration of the underlying futures contract. So, for natural-gas options, as an example, it's one day prior to the expiration of the underlying contract. And we know that the underlying contract for natural gas on NYMEX expires three working days prior to the first of the month. Therefore natural-gas options expire four working days prior. So, they have to be executed or they just go ahead and settle.
And the Greeks, these are the theoretical values projected from mathematical models that are used to measure the sensitivity of an options price to quantifiable factors. When we refer to the Greeks, we're talking about delta, gamma, theta, vega, and rho. And again, I'm not going to hold you responsible for these, but these are the definitions of the Greeks themselves.
Benefits of an option-- the option premium is a fraction of the cost of the underlying commodity. So, think about the fact that, say again, you're a crude refiner and you want to go out and you need to secure some crude supplies in the future. You could buy the contracts outright or you could buy a call option where you have the right to purchase those at a certain price level if, in fact, you need to exercise it, but it's only costing you the premium upfront. You're not buying the contracts unless the price exceeds your option price and then you want to enter into those contracts.
And because of that, you can potentially control a large number of futures contracts for a relatively small cost. So, you could hold several contracts of crude oil, and rather than buy them outright, you're paying the premium on a call option. This gives you a considerable amount of leverage in the marketplace. Now the option buyer's risk is known and limited to the amount paid for the option premium. So, again, your exposure as someone who buys the option is strictly what you paid. You can't lose any more than the premium.
Now the Risk-- the risk is that these are time-sensitive investments. Basically, the value of the options can tend to deteriorate from the time at which they're exercised until the actual expiration date. Now the Option Seller is the writer of the option. That's the other term we use for them, and they are at risk to unlimited potential losses. If you're buying a call option, you're buying a ceiling price. You will never pay more than the strike price in your agreement. Well, the seller of that option or the writer of that option has that exposure if the price runs right through that.
When options expire, they can expire worthless. In other words, you never executed the option. They can be sold for the intrinsic value if one is in an option-buyer position where the option is purchased for its intrinsic value if one is in an option-seller position. So, in other words, as we talked about the intrinsic value, as the options come up anytime between the time they're executed and the time that it expires, if there's value in that, someone trading options could, in fact, cash that in or settle it and make some money on it, or the option gets exercised sometime before expiration, or it automatically is exercised on expiration.
How do they come up with premiums? Well, options are generally valued using pricing theory and/or pricing models.
One of the more popular models used for option evaluation is the Black Scholes model. Now, some of the large firms that actually buy and sell options or they'll write options, they may have some proprietary models that were developed by some quantitative analysts.
Here is what the inputs look like on a Black Scholes model.
| S (Asset $) | 50.00 |
| X (Strike) | 55.00 |
| T (Time to expiry) | 0.055 |
| r (risk free rate) | 0.083% |
| v (Volatility) | 50.0 % |
| d1 | -0.7554 |
| d2 | -0.8725 |
| call value | 0.7191 |
| put value | 5.7166 |
As an example, one can evaluate an option's value at contract expiration. As previously stated, at expiration, the contract has no time value and one would expect the options value to be solely intrinsic.
So, if you have a model-- and I've put a spreadsheet, Excel spreadsheet, out in Canvas under the lesson resources. It's an example of the Black Scholes model. And these will be the inputs.
The asset price-- that's the current market price. In this scenario, the current market price for crude oil was $50, the desired strike price for the option was $55. So, in this particular case, this would be a call option. The time to expiration-- in the spreadsheet, you enter in the number of days to expiration in the one cell, and it automatically calculates this fraction.
The risk-free rate-- you have to put in an interest rate because the idea is, you are paying the premium at the time that you execute the options contract. So, there's cash sitting out there, which could be drawing interest as an alternative. So, this is your so-called opportunity cost. And then, the volatility-- you're going to get that from the marketplace-- the daily implied volatility.
D1 and D2-- those are deltas. Do not worry about those.
But you can see what it spits out are call values and put values. So, a call value-- it's going to cost you $0.72 to get a $55 call in a $50 market with those other parameters that you've entered into it.
From the put side-- and again, remember, the put allows you to sell at a certain price level. Well, if we look at this, if you want to sell at $55 and the market is $50, well, obviously the intrinsic value is $5. So, at a minimum, it's going to cost you $5. And in this scenario, though, the extrinsic value of it is $0.72 as well.
One could also anticipate the value utilizing basic understandings. The purchaser of a call option is anticipating the price of the underlying security to increase. So, one would expect the call option's value to increase with an increase in commodity prices. If the strike price were higher than the actual commodity price, the option should have little to no value.
So, some of the learning points of these things-- the purchaser of a call option expects the price of the future contract to increase. OK. So, their sentiment or their outlook is that they're bullish on the underlying commodity. If they think prices are going to go up, they would enter into a call option.
The purchaser of a put option expects the price of the future contract to decrease. So, their sentiment is bearish on the underlying commodity. They expect prices to fall. And as a result, they want to establish a floor price. OK.
Options are referred to as being asymmetrical. It's a right, but not an obligation for the buyer of the option.
Options are financial in nature. Delivery of the physicals is relatively rare. And options premium typically moves in concert with an option's valuation. That only makes sense because you're going to put a value on the option and the premium should be the result of those calculations.
At expiration, the time value portion of the premium is equal to zero. So, in other words, on the day of expiration, all you've got left is intrinsic value. What's the strike price in the options contract versus the asset or market value at that time?
And then, options trading is a zero-sum game. We talked about this with the underlying futures and forwards contracts. For every buyer, there's a seller and vise versa. Same thing here-- if you want to buy an option, there has to be a seller in the marketplace.
Options rights and obligations-- so, let's break this down a little bit. In terms of call options, the actual buyer has the right to buy a futures contract at a predetermined price on or before a defined date. They expect prices to rise. They want to establish a ceiling price, a price at which they're guaranteed to purchase the underlying contracts.
The seller, on the other side, they're granting that right to the buyer. So, they have the obligation to sell futures at the predetermined price at the buyer's sole option. In other words, the seller of the option can't call up the buyer and say, hey, I would really like you to go ahead and exercise these. It is up to the buyer.
In terms of a put option, this gives the buyer the right to sell futures contracts at a predetermined price on or before a defined date. Why? Because their expectation is that prices will fall and they want to establish a floor price, a guaranteed minimum price.
The seller then grants the right to the buyer. So, they've got the obligation to potentially have to buy futures at a predetermined price, which is the price stated in the contract, the strike price, at the buyer's sole expectation.
The seller, in this case, they're expecting neutral or rising prices. So, in other words, if they sell a put option, their hope is that the prices don't ever fall. If they stay the same, they're going to collect the premium and they won't have to pay anything out. But if prices rise, the same thing happens as well. They're not going to have to purchase contracts in a falling marketplace.
OK. Again, here is just the determinant of options prices themselves.
| Increase in | Call Value | Put Value |
|---|---|---|
| Underlying Price | increasing | decreasing |
| Strike Price | decreasing | increasing |
| Volatility | increasing | increasing |
| Expiration Time | increasing | increasing |
| Interest Rate | decreasing | decreasing |
If there's an increase in the underlying price, that's going to increase the value of the call and it'll decrease the value of the put. OK. If there's an increase in the strike price, that's going to lower the call value and increase the put value.
If volatility increases, both the value of the call and the put are going to increase. I mean, as you can imagine, if there's volatility in the marketplace, then those models, like the Black Scholes and others, are going to reflect that added volatility. So, the risk or the exposure by the writers of the options is going to increase.
Time to expiration-- the further the time out from the time you enter into the options contract until expiration, both the put value and the call value could also increase. And then, interest rates-- if there's an increase in the interest rate, both the call value and the put value are going to decline.