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.
Key Learning Points for the Mini-Lecture: Options Contracts
While watching the Mini-Lecture, keep in mind the following key points and questions 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.