The components of an options contract are:
- option type (call/put)
- strike price (price at which the contracts can be bought or sold by buyer)
Option types are:
- “Calls” – these give the buyer the right but not the obligation to buy the underlying financial energy contracts should the market price exceed the “strike price” of the option contract. In that case, the buyer would “call” the seller of the option and request the contracts.
- “Puts” – these give the buyer the right but not the obligation to sell the underlying financial energy contracts should the market price fall below the “strike price” of the option contract. In that case, the buyer would “put” the contracts to the seller of the option, who must purchase them.
The buyer of an option’s exposure is merely the cost of the option, i.e., the premium. They will never pay more than that. On the other hand, the seller, or “writer,” of an option bears all the risk and is exposed to any price movement above the strike price of the call option, and below the price of the put option.
One of the main advantages is that, since only a premium is paid up front, the buyer of the options can control a large amount of contracts for a small price. For example, with a call option, they are not buying the underlying contracts outright, but are buying the right to purchase them at a set price (“strike price”) if necessary. The buyer could have the right to buy 100 contracts and only have to pay the premium for the option and not pay the total cost of 100 contracts.
So, who would use options contracts for hedging? Let’s take a crude oil refiner as an example. The company is concerned about rising crude oil prices. But rather than go out and buy hundreds of futures contracts and lock-in the price now, they decide to purchase a call option at a strike price that limits their exposure to rising prices. In doing so, they establish a maximum, or “ceiling,” price. So, for December 2018, they buy a crude oil call option at a strike price of $70.00 since the current price is $65.00. If December prices remain below $65.00, the refiner does nothing and is out only the premium. However, should December prices exceed $70.00, the refiner calls the option seller and requests the number of crude oil contracts agreed upon at the $70.00 strike price (or, they could ask for payment of the price difference in the market). In this scenario, the refiner will never pay more than $70.00 for their crude supply. And, they capture all the downside of prices should the market fall.
On the flip side, let’s consider the crude oil producer who is worried about falling prices, so they enter into a put option to establish a “floor” price. For December, they choose a $60.00 strike price, thus establishing the lowest price at which they will have to sell their crude oil. Should prices fall below that level, they will contact the options seller and request their right to sell the underlying financial contracts at $60.00. Should prices remain above $60.00, the producer would do nothing and be out only the price of the option (premium). In this way, the producer can reap all the benefits of higher prices regardless of how high they go.
If not exercised, options expire worthless, and, options are time-sensitive. The closer to the expiration date, the less value the option has (less risk exposure with less time remaining).
There are numerous mathematical models that are used to determine options premium values. The most well-known is the Black-Sholes model. It is an extensive algorithm that only needs a few inputs to calculate an option’s value.
- asset price (current market price)
- strike price (buyer’s desired price)
- days to expiration (of the underlying commodity contract)
- volatility of the underlying contract (available market data)
- interest rate (This is the opportunity cost of paying the premiums upfront vs. investing the cash in something else. The Federal Reserve’s Prime Rate is normally used.)
A spreadsheet with the Black-Sholes model and sample inputs can be found in the Canvas Modules under Lesson 10: Advanced Financial Derivatives - Swaps, Spreads, and Options.