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Overview of Options An Introduction

October 2004

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 (APOs) Path Dependency, Barriers, Look-Backs, KOs

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
Very common jargon in financial trading Delta Vega V
Gamma Theta

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 Becomes More 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 Pricing Sample

Brent Crude Oil Options
Calls: With Underlying @ $28.99 Current Exercise Settlement Implied Open Price Price Volatility Interest $28.50 85 32.52% 440 $29.00 57 31.93% 993 $29.50 37 32.49% 201

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 Traders 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-Scholes Options 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-Scholes Options Pricing Model

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

Black-Scholes Options 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-Scholes Options 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-Scholes Options 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-Scholes Options 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

Monte Carlo Methodology

r2u2Sp
ruSp

Sp
rdSp

r2duSp
r2d2Sp

Probability Of Outcomes

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 Plants [Or Portfolios] 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

Returns On Basic Options

Payoff Diagram
60 40

Payoff

20 0 1 -20 -40 -60 2 3 4 5 6 7 8 9 10 11

Long Underlying Asset Short Put Option Long Call Option

Spot Price

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 APOs 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 APOs Are Path Dependent, Option Writers May Use Monte Carlo Simulations To Estimate Value
Computational Techniques May Improve The Accuracy Of These Simulations Delta Hedging APOs May Require Frequent Adjustments Early In Options 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 Party Credit 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

Overview of Options An Introduction