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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 (APO’s)
– Path Dependency, Barriers, Look-Backs, KO’s
• 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 
• 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
Trader’s 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 r2duSp
rdSp
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 Plant’s
[Or Portfolio’s] 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

20 Long Underlying
Asset
Payoff

0 Short Put Option

1 2 3 4 5 6 7 8 9 10 11
Long Call Option
-20

-40

-60

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 APO’s 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 APO’s Are Path Dependent, Option
Writers May Use Monte Carlo Simulations
To Estimate Value
– Computational Techniques May Improve The
Accuracy Of These Simulations
– Delta Hedging APO’s May Require Frequent
Adjustments Early In Option’s 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