Overview of Options An Introduction

1
Overview of Options An Introduction
Return to Risk Limited website
www.RiskLimited.com

• October 2004

2
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.

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Options Markets

• Over-The-Counter (OTC)
• And Physicals Market, Tailored
• Exchange Traded
• Standardized Terms
• Style
• Expiry Dates
• Strike Levels

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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

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Basic Options Structures

• All option products strategies are some
  combination of buying or selling of calls or puts

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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

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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?

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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

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Option Exercise Provisions or Style

• American - Style
• European - Style
• Asian - Style
• Bermudan - Style
• What is the impact on option value?

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American-style Exercise Provision

• Buyer (Holder) may exercise at any time prior to
  expiry
• Value factor related to dividends on equity
  options

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European-style Exercise Provision

• Buyer (Holder) may exercise only on expiry date
• Valuation difference

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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

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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

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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

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Volatility Factor

• Measure Of The Degree Of Change In The Value Of
  The Underlying Asset
• Historical Volatility
• Implied Volatility

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The Greeks

• Very common jargon in financial trading
• Delta
• Vega
• Gamma
• Theta

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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

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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

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The Greeks - Vega

• Vega Is Closely Followed By Traders Since Trading
  Options Is Viewed As Trading Volatility

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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?

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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

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The Greeks Theta ?

• Time Value Decreases At A Faster Rate As Option
  Expiry Date Is Approached

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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

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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?

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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?

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Complex Options Structures

• Path Dependent Options
• Asians
• Combinations Of Options
• Or Combos Of Options
  Other Instruments Such As Swaps
• Embedded Options
• Building Blocks

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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

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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

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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

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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

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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

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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

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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

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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

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Options Pricing Sample
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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

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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

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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

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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

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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

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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.

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Black-ScholesOptions 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

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Black-ScholesOptions Pricing Model

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

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Black-ScholesOptions 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

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Black-ScholesOptions 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

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Adjusted Black-ScholesOptions 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

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Adjusted Black-ScholesOptions 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

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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

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Monte Carlo Methodology

• Probability Of Outcomes

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ruSp
Sp
r2duSp
rdSp
r2d2Sp
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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

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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

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Likely Factors Influencing Pricing Of Options

• Terms And Conditions
• How Could One Impact The Price Of An Option
  Through Contract Provisions?

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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

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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

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Optimizing Options Value Realized For Generation

• Retail Sales Are The Sale Of The Plants Or
  Portfolios Option Value
• Struck At The OM Cost
• Fuel As The Variable Cost
• Spark Spread

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Price Distribution

• Lognormal Bell Shaped Curve
• Skew
• Event Risk
• Fat Tails
• Probability
• Degree Of Certainty

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Returns On Basic Options
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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

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Option Pricing

• Theory Aside, The Practical Pricing Issues Can
  Sometimes Be A Bit Difficult

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Option Pricing

• Valuation
• Price Discovery
• Timing
• Expertise
• Basis
• Risk Free Interest Rate

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Option Pricing Factors

• Higher The Volatility, The More Expensive The
  Option
• Longer The Life Of The Option, The More Expensive
  The Option

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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

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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

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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)

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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

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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

67
Delta Hedging

• Delta-Neutral Maintaining A Risk Neutral
  Position (Hedging)
• Requires Continual Monitoring And Managing
• Trading Expertise

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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

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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

70
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
  

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Option Value

• Deep In-The-Money
• Deep Out-Of-The-Money

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Selling Uncovered Calls

• Naked Option Sold When The Option Seller Does
  Not Own The Underlying Asset
• Risk Factor

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Selling Covered Calls

• Option Sold When The Seller Owns The Underlying
  Asset
• For Example, A Power Generator
  Selling Calls On
  Capacity
• Opportunity Cost

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Options On Spreads

• Price Distribution Is Likely Not Lognormal
• Price Spread Can Be Negative
• Complex Pricing Issues
• Refinery Crack Spreads
• Power Spark Spreads

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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

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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?

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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

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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

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Using Options

• High Potential Opportunity In Energy Options
• But Potentially Very Dangerous If A Blunder Made
• Numerous Areas
  Of Possible Risk

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Overview of Options An Introduction
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