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Introduction to Options

Since 1987, the New York Mercantile Exchange has introduced options contracts on the major energy futures contracts. The flexibility of these contracts has ensured their continued success in years to come.

Options Benefits

The value of the options market to both hedgers and speculators can not be understated. For example:

  • Options provide hedgers with the ability to hedge cash and futures positions against adverse price fluctuations, while still allowing for profit on favorable price swings.
  • Options offer the availability of hedging insurance at many different levels of cost and degrees of protection.
  • Options provide a host of complex strategies that can be used alone, or in combination with futures contracts. They can be tailored to fit any risk profile, time horizon, or cost consideration.
  • In contrast to futures, there are no margin calls for option buyers. If the market moves against a position, and a trader holds on to their option, the maximum loss is the amount they paid for the option. Conversely, if the market moves in a trader's favor, the unlimited profit potential of an option can ultimately parallel that of a futures position.
  • With the exception of the spot month, futures contracts are subject to limits on daily price movements. However, there are no restrictions on how much fluctuation there can be on an options contract. Therefore, options may be traded during times of extreme volatility when futures contracts are locked limit and unable to trade.

Options Defined

Simply stated, a participant who buys an option is given the right, but not the obligation, to require the seller (writer) to perform according to the provisions stated in the contract. Options are segregated by calls and puts, contract month, and strike price.

Calls and Puts

There are two types of options: calls and puts.

  • A call option is a contract that gives the buyer the right but not the obligation to buy a fixed number of futures contracts at a fixed price at any time on or before a fixed date.
  • A put option is a contract that gives the buyer the right but not the obligation to sell a fixed number of futures contracts at a fixed price at any time on or before a fixed date.

Option Premiums

The price paid or collected for an option is called the premium. The value of the premium is established by a price quotation in the same manner as a futures contract. Factors that affect the value of the premium are:

  • The commodity price in relation to the option strike price
  • The time remaining before an option expires
  • The price volatility of the underlying commodity
  • Option supply and demand
  • Interest rates

Generally speaking, an increase in futures prices will cause call premiums to rise and put premiums to fall. Conversely, a decrease in futures prices would generally cause put premiums to rise, and call premiums to fall.

Strike Price

Several references have been made to the term strike price. The strike is the price at which the buyer of the option may exercise their right to buy or sell. Moreover, it serves as the benchmark for an option's value. Strike prices are set by the exchange at, above, and below the current futures price. There are always several strikes that trade simultaneously.

Intrinsic Value

An option's value is comprised of two elements: intrinsic value and extrinsic value (time value). The intrinsic value of a call option can be expressed as the positive amount an underlying future is above the option's strike price. The intrinsic value of a put is the positive amount that the underlying future is below its strike price. For instance, if crude oil futures are trading at $40.15, the $40.00 calls will have an intrinsic value of .15. A  $40.00 put will have intrinsic value of .15 if the futures are trading at $39.85. If an option has intrinsic value, it is said to be "in-the-money" by that amount. If the futures contract price is below the call's strike price, or above the puts strike price, the option is "out-of-the-money". When the option's strike price is the same as the futures price, the option is considered to be "at-the-money". 

Extrinsic Value (time value)

Time is an important component of an option's premium. The more time that remains before an option expires, the greater its time value will be. Extrinsic value is the amount that option buyers are willing to pay for the option in expectation that it will move into the money, and become profitable to exercise. To determine an option's time value, you subtract the intrinsic value from the premium. The time value is what remains. As an option approaches maturity, its time value will decline. Therefore an option is a "wasting" or declining asset. This concept is essential because a profitable position will decline in value if market movement does not offset the loss of time value.

Volatility

An important factor in the pricing of energy options is volatility. Options premiums increase when there are frequent and broad fluctuations in futures prices. Heightened volatility implies that the option has a greater chance of gaining intrinsic value before expiration. Consequently, option writers (sellers) demand higher premiums during times when volatility is excessively high.

Option Supply and Demand

Options prices are subject to the same supply and demand factors that influence futures prices. Premiums rise when buyers out number sellers, and fall when sellers out number buyers.

Interest Rates

The fluctuation of interest rates have only a minor impact upon the value of option premiums. However, if interest rates steadily rise, the cost of carry will also increase, in turn causing distant futures prices to rise. As a result, call premiums will rise and put premiums will fall.

The Rights and Obligations of the Participants

Call Options : Buyer

Entitles the person to buy a futures contract at a predetermined strike price at or before the expiration date. This position would be taken in expectation of rising futures prices. Risk is limited to the amount paid for the premium. 

Seller: The participant grants the right to the buyer, and collects the premium. The person has the obligation to sell the futures at a predetermined price, at the discretion of the call buyer. This position would be profitable if prices fall or remain the same. Risk is unlimited because the effect is similar to an outright short futures position if prices move above the strike price.

Put Options : Buyer

Entitles the person to sell a futures contract at a predetermined price on or before the date of expiration. This position would be taken in expectation of declining prices. Risk is limited to the amount paid for the premium. 

Seller: Grants the right to the buyer and collects the premium. Conversely, this person has the obligation to buy the futures at a predetermined price at the discretion of the put buyer. A profit for the seller (option writer) would result if prices rise or remain the same, and the buyer's option expires worthless. Risk is unlimited because the effect is similar to an outright long futures position if prices move below the strike price.

How to Terminate an Option

As an option approaches expiration, a decision must be made as to whether an option should be terminated or held to maturity. There are three ways to dispose of an option:

  • It can be exercised (exchanged for futures)
  • It can be liquidated (off-set)
  • It can simply expire

Liquidation is the most common method of disposing with an option. The flexibility of being able to trade in and out of positions is one of the key strengths of options contracts. However, there may be circumstances when it may be more advantageous to exercise the option. For example, if your company's objective is acquiring a long or short futures position, exercising the option would be the most cost efficient alternative. Allowing an option to expire would make sense only when the premium remaining is less than the commissions incurred to liquidate or exercise the option.

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