Transcript Overview of Options – An Introduction

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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
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–
–
–
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”
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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
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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”
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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
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–
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–
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
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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
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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
r2duSp
Sp
rdSp
r2d2Sp
Probability Of Outcomes…
Cox-Ross-Rubenstein Option
Pricing Model
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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
Payoff
40
Long Underlying
Asset
Short Put Option
20
0
1
2
3
4
5
6
7
8
-20
-40
-60
Spot Price
9 10 11
Long Call Option
Option Pricing
• Various Theoretical Pricing Basis For Options
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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
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Historical Volatility Is Determined From
Past Price Data
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Selection Of Appropriate Time Period
Historical Volatility Can Be Estimated By
Calculating The Square Root Of Variance
Implied Volatility
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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
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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
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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
Possible Risk
Of
Overview of Options
An Introduction