Title: Overview of Options An Introduction
1Overview of Options An Introduction
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2Options 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.
3Options Markets
- Over-The-Counter (OTC)
- And Physicals Market, Tailored
- Exchange Traded
- Standardized Terms
- Style
- Expiry Dates
- Strike Levels
4Basic 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
5Basic Options Structures
- All option products strategies are some
combination of buying or selling of calls or puts
6Basic 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
7Basic 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?
8Basic 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
9Option Exercise Provisions or Style
- American - Style
- European - Style
- Asian - Style
- Bermudan - Style
- What is the impact on option value?
10American-style Exercise Provision
- Buyer (Holder) may exercise at any time prior to
expiry - Value factor related to dividends on equity
options
11European-style Exercise Provision
- Buyer (Holder) may exercise only on expiry date
- Valuation difference
12Asian-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
13Early Exercise Of Options
- Exercising an option prior to expiration date
- Would that be economically attractive?
- Provisions for automatic exercise of
In-the-Money Options
14Option 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
15Volatility Factor
- Measure Of The Degree Of Change In The Value Of
The Underlying Asset - Historical Volatility
- Implied Volatility
16The Greeks
- Very common jargon in financial trading
- Delta
- Vega
- Gamma
- Theta
?
V
?
?
17The 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
18The 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
19The Greeks - Vega
- Vega Is Closely Followed By Traders Since Trading
Options Is Viewed As Trading Volatility
20The 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?
21The 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
22The Greeks Theta ?
- Time Value Decreases At A Faster Rate As Option
Expiry Date Is Approached
23The 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
24Delta 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?
25Delta 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?
26Complex Options Structures
- Path Dependent Options
- Asians
- Combinations Of Options
- Or Combos Of Options
Other Instruments Such As Swaps - Embedded Options
- Building Blocks
27Examples 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
28Decomposing 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
29When 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
30When 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
31When 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
32When 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
33When 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
34Options 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
35Options Pricing Sample
36Options 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
37Options 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
38Options 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
39Options 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
40Options 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
41Options 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.
42Black-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
43Black-ScholesOptions Pricing Model
- Derived From Observation Of Mathematics From
Physical Phenomena (Heat-Exchange Equation) - Widely Used,
Extensively Studied
44Black-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
45Black-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
46Adjusted 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
47Adjusted 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
48Monte Carlo Methodology
- Simulation Of Possible Outcomes
- Probability Assessment
- Various Methodologies
- Computer Resource Intensive
-
- Options Price Simulation Based On Assumptions
Probabilities, Not A Clarivoyant Prediction
49Monte Carlo Methodology
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ruSp
Sp
r2duSp
rdSp
r2d2Sp
50Cox-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
51Likely 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
52Likely Factors Influencing Pricing Of Options
- Terms And Conditions
- How Could One Impact The Price Of An Option
Through Contract Provisions?
53Physical 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
54Writing 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
55Optimizing 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
56Price Distribution
- Lognormal Bell Shaped Curve
- Skew
- Event Risk
- Fat Tails
- Probability
- Degree Of Certainty
57Returns On Basic Options
58Option 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
59Option Pricing
- Theory Aside, The Practical Pricing Issues Can
Sometimes Be A Bit Difficult
60Option Pricing
- Valuation
- Price Discovery
- Timing
- Expertise
- Basis
- Risk Free Interest Rate
61Option Pricing Factors
- Higher The Volatility, The More Expensive The
Option - Longer The Life Of The Option, The More Expensive
The Option
62Historical 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
63Implied 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
64Average 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)
65Average 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
66Delta 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
67Delta Hedging
- Delta-Neutral Maintaining A Risk Neutral
Position (Hedging) - Requires Continual Monitoring And Managing
- Trading Expertise
68Option 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
69Option 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
70Option 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
71Option Value
- Deep In-The-Money
- Deep Out-Of-The-Money
72Selling Uncovered Calls
- Naked Option Sold When The Option Seller Does
Not Own The Underlying Asset - Risk Factor
73Selling Covered Calls
- Option Sold When The Seller Owns The Underlying
Asset - For Example, A Power Generator
Selling Calls On
Capacity - Opportunity Cost
74Options On Spreads
- Price Distribution Is Likely Not Lognormal
- Price Spread Can Be Negative
- Complex Pricing Issues
- Refinery Crack Spreads
- Power Spark Spreads
75Financial 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
76Financial 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?
77Credit 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
78Credit 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
79Using Options
- High Potential Opportunity In Energy Options
- But Potentially Very Dangerous If A Blunder Made
- Numerous Areas
Of Possible Risk
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81Overview of Options An Introduction
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