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Overview of Options An Introduction

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Over-The-Counter (OTC) And Physicals Market, Tailored ... At any preferred level OTC. How would you set the strike? Basic Options Provisions - Premium ... – PowerPoint PPT presentation

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Title: 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.

3
Options Markets
  • Over-The-Counter (OTC)
  • And Physicals Market, Tailored
  • Exchange Traded
  • Standardized Terms
  • Style
  • Expiry Dates
  • Strike Levels

4
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

5
Basic Options Structures
  • All option products strategies are some
    combination of buying or selling of calls or puts

6
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

7
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?

8
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

9
Option Exercise Provisions or Style
  • American - Style
  • European - Style
  • Asian - Style
  • Bermudan - Style
  • What is the impact on option value?

10
American-style Exercise Provision
  • Buyer (Holder) may exercise at any time prior to
    expiry
  • Value factor related to dividends on equity
    options

11
European-style Exercise Provision
  • Buyer (Holder) may exercise only on expiry date
  • Valuation difference

12
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

13
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

14
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

15
Volatility Factor
  • Measure Of The Degree Of Change In The Value Of
    The Underlying Asset
  • Historical Volatility
  • Implied Volatility

16
The Greeks
  • Very common jargon in financial trading
  • Delta
  • Vega
  • Gamma
  • Theta

?
V
?
?
17
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

18
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

19
The Greeks - Vega
  • Vega Is Closely Followed By Traders Since Trading
    Options Is Viewed As Trading Volatility

20
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?

21
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

22
The Greeks Theta ?
  • Time Value Decreases At A Faster Rate As Option
    Expiry Date Is Approached

23
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

24
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?

25
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?

26
Complex Options Structures
  • Path Dependent Options
  • Asians
  • Combinations Of Options
  • Or Combos Of Options
    Other Instruments Such As Swaps
  • Embedded Options
  • Building Blocks

27
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

28
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

29
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

30
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

31
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

32
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

33
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

34
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

35
Options Pricing Sample
36
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

37
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

38
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

39
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

40
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

41
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.

42
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

43
Black-ScholesOptions Pricing Model
  • Derived From Observation Of Mathematics From
    Physical Phenomena (Heat-Exchange Equation)
  • Widely Used,
    Extensively Studied

44
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

45
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

46
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

47
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

48
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

49
Monte Carlo Methodology
  • Probability Of Outcomes

r2u2Sp
ruSp
Sp
r2duSp
rdSp
r2d2Sp
50
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

51
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

52
Likely Factors Influencing Pricing Of Options
  • Terms And Conditions
  • How Could One Impact The Price Of An Option
    Through Contract Provisions?

53
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

54
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

55
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

56
Price Distribution
  • Lognormal Bell Shaped Curve
  • Skew
  • Event Risk
  • Fat Tails
  • Probability
  • Degree Of Certainty

57
Returns On Basic Options
58
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

59
Option Pricing
  • Theory Aside, The Practical Pricing Issues Can
    Sometimes Be A Bit Difficult

60
Option Pricing
  • Valuation
  • Price Discovery
  • Timing
  • Expertise
  • Basis
  • Risk Free Interest Rate

61
Option Pricing Factors
  • Higher The Volatility, The More Expensive The
    Option
  • Longer The Life Of The Option, The More Expensive
    The Option

62
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

63
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

64
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)

65
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

66
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

68
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

69
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

71
Option Value
  • Deep In-The-Money
  • Deep Out-Of-The-Money

72
Selling Uncovered Calls
  • Naked Option Sold When The Option Seller Does
    Not Own The Underlying Asset
  • Risk Factor

73
Selling Covered Calls
  • Option Sold When The Seller Owns The Underlying
    Asset
  • For Example, A Power Generator
    Selling Calls On
    Capacity
  • Opportunity Cost

74
Options On Spreads
  • Price Distribution Is Likely Not Lognormal
  • Price Spread Can Be Negative
  • Complex Pricing Issues
  • Refinery Crack Spreads
  • Power Spark Spreads

75
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

76
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?

77
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

78
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

79
Using Options
  • High Potential Opportunity In Energy Options
  • But Potentially Very Dangerous If A Blunder Made
  • Numerous Areas
    Of Possible Risk

80
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81
Overview of Options An Introduction
82
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