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1 Return to Risk Limited website: Overview of Options An Introduction

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 (APO s) Path Dependency, Barriers, Look-Backs, KO s 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 Δ V Θ Γ

17 The Greeks - Delta Δ 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 Γ 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 Θ 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 Θ Time Value Decreases At A Faster Rate As Option Expiry Date Is Approached

23 The Greeks Rho ρ 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 Extendables Examples Of Options Structures 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 Brent Crude Oil Options Calls: With $28.99 Exercise Price Current Settlement Price Implied Volatility Open Interest $ % 440 $ % 993 $ % 201

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 Trader s 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-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

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

44 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

45 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

46 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

47 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

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 rus p r 2 u 2 S p Sp r 2 dus p rds p Probability Of Outcomes r 2 d 2 S p

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 Plant s [Or Portfolio s] Option Value Struck At The O&M 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 APO s 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 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

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 Option Were Exercised Easy Valuation If Immediately

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

81 Overview of Options An Introduction

82

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