The basics of options

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When playing the market, options can be as simple or complex as you desire to make them

by James M. Burr


This month we will discuss the basics of options. You cannot effectively use options tools in your hedging portfolio until you understand how they work. This discussion will focus on how options work, while future articles will delve into how to utilize them as a hedging tool for your business.
An option is a choice. When you purchase an option on a futures contract, you have purchased the ability to choose to turn this option into a futures contract if it is financially feasible. If it does not make economic sense to turn it into a futures contract, you do not have to; you have the ‘option.” The purchase of a ‘put option” is the right to turn the option into a short futures position and the purchase of a ‘call option” is the right to chose to turn the option into a long futures position.

In the first article of this series, we discussed futures and in the second article we discussed swaps. You can trade options on either the futures market or the swap market. An option on a futures contract will be executed and cleared on an exchange such as the New York Mercantile Exchange, while an option on a swap contract will be privately negotiated. However, some swaps and options on swaps are now cleared through the exchange. Options on a swap (referred to as swaptions) will be based on an index and have a settlement style that is agreed to by both parties.


Settlement styles
There are three basic settlement styles for options: American, European and Asian.

American:
An American-style settlement is the type used on the NYMEX option contract. This means that at any time the NYMEX is open and trading, you can liquidate your option at the current value for that time frame. An example would be on Nov. 1 you bought one January NYMEX heating oil call option with a strike price of $1.50 and paid a premium of 5 cents per gallon. This trade can be liquidated on any day that the NYMEX is open and trading at the then-current value for January heating oil calls with a strike price of $1.50 per gallon.
European:
A European-style settlement is one in which the original transaction specified an exact date on which the trade will be liquidated. An example would be on Nov. 1 you bought one January Gulf Coast low-sulfur heating oil call option with a strike price of $1.50 and paid a premium of 5 cents per gallon, European settle, with a settlement date of Dec. 15, based on the average Platts reported price for that day.
Asian:
An Asian-style settlement is the most common style used with swaps and options on swaps. An Asian style settlement means that the settlement price will be the average index price agreed to in the contract during a time frame agreed to by both parties and specified in the contract. An example would be on Nov. 1 you bought one January Gulf Coast low-sulfur heating oil call option with a strike price of $1.50 and paid a premium of 5 cents per gallon, Asian settle, with a settlement period of the calendar month of January, based on the monthly average of the daily average price as reported by Platts.

Premium
Premium is the amount that the option buyer pays the option seller for the price protection the option provides.

There are several factors that make up the price the premium trades at, but the two primary ingredients are time and volatility. Continuing with the insurance analogy, if you want to insure your house for one year, it would cost more than if you wanted to insure it for one month because you are allowing for more time that it could burn down or be damaged. If you attempted to buy homeowner’s insurance on your home during an earthquake, undoubtedly the premium would be high.

This is what has happened to the premium cost on options in the energy sector recently. As the market volatility has increased, and prices have soared to record highs, the premium cost of options has greatly increased.


Buyers/sellers/puts/calls
There are four basic types of options: long puts, short puts, long calls and short calls.

Buyers and sellers:
The buyer of an option can be thought of as a buyer of price insurance. The option buyer pays the premium and can never lose more than this premium amount paid for the option and has unlimited gain potential on this long option trade.

The seller of an option can be thought of as the seller of an insurance policy. The seller collects the premium and this premium amount is the maximum that the seller can make on the transaction while the loss potential for the seller is unlimited. If the event happens that lets the insurance buyer collect on his policy, the insurance seller must pay. While the option buyer has limited risk (the premium amount) and unlimited gain potential, the seller of the option has the reverse position, limited gain (the premium amount) and unlimited risk potential. The long and short positions are mirror images of each other.
Calls and puts:
The buyer of a call option pays a premium and gains if prices move higher and the seller of call options has a gain that is limited to the premium collected, so the seller of a call option wants the market to trade sideways to lower.

The buyer of a put option pays a premium and gains if prices move lower and the seller of put options has a gain that is limited to the premium collected, so the seller of a put option wants the market to trade sideways to higher.

Strike price
The strike price is the level at which the option buyer is protected. On the NYMEX, heating oil and gasoline trade in strike prices set in one-cent increments, i.e. $1.40, $1.41, $1.42, etc. When you trade options on swaps, the strike price is set in exact prices, for example, $1.4127 per gallon.

The strike price that is closest to the current price of the underlying commodity is referred to as ‘at-the-money” (ATM). If the July heating oil futures were trading at $1.4235, the ATM strike price would be $1.42. If you wanted to buy a call option, but wanted to assume some risk in return for a less expensive option premium, you would buy a call option with a strike price above the current market. For example, if the current price of July heating oil was $1.4235 and a $1.42 call cost 6 cents, a $1.50 call might only cost 2 cents per gallon. In this example, the call buyer was willing to assume the first 8 cents move higher in the market in return for 4 cents cheaper cost of protection.

The subject of options is a big one to tackle in a few pages. Options can be as simple or as complex as you desire to make them. Next month we will discuss the basics of hedging and why you should be have a hedging program in place.


James M. Burr is the vice president of FCStone. You can reach him at (816) 457-6217.

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