 The last advanced financial derivative we're going to talk about are options. And again, I've given you pretty extensive notes and some good examples of what options are and how they're utilized and how they're valued. So these slides just represent pretty much an overview of the notes from the lesson content. We'll actually, we'll talk about the definition, the types of options, some of the terminology, the benefits and risks of using options, what happens when options expire, how options are valued, and then we'll just have a summary of the key learning points. Options are another type of financial instrument used to manage risk and or to speculate. An option contract gives the holder the right but not the obligation to buy or sell futures contracts at a specified price at any time in the future prior to the expiration of the option contract. Now, keep this in mind, this is an important point. If you're buying an option, in other words, you're the holder of the option, you have the right but not the obligation to either buy underlying contracts or sell them. You do not have to. Types of options contracts, there's two types, the call and the put. A call is an option to buy. In other words, within the option, you have a designated commodity and the number of contracts and a specified price. Your option position is long. Once you buy a call option, since you have the right to buy the contracts, your option position is considered long. Many times, the holder is short the underlying commodity. In other words, let's say a crude oil refiner would want to buy a call option for crude oil contracts, thus having the right to buy the crude oil contracts at a certain price. Again, not the obligation. So while their physical position is short, their options position is long. On the flip side, we have the put option. This is an option to sell the underlying contracts. Again, the option position here is short. Why? Because they have the right to sell. Many times, the holder is long the underlying commodity. For example, a crude oil producer may want the right to sell their crude or to sell contracts in the financial marketplace at a predetermined price, which is stated in their option. Again, to the extent that they exercise, they have the right to sell. We consider their option position to be short because their physical commodity position is in fact long. The most popular type of option is the futures option or the commodity option. It is exchange traded option calling for the delivery of a futures contracts. However, options can be traded in the over-the-counter market and at times can call for physical delivery. And then note, my footnote, having the options contract means you have the right. You have contracts or can sell contracts. The premium, this is the price of the option. The premium value reflects the risk of the underlying commodity and its value is made up of two components. In other words, this is the price you'll have to pay. Just as in the lesson notes, I talked about car insurance and you have a premium. The premium is what will cost you to have this type of risk insurance. There are two pieces, the intrinsic and the extrinsic. When you think of the intrinsic, think of the embedded value. As soon as you execute the option, you're going to have a strike price and there's going to be a market price or what we call the asset price. So it's the positive difference between the strike price and the price of the underlying commodity. So for example, if in your contract you set a strike price of $52 and the current market is $50, the intrinsic value of that is $2. So we know that the premium would be at least $2. The writer or seller of the option you're dealing with isn't going to make any money. Part two of the premium then is what we call extrinsic, which is the time value of money. So think about it this way, you enter into an options contract on a particular day but that particular underlying contract won't expire until some point in time in the future. Well, every single day with market changes in price, volatility and those types of things as well as the time that gets closer and closer to expiration, the value of that option changes. So in other words, the premium that the writer of that option would then charge you is going to change every day and this is reflected in what we know as the Greeks, the theoretical models that calculate the various differences in the extrinsic value. So when you have the premium and you know what the intrinsic is, all remaining value other than the intrinsic is the extrinsic and it consists of the components that we talk about as the Greek values. So for the example above, if the premium for this particular option of $52 was $2.50, we know based on the fact that the intrinsic is $2 that the extrinsic part of the premium or the time value of that premium is $0.50. Okay, the strike price, that's the buyer-sell price as detailed in the options contract also known as the exercise price. Expiration, which again, it's the date by which the outcome of the options contract, whether it's sold, exercised or just abandoned, has to be determined. Now the options expire typically one to three days prior to the expiration of the underlying futures contract. So for natural gas options as an example, it's one day prior to the expiration of the underlying contract and we know that the underlying contract for natural gas on NIMEX expires three working days prior to the first of the month. Therefore, natural gas options expire for working days prior. So they have to be executed or they just go ahead and settle. And the Greeks, these are the theoretic values projected from mathematical models that are used to measure the sensitivity of an option's price to quantifiable factors. When we refer to the Greeks, we're talking about delta, gamma, theta, vega and rho. And again, I'm not going to hold you responsible for these, but these are the definitions of the Greeks themselves. Benefits of an option, the option premium is a fraction of the cost of the underlying commodity. So think about the fact that let's say, again, you're a crude refiner and you want to go out and you need to secure some crude supplies in the future. You could buy the contracts outright or you could buy a call option where you have the right to purchase those at a certain price level if in fact you need to exercise it. But it's only costing you the premium upfront. You're not buying the contracts unless the price exceeds your option price and then you want to enter into those contracts. And because of that, you can potentially control a large number of futures contracts for relatively small cost. So you could hold several contracts of crude oil and rather buy them outright, you're paying the premium on a call option. This gives you considerable amount of leverage in the marketplace. Now, the option buyer's risk is known and limited to the amount paid for the option premium. So again, your exposure as someone who buys the option is strictly what you paid. You can't lose any more than the premium. Now, the risk is that these are time-sensitive investments. They basically, the value of the options can tend to deteriorate from the time in which they're exercised until the actual expiration date. Now, the option seller is the writer of the option. That's the other term we use for them. And they are at risk to unlimited potential losses. If you're buying a call option, you're buying a ceiling price. You will never pay more than the price, the strike price in your agreement. Well, the seller of that option or the writer of that option has that exposure if the price runs right through that. When options expire, they can expire worthless. In other words, you've never executed the option. They can be sold for the intrinsic value if one is in an option buyer position, or the option is purchased for its intrinsic value if one is an option seller position. So in other words, as we talked about the intrinsic value, as the options come up anytime between the time they're executed and the time that expires, if there's value in that, someone trading options could in fact cash that in or settle it and make some money on it. Or the option gets exercised sometime before expiration or it automatically is exercised on expiration.