 We'll now take a look at another financial energy derivative that is options contracts specifically as they relate to energy trading. We'll define what options are, the types of options, some of the major terms, the benefits and risks of using options, what happens to options at expiration, how are options valued, and then just a summary of some of the key learning points relative to options themselves. By definition, options are another type of financial instrument used to manage risk and or speculate. An option contract gives the holder of the option contract 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. I want to stress again that the buyer of an option contract has the right but not the obligation, similar to what I mentioned about car insurance. You pay a premium, if you don't have an accident and the year goes by, you're strictly at the premium, you don't have to call the insurance company and make some type of a claim. It's your right to do that but you have no obligation to do so. Types of contracts, we have calls and we have puts. In a call option, the buyer has the option to buy futures contracts, therefore we say that their options position is long because the contract they have gives them the right to purchase futures contracts. So they are long the financial contracts. So a lot of these times the holder is short the underlying commodity. A good example of a purchaser of a call option would be a crude refiner. They may be concerned about rising prices for crude oil and therefore they may enter into a call option whereby they have the right to buy contracts in the future at some set price. Conversely, a put option gives the buyer the option, the right to sell futures contracts at some point in time. The options position is considered to be short and many times the holder is long the underlying commodity. That is, for example, we could use a crude producer. Crude producers want to guarantee themselves a market in the future. They may be concerned about falling prices. If they purchase a put option, they're given the right to sell futures contracts against their production in the future at some known price. The most popular type of option is the futures option, commodity option. It is exchange traded option calling for the delivery of a futures contract. However, options are also traded in the over the counter market and some of those can call for physical delivery. Options types, we have calls and puts. The commodity is listed in the contract. The date, that is the particular month for the futures contracts. The strike price, that is the greed upon price, the exercise price that the holder or buyer of the options has in there, and then the premium. That's the amount paid to the seller of the option for the contract. The premium, that's the price of the option. The premium value reflects the risk of the underlying commodity, its value is made up of two components. The first component is what is known as the intrinsic value. It's the positive difference between the strike price and the current price of the underlying commodity. So, if a crude refiner purchased a call option for the month of October at $95 and the current market was at $98, the intrinsic value would be $3. Time value, all other remaining value than the intrinsic, consists of several components we refer to these as the Greeks, these are the analytics that make up the other portion of the premium. The strike price is the buy or sell price as detailed in the options contract, it's also known as the exercise price. The expiration, it's the date by which the outcome of the option contract, whether it's sold, exercised, or abandoned, must be determined. It is typically one to three days prior to the expiration of the underlying futures contract. For example, the New York Mercantile Exchange natural gas contract, options expire one day to the expiration of the contract itself, which is three business days prior to the first of the month. Again, the Greeks, these are just theoretical values, they're projected from mathematical models and they're used to measure the sensitivity of an option's price to quantifiable factors. The Greeks are delta, gamma, theta, vega, and rho, and each one of them represents a different portion of the option's value. An option's premium is a fraction of the cost of the underlying commodity that potentially gives you control of a large number of futures contracts for relatively small price. Take for instance the crude refiner, they could go out and buy contracts outright for the month of February, excuse me, for the month of October. They would have to pay the entire sum total within two days of the value of the contracts that they purchased, or they could turn around and purchase a call option at a premium price per contract that would be considerably less cash out late to do that than to do the other. This allows them to go out and potentially purchase or have the potential to purchase several times the amount of contracts that they otherwise could afford to do, and this does give them leverage in the futures markets. The options buyer's risk is known, it's limited to the amount paid for the option premium. Again, looking at car insurance, you're going to pay a set premium every year, your exposure is no more than that. If you have an accident and you call your insurance company, the most that you're exposed for is your deductible, which is basically your strike price. If you don't have an accident, all you're out is the premium you paid for that particular year. In the case of options buyer's, the same thing applies. They know what the premium is, they pay that premium and that is their maximum exposure. The risk involved with options, it's a time sensitive investment. As the options expiration gets closer and closer, the value of the options tends to decrease. The further out an option is, the higher the value and premium for the option. The options seller, also known as the writer of the options, they are at risk for unlimited potential losses. What they want to be able to do is to collect the premium from the options purchasers and never have to have to go out and cover those options. Again, much like your insurance company, they just want to collect the premiums, they don't want you to have an accident and they don't want to have to pay out claims. Here are three options that can occur for options at expiration. If you will, the option can expire worthless. If it's never executed by the buyer, then the options will just expire worthless. If you're trading options, the option can be sold for intrinsic value if there still is intrinsic value left come expiration day. So it's sold for its intrinsic value if one is in an option buyer position or the option is purchased for its intrinsic value if one is in a seller or writer position. More than likely the option could be exercised by the buyer of the option. If the price, the strike price is exceeded, then the options buyer will go ahead and exercise the option. Options are generally valued using pricing theory and or pricing models. The most popular model and the most well known for options valuation is the Black Shoals model. Here's an example of the Black Shoals model. You can evaluate the options value at contract expiration and as previously stated at expiration the contract has no more time value and won't expect the options value to be solely the intrinsic value. Here are the inputs to the Black Shoals model. You need the asset price, which is the current market price of the commodity. A strike price, in this case $2.00. Time to expiration, this is a fractional percentage of 365 days. So whatever days are remaining until the expiration of the option divided by 365 gives you the fractional input for this. The risk-free rate, this is the interest rate whereby if the cash was not deployed to purchase options it could be used. This is your so-called opportunity cost and we calculate that as an interest rate. And then volatility, the volatility of the commodity is extremely important because as we've talked about before, volatility not only represents the magnitude of change in price but also the speed with which prices change. The D1 and D2 are the delta figures but you can see here then for a $2.30 market someone wishing to buy a call option at $2 would be paying $0.32. $0.30 of that obviously is the intrinsic value and the remaining $0.02 represents time value. Conversely in a $2.30 market a $2.00 put would be fairly inexpensive in this case it's only $0.02. One can also anticipate the value utilizing just basic understandings. The purchaser of a call option is anticipating the price of the underlying security to increase. They're worried about higher prices and they want to establish a ceiling price. So one would expect the call option's value to increase within the increase in the commodity price. If the strike price were higher than the actual commodity price the option should have little to no value. So to kind of summarize here the purchaser of a call option expects the price of the futures contracts to increase. That means their sentiment is bullish on the underlying commodity. The purchaser of a put option expects the price of the futures contract to decrease so they are said to be bearish on the underlying commodity. Options are referred to as being asymmetrical. It is a right but not an obligation. Options are financial in nature delivery of physicals is relatively rare. An options premium typically moves in concert with an options valuation. At expiration the time value portion of the premium is equal to zero and options trading is a zero sum game for every buyer of an option there has to be a seller or writer of an option out there. And finally a quick cheat sheet here so that you can understand the calls and puts and the positions that the buyers and sellers have under each of these respective options contracts.