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Understanding Options

In this issue we provide an introduction to option agreements, reviewing the characteristics of options and how they are used in the energy commodity markets. From an energy commodity perspective, an option is an agreement in which the buyer acquires the right, but not the obligation, from the seller to buy (in the case of a call option) or sell (in the case of a put option) a defined amount of a commodity (either physically or financially) at an agreed-upon price (called the strike price) during a defined period of time, on (or in some cases before) a specific date (called the exercise date or the expiration date) in exchange for a defined up-front payment (the premium). There’s a lot going on in this definition, so let’s take a closer look at each piece of the definition.

Let’s start with a simple example to illustrate the basic mechanics. Assume our trader buys the right to buy 10,000 MMBtu/day for the month of October 2012 at a defined location in exchange for $2.50. Our trader can require that her counterparty deliver this volume at a price of $2.50/MMBtu. Conversely, if our trader decides, for whatever reason, that she doesn’t want to receive the 10,000 MMBtu/day, she can simply choose not to exercise. In other words, the trader has the “option” to require performance. This optionality in our definition is covered by the “acquires the right, but not the obligation” phrase. This is what makes an option such a powerful risk management instrument. Since the buyer of the option can choose whether or not to exercise, an option agreement can only provide a benefit to the buyer. For example, assume our trader purchases an option in which she will receive the NYMEX LD1 settle price (on volume of 10,000/day for October 2012) in exchange for a strike price of $3.00. In this situation, if the option is …

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