Fundamentals of Energy Options & Option Hedging
This course follows on from the Fundamentals of Energy Trading & Hedging program, extending the hedge strategies to include options and options-based structures.
CPE Credits: Accounting & Auditing 1; Consulting Services 0; Management 1; Specialized Knowledge & Applications 12: Total=14.
Day 1
Review of Basic Risk Concepts in Energy

Key Concepts and Definitions

• Identifying directional price risk positions
• Indifference between physical and Index cash flows
• Physical supply risk and its impact on forward pricing
• Defining the price curve
• Symmetrical vs. asymmetrical risks

Fundamentals of Energy Options

Following a review of the fundamentals of option structures and pricing, the program takes participants into the world of option structures being used today. It explores opportunities that can be developed using creative combinations of option and swap structures. Participants will also explore the economic values associated with options, a critical tool for their future understanding of risk management structures.

Fundamentals of Options

• Option as an asymmetrical payout
• Option structures and payouts
• Option terminology
• Intrinsic and time (extrinsic) value
• Identifying embedded options

Timing of Exercise

• European vs. American options
• Variations in American-style energy options
• Embedded financial storage in certain American options

Basics of Pricing Energy Options


Option Pricing Basics

• Concept of an option premium
• Influence of the price curve
• Time value and time decay
• How energy options differ from financial product options
• Understanding volatility

Option Premium Arbitrage

• Put-call parity
• Creating synthetic puts and calls
• Arbitrage conditions for option premiums
• Using parity concepts in structuring and risk analysis
• Structure of option time value
• Volatility smiles
• Positive and negative volatility skews
• Term structure of implied volatility


Hedging Energy Risks with Options

Buying Options to Hedge Energy Risk Position

• Hedging a buyer with a call
• Hedging a seller with a put
• Options as insurance
• Option vs. fixed-price hedging strategies
• Physical vs. financial settlement
• Risk-reward trade off
• Identifying options embedded in physical transactions

Cost Improvement / Revenue Enhancement from Selling Options

• Covered vs. naked options
• Cost structure after selling options

Option Packaging

• Option strips
• Calls strips as a synthetic generator
• Costless collars
Day 2
Workshop: 4-C Fertilizer

Seminar participants will be divided into project teams, each assigned a detailed case study of a company with energy risk management needs. The teams will be required to apply option risk management concepts and analytics to solve the company’s problems. The case study provides a realistic corporate management context through which the marketing of energy derivatives can be better understood.

Structuring Option Hedges


Combined Option Structures

• Call spreads & put spreads
• Engineering zero-premium hedges
• Costless collar variation
• 3-way collars: selling the spread/buying the spread
• Participatory Structures

Options on Term Contracts

• Compared against strips
• Call swaption
• Put swaption

Swaption Structures

• Option embedded in cancelable/extendible contracts
• Embedding a swaption to create a cancelable/extendible contract
• Reducing energy costs with an embedded option
• “Blend & Extend” Swaptions

‘Exotic’ Optionality

• Defining ‘Exotic’ Options
• How standard European options ‘overhedge’
• Option structures that avoid overhedging

Path Dependent Options

• American options exercise into futures
• American options exercise into current period energy
• Asian options
• Comparing pricing of an Asian and European option

Barrier Options

• Most common barriers: knock-outs & knock-ins
• Reducing hedging cost using barrier options
• Barrier option pricing parity
• Pricing barriers using Monte Carlo simulations

Spread Options

• The right to buy or sell a spread
• Spread option pricing depends on assumed correlation
• Rainbow/chooser options as spread options
• Rainbow options common in the energy business
• Spark spread options inherent in cycling generation
• Monetizing optionality in generation
• Dispatch options
• Basket options


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