At its simplest an energy option is an instrument that gives the buyer the right, but not the obligation, to buy, or to sell, a commodity at a specified price at some point in the future.
More complex options may be financially settled, the payout being dependent on some condition(s) being met, and varying with some observable value(s) at the time of exercise
There is usually a single non-refundable payment made by the buyer of the option (the holder) to the seller of the option (the writer) - this is the option premium
Detail
First, let's try and categorize the different types of options we'll come across, and then describe each in detail, starting with the simplest:
1. Vanilla options - so called because they are a standard "flavour", which may themselves be divided into:
a) Simple physical options - already briefly described above, these include European and American options
b) Financially settled options - these pay out if some measurable, usually a published index, meets some specified criteria. The payout varies with this or other measurables. This category includes Asian options
c) Simple combination options - not strictly different types of options, but traders frequently combine simple options to tailor risk and payout to their circumstances
2. Exotic options - in contrast to vanilla options, exotic options are non-standard, usually complex and are designed to offer, or conceal, a combination of characteristics
The type of the option - which determines the exercise time or period, that is when the buyer of the option may exercise their right
A European option may be exercised at a specific date, specified at time of execution
An American option may be exercised at any time in a date range, specified at time of execution
It also follows that the Option terms must include all terms of the potential Forward Contract, that is deliverylocation, volume and timing
Financial options
Financial options pay out a cash amount if they are in the money - the cash payout usually being the difference between a fixed strike price, and some variable observable, usually the published price of a energycommodity or product
Spread options and options on swaps (swaptions) are types of financial options
Asian options are financial options which pay out on the average price of an underlier over the delivery period - assuming they are in the money