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
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
Let's look at the simpler types in more detail
Simple physical options
Simple physical options may be thought of as an option to execute a Forward Contract. Indeed, if the option is exercised it effectively becomes a Forward Contract
When the option is traded the following terms are agreed:
  • Whether the option buyer has the right to sell the commodity or buy it - that is whether the Forward would be a buy or sell:
    • An option to buy is a call option
    • An option to sell is a put option 
  • The price that the commodity will be bought or sold at - the strike price of the Forward Contract
  • 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 delivery location, 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 energy commodity 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


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