858 Options

Two classes of options are increasingly used in the energy trade. Exchange-traded options and OTC options, traded outside the regulated exchanges, both exist. The buyer of an option has the right, but not the obligation, to buy or sell an underlying commodity at a fixed price, called the strike price. All options have expiration dates that define the time in which this right can be exercised. A put is an option to sell a commodity at the strike price. The buyer of a put option has the right to sell the underlying commodity. The seller of a put option must stand ready to buy the underlying commodity. A call is an option to buy a commodity at the strike price. The buyer of a call option has the right to buy the underlying commodity. The seller of a call option must stand ready to sell the underlying commodity.

OTC options offer a distinct advantage over forwards, futures, and swaps in that the need to arrange back-to-back transactions is eliminated. There is no need to match buyer or seller. This offers a particular advantage to producers and consumers because there is little chance of doing back-to-back transactions due to mismatched cash flow of the market makers. This greater flexibility makes OTC options easier to market than the other instruments.

While options have an upfront cost or premium, these costs can often be built into the transaction when it is used for longer-term project finance. Longer-term options can range in length from one to five years. Most option deals are written for three years or less, however. Options can be used to set floor prices for producers, making them ideally suited to long-term project finance since they lock in cash flow.

Options premiums have two components: intrinsic value and time value. Intrinsic value is the difference between the strike price and the price of the underlying commodity. It cannot be less than zero. A put has positive intrinsic value, or is "in the money," when the market price is less than the strike price — exercise will be profitable. It is "at the money" when the market price equals the strike price. It is "out of the money" when the market price is greater than the strike price. A call is in the money when the market price is greater than the strike price. It is at the money when the market price equals the strike price. It is out of the money when the market price is less than the strike price.

Time value is a function of time to expiration and the volatility of the price of the underlying commodity. The value of an option declines each day until expiration because as time to expiration diminishes, the probability of the option expiring in the money also diminishes. Greater volatility will increase the price of an option because it increases the probability that the option will expire in the money. Volatility is a measure of how much prices fluctuate. Past volatility can be measured and used as a gauge, but future volatility cannot be predicted with certainty. However, if the market is operating efficiently, the prices of active, at-the-money options can be considered fair. Because the strike price, the price of the underlying commodity, and the time to expiration are known, an implied volatility value can be derived from the price of the option. Market sentiment will affect how the actual price of the option compares to the theoretical price: the expectations of the buyers and sellers will make some options relatively more valuable than others.

As a rule, the less liquid the commodity, the higher the options premium because the seller is assuming more risk. Energy options prices are very volatile, reflecting the nature of the underlying energy markets. Options volatility comes in when there is more certainty in the energy markets. Because of this high price volatility, options would help to smooth some of the erratic price movements that occur with pricing due to seasonality and unexpected events in energy markets. In structuring longer-term risk management agreements, options are used to reduce risk and smooth volatility for energy producers and users.

Options portfolios require active management to adjust to changing market conditions. Options can also be used to structure indexed deals, which should gain popularity in coming years. Indexed deals are transactions that use an agreed-upon index such as in-trade publications, McGraw-Hill's Power Markets Week, NYMEX, Dow Jones' COB Index, or any other agreed-upon index.

The dynamism of options can be illustrated by a trading technique called stacking and rolling. In this strategy, a portfolio manager buys options to hedge a swap agreement as far forward as possible, usually 6 months to 3 years, and then rolls over the hedge each month to adjust the portfolio. Options can be bought on a daily basis for shorter-term deals to further fine-tune the portfolio. Sophisticated computer software for modeling options pricing is employed to optimize the series of transactions. This constant management factor, with its additional transaction costs, makes stacking and rolling with OTC options more expensive than hedging with futures, but costs often can be embedded in the deal. If not properly managed, this strategy can lead to disastrous results, as was evidenced by the Metallgesellschaft oil trading fiasco in December 1993.

Solar Stirling Engine Basics Explained

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The solar Stirling engine is progressively becoming a viable alternative to solar panels for its higher efficiency. Stirling engines might be the best way to harvest the power provided by the sun. This is an easy-to-understand explanation of how Stirling engines work, the different types, and why they are more efficient than steam engines.

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