fm-principal of trading & hedging with option

8/7/2019 FM-Principal of Trading & Hedging With Option

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Topic

Group 11:- PRINCIPAL OF TRADING & HEDGING WITH OPTIONS

Terminology call, put, writer, buyer, premium, intrinsic value, time value, expiry date,

Settlement date, stock price, ATM, OTM & ITM, The Greeks -(Delta, Gamma, Theta , Vega)

SUBMITTED TO- MOHINA KULKARNI

Presented by-

Name Roll No.

Rohit Gupta 40

Mohsin Khan 41

Ankur Nagwan 42

SHARE MARKET

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A share markets is an open market for fiscal operations such as trading of a firm's

share and derivatives at a fixed cost. These securities are further listed on a stock exchange. A

Share market does not offer any corporeal service and is not a separately owned business entity.

It was in 1875 that the Indian Share Market first started functioning. The first share

trading association in India was known as the Native Share and Stock Broker's Association, only

to become the Bombay Stock Exchange (BSE) later on. This trading association started off its

operations with around 318 members.

Main components of Indian Share Market

Bombay Stock Exchange (BSE)

Bombay Stock Exchange is known to be the oldest stock exchange in the entire Asian

region. If someone wants to know about the history of the India share market, it becomes

synonymous with the history of the Bombay Stock Exchange. It started functioning in 1875 with

the name 'The Native Share and Stock Broker's Association'. Under the Securities Contracts

(Regulation) Act, 1956, the association got its recognition as a stock exchange in 1956. When itstarted, it was just an association of persons but with the recognition it got transferred to a

corporate and demutualised entity.

Trading items in Bombay Stock Exchange

1. Equity or Shares.

2. Derivatives (Futures and Options)

3. Debt Instruments

The main index of BSE is known as the BSE SENSEX or simply SENSEX (Sensitivity

Index). It is an index which comprises of 30 financially sound company scrips, with an option to

be reviewed and modified from time-to-time. The index calculation is based on the 'Free-float

Market Capitalization' methodology. Leading bourses like the Dow-Jones also follow this

methodology. Currently the Sensex is hovering around the 17,000 mark, all expected to touch

20K by 2010. But then volatility has its important role to spoil the entire game.

National Stock Exchange (NSE)

National Stock Exchange (NSE) is considered to be the leader in the stock exchange scenario

in terms of the total volume traded. The market capitalization the National Stock Exchange

touched about $921.31 billion at the end of May 2009. The National Stock Exchange received

the recognition of a stock exchange in July 1993 under Securities Contracts (Regulation) Act,

1956.

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Trading items in National Stock Exchange

1. Equity or Share.

2. Futures (both index and stock).

3. Options (Call and Put).

4. Wholesale Debt Market.

5. Retail Debt Market.

NSE has a fully automated screen based trading system which is known as the NEAT

system. The transactions are carried on with speed, efficiency, and are all transparent. The risk

management system of the National Stock Exchange is world class and can be considered as the

benchmark for other bourses.

The leading index of NSE is known as Nifty 50 or just Nifty. It comprises of 50

diversified benchmark Indian company scrips and is constructed on the basis of weighted

average market capitalization method.

Regulatory Authority of Indian Share Market

SEBI or Securities and Exchange Board of India is the market watchdog and has the

responsibility of protecting the investors' interests, develops regulatory norms and helps in the

development of the securities market in India.

Security market is a board term embracing a number of markets in which securities are

bought and sold. One way in which securities market may be classified is by the type of

securities bought and sold there. The broadest classification is based upon whether the securities

are new issue or are already outstanding and owned by investors. New issue are made available

in the primary markets; securities that are all ready outstanding and owned by the investors are

bought and sold in the secondary market. Another classification is by maturity; Securities with

maturities of one year or less normally trade in the money market; those with maturities of more

than one year are bought and sold in the capital market.

The existence of markets for securities is of advantage to both issuers and investors. As to

their benefit to issuers, securities market assist business and government in raising funds. In a

society with private ownership of the means of production and distribution of goods and services

saving must be directed toward investment in industries where capital is most productive.

Government must also be able to borrow for public improvements. Market mechanisms make

possible the transfer of funds from surplus to deficit sectors, efficiently and at low cost. Investors

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are also benefit from market mechanism. I f investors could not resale the securities readily they

would be hesitant to acquire them and such reluctance would reduce the total quantity of fund

available to finance industry and government. Those who own securities must be assured of a

fast, fair, orderly and peon system of purchase and sale at known prices.

The classification of market we are most interested in is the one that differentiates between

new and old securities the primary and secondary market. In recent years the secondary market

has been further fragmented, creating third and fourth market.

Primary Market

Securities available first time are offered through the primary securities market. The issuer

may be a brand new company or one that has been in business for many years. The securities areoffered may be a new type for the issuer or additional amount of a security used frequently in the

past. The key is that these securities absorb new funds for the coffers of the issuer, whereas in the

secondary market existing securities are simply being transferred between parties and the issuer

not receiving new funds.

After their purchase in the primary market. Securities are traded subsequently in the

secondary Risk is a characteristic feature of all commodity and capital markets. Prices of all

commodities markets. Billions of dollars worth of new securities reach the market each year. The

traditional middlemen in the primary market are called an investment banker. The investment

bankers principle activity is to bring sellers and buyers together thus creating a market Henormally buys the new issue from the issuer to at an agreed upon price and hopes to resale it to

the investing public at a higher price. In this capacity investment, bankers joins to underwrite a

security offering and form what is called an underwriting syndicate. The commission received by

the investment banker in this case is the differential, or spread, between his purchase and resale

price, the risk to the underwriter is that the issue may not attract buyers at a positive differential.

Secondary Markets-The Organized Exchange

Once new issues have been purchased by investors they change hands in the secondary

markets. There are actually two broad segments of the secondary markets. The organize & theover the counter (OTC) market.

The primary middleman in the secondary market is brokers & dealers. The distinction

between the two is important. The technical difference rest upon whether the person acts as an

agent (broker) or as a principal (dealer) in a transaction.

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Organize exchange are physical market places where the agents of buyers & sellers

operate through auction processes. There are number of organize exchange. Two are truly

national market places, & the other is regional or local.

WHAT ARE DERIVATIVES

A derivative instrument, broadly, is a financial contract whose payoff structure is determined

by the value of an underlying commodity, security, interest rate, share price index, exchange rate

oil price and the like. Thus the derivative instrument derives its value from some underlying

variable. A derivative instrument by itself does notconstitue ownership. It is instead a promise to

convey ownership.

All derivatives are based on some cash product. The underlying basis of a derivative

instrument may be any product including

Commodities including grain, coffee, beans, orange, juice etc

Precious metal like gold and silver

Foreign exchange rate

Bonds of different types including medium to long term negotiable debt securities issued

by government companies etc

Short term debt securities such as T-bills; and

Over the counter (OTC) money market products such as loans and deposits...

Derivative are specialized contract which are employed for a variety of purposes including

reduction of funding costs by borrowers enhancing the yield on assets, modifying the payment

structure of assets to correspond to the investors market view. Etc. However the most important

use of derivatives is in transferring market risk called hedging, which protection against losses is

resulting from unforeseen price or volatility changes. Thus derivative is very important tool of

risk management. As awareness about the usefulness of derivatives as a risk management toolhas increased the market for derivatives too has grown. Of late, derivatives have assumed a very

significant place in the field of finance and they seem to be driving global finance markets.

There are many kind of derivatives including futures, options, interest rate swaps, and

mortgage deratives.To understand the nature of future and options let us begin with the idea of

forward and future contract.

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What are Forwards

Farming is a risky venture. A lot of money, time, and effort is needed to produce farm

products, with many risks, such as weather or price fluctuations in the market, which can result

in high or low prices in the spot market (aka cash market), which is the market where the buyer

pays cash to the seller for the immediate delivery of the commodity. Since the farmer can only

sell in the spot market when the product is ready for delivery, there is no way to know

beforehand what the price will be, and the same is true for the buyerboth have price risk.

The spot market is a zero-sum tradeif prices are too high or too low, either the buyer or the

seller profits at the expense of the other. Thus, if grain prices rise, farmers benefit, but millers

suffer because they have to pay higher prices for their grain. If prices fall, then farmers suffer,

but millers benefit. Forward contracts became common in the 1800's to protect both the buyer

and the seller by agreeing to a set price ahead of time.

A forward contract (sometimes called a cash forward sale) is a contract to supply a

commodity at a given date for a specified price. No money is paid until the date of delivery.

Before the organized exchanges, forward contracts were signed where farmers happened to be

selling their goods, such as farmers markets, public squares, and street curbs. But there were 3

main problems with individual forward contracts:

Eventually, organized exchanges developed that solved these basic problems. To lower the

risk of default, the exchanges required that money be deposited with a 3rd party to ensure the

performance of the contract.

The exchanges also standardized the contracts by stipulating the types of contracts that they

would sell, including its terms. Standardized contracts were easier to sell or to offset with

another contract that eliminated the liability of the original contract. Standard specifications

include the amount of the commodity, the grade, and delivery dates. These standard forward

contracts were called futures, and the exchanges developed listings for these contracts that

greatly increased their liquidity.

More recently, futures were created based on assets completely different from agricultural

products, such as stock indexes, interest rates, and even the weather, and provided more

investment opportunities for many more investors. They became great tools to hedge portfolios

or to simply profit from speculation.

The buyers and sellers of futures can be classified as hedgers or speculators. Hedgers use

futures to minimize risk, like the farmers who use futures to guarantee a price for their product,

or a miller who wants a set price for grain when it is harvested. Futures can also be used to hedge

investment portfolios. Thus, futures is a significant means of price risk transfertransferring

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price risk to someone with an opposite risk, or to a speculator who is willing to accept risk to

make a profit

Imagine you are a farmer. You grow 1,000 dozens of mangoes every year. You want to sell

these mangoes to a merchant but are not sure what the price will be when the season comes. You

therefore agree with a merchant to sell all your mangoes for a fixed price for Rs 2 lakhs.

This is a forward contract wherein you are the seller of mangoes forward and the merchant is the

buyer. The price is agreed today in advance and the delivery will take place sometime in the

future

FEATURES OF A FORWARD CONTRACT

The essential features of a forward contract are:

Contract between two par ties (without any exchange between them)

Price decided today

Quantity decided today (can be based on convenience of the parties)

Quality decided today (can be based on convenience of the parties)

Settlement will take place sometime in future (can be based on convenience of the

parties)

No margins are generally payable by any of the par ties to the other

Where are forwards used

Forwards have been used in the commodities market since centuries. Forwards are also

widely used in the foreign exchange market.

What are futures &How are they different from forwards

Futures are similar to forwards in the sense that the price is decided today and the

delivery y will take place in future. But Futures are quoted on a stock exchange. Prices are

available to all those w ho want to buy or sell because the trading takes place on a transparent

computer system.

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What are the features of Futures

The essential features of a Futures contract are:

Contract between two parties through an exchange

Exchange is the legal counterparty to both par ties

Price decided today.

Quantity decided today (quantities have to be in standard denominations specified by the

exchange.

Quality decided today (quality should be as per the specifications decided by the

exchange).

Tick size (i.e. the minimum amount by which the price quoted can change) is decided by

the exchange.

Deliver y will take place sometime in future (expiry date is specified by the exchange)

Margins are payable by both the parties to the exchange.

Who invented Forwards and Futures

It is difficult to say that somebody invented them. Forwards have been used since

centuries especially in commodity trades. Futures are specialized forwards which are supported

by a stock exchange. Futures, as we know them now, were first traded in the USA, in Chicago.

What are the limitations of forwards

Forwards involve counter party risk. In the above example, if the merchant does not buy

the mangoes forRs 2 lakhs when the season comes, what can you do? You can only file a case in

the court, but that is a difficult process. Further, the price of Rs 2 lakhs was negotiated between

you and the merchant. If somebody else wants to buy these mangoes from you, there is no

mechanism of knowing what the right price is.

Thus, the two major limitations of forwards are:

Counter party risk

Price not being transparent

Counter party risk is also referred to as default risk or credit risk.

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How do Futures overcome these difficulties

An exchange (or its clearing corporation) becomes the legal counterparty in case of

futures. Hence, if you buy any futures contract on an exchange, the exchange (or its clearing

corporation) becomes the seller. If the other party (the real seller) does not deliver on the expiry

date, you do not have to worry. The exchange (or its clearing corporation) will guarantee you the

delivery. Further, prices of all Futures quoted on the exchange are known to all players.

Transparency in prices is a big advantage over forwards.

Do Futures suffer from any limitation

Futures suffer from lack of flexibility. Suppose you want to buy 103 shares of Satyam for

a future delivery date of 14February, you cannot buy.

The exchange will have standardized specifications for each contract. Thus, you may findthat you can buy.Satyam futures in lots of 1200 only. You may find that expiry date will be the

last Thursday of every month.

Thus, while forwards can be structured according to the convenience of the trading

parties involved, futures specifications are standardized by the exchange.

What is the meaning of expiry of Futures

Futures contracts will expire on a certain pre-specified date. In India, futures contractsexpire on the last Thursday of every month.

For example, in a February Futures if the last Thursday is a holiday, Futures and Options will

expire on the previous working day. On expiry, all contracts will be compulsorily settled

Settlement can be effected in cash or through delivery.

What does Cash Settlement mean

Cash settlement means that one of the parties will pay the other party the difference incash.

For example; if you bought Sensex Futures for 3350 and the closing price on the last Thursday

was 3360, you will be paid profit of 10 by the exchange. The exchange will collect the 10 from

the party who sold the Futures, because that party would have made a loss of 10. In reality, the

amount would not be 10, because the number of Sensex Units in a contract would be considered.

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One Sensex contract is made up of 50 Units. Therefore, a profit of 10 above would translate into

a profit of Rs 500 (50 Sensex Units x 10).

Thus, Cash Settlement means settlement by payment/receipt in cash of the difference

between the contracted price and the closing price of the underlying on the expiry day. In the

Cash settled system, you can buy and sell Futures on stocks without holding the stocks at any

time.

For example, to buy and sell Futures on Satyam, you do not have to hold Satyam shares.

Therefore assume that contracts will be settled in cash. It is widely expected that we will move to

a physical deliver y system soon. However, Index based Futures and options will continue to be

based on Cash Settlement system.

How is the Value of a Futures Contract worked out & what does Delivery based Settlement

mean

In Deliver y based Settlement, the seller of Futures delivers to the Buyer (through the

exchange) the physical shares, on the expiry day.

For example, if you have bought 1,200 Satyam Futures at Rs 250 each, then you will (on the day

of expiry) get 1,200 Shares of Satyam at the contracted Futures price of Rs 250. It might happen

that on the day of expiry, Satyam was actually quoting at Rs 280. In that case, you would still get

Satyam at Rs 250, effectively generating a profit of Rs 30 for you

What is the Current System in India

Currently in India (as on the date of writing this Work Book), all Futures transactions are

settled in Cash. There is no system of physical delivery.

Contract Value is the price per Futures Unit multiplied by the lot size. The lot size can

also be referred to as the Contract Multiplier. For example, if Sensex Futures are quoting at 3,400

and the Contract Multiplier is 50 Units, the Value of one Futures contract will be Rs 170,000.

What does the Exchange do in Futures

The exchange decides the specifications of each contract. For example, it would decide

that Sensex Futures will have a lot size of 50 units. It would decide that Futures would expire on

the last Thursday of every month, etc. The exchange will also collect Margins from both buyers

and sellers to ensure that trading operates smoothly without defaults. The exchange does not buy

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or sell any shares or index futures or commodities. It does not own any shares. Or index futures

or commodities which might be traded on the exchange. For example, an exchange where gold

fu It is not necessary that trading in commodities also should happen in those exchanges where

commodity futures are traded. For example, an exchange where gold futures are traded might not

allow trading in physical gold at all.

The exchange is supposed to carry out on-line surveillance of the derivatives segment.

Turns are traded might not own any gold at all. Futures are allowed on what underlying.

Currently in India, Futures are allowed on 2 Indices (viz. Sensex and Nifty) and on 31

individual stocks. These individual stocks are carefully selected based on various parameters.

How many month Futures are available at any point of time

Exchanges have currently introduced three series in Futures and Options. For example

during the month of February on any day on or before last Thursday, you will find three Series

available viz. February, March and April. The February Series will expire on the last Thursday of

February. On the next working day, the May Series will open. Thus, on a rolling basis, threeSeries will be made available.

What is the Lot Size for Futures and Options contracts

Lot size differs from stock to stock and index to index. For example, the lot size for

Sensex Futures and Options is 50 units, while the lot size for Satyam Futures and Options is

1,200 units.

When should I buy Futures and when should I sell Futures

Futures can be bought or sold in various circumstances. But the simplest of these circumstancescould be:

Buy Futures when you are Bullish

Sell Futures when you are Bearish

Who decides the price of Futures

Prices of Futures are discovered during trading in the market. For example, who decides the

price of Infosys in the regular cash market? It is discovered based on trading between various

players during market hours. The same logic applies to Futures and Options.

Who are Hedgers

Hedgers are people who are attempting to minimize their risk. If you hold shares and are

nervous that the price of these shares might fall in the short run, you can protect yourself by

selling Futures. If the market actually falls, you will make a loss on the shares, but will make a

profit on the Futures. Thus you will be able to set off your losses with profits.

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When you use some other asset for hedging purposes other than the asset you actually

own, this kind of hedge is called a cross-hedge.

Can Hedging help me to make more profits

No, Hedging is meant for minimizing losses, not maximizing profits. Hedging helps tocreate a more certain outcome, not a better outcome.

How can businessmen use Futures/Forwards

Suppose you are a trader of rice. You expect to buy rice in the next month. But you are

afraid that prices of rice could go up within the next one month. You can use Rice Futures (or

Forwards) by buying Rice Futures (or Forwards) today itself, for delivery in the next month.

Thus you are protecting yourself against price increases in rice. On the other hand, suppose you

are a jeweler and you will be selling some jewelry next month. You are afraid that prices of gold

could fall within the next one month. You can use Gold Futures (or Forwards) by selling Gold

Futures (or Forwards).

Thus, if the price of jewelry and gold falls, you will make a loss on jewelry but make a

profit on Gold Futures (or Forwards) .If you are an importer and you need dollars to pay for your

imports in the next month. You are afraid that dollar will appreciate before that. You should buy

futures/forwards on Dollars. Thus even if the dollar appreciates, you will still be able to get

Dollars at prices decided today. If you are an exporter and you are expecting dollar payments in

the next month. You are afraid that Dollar might depreciate in that period. You can sell

futures/forwards on Dollars. Thus even if the dollar depreciates, you will still be able to get

Dollars converted at the prices decided today

How are Futures prices determined

Prices are determined based on forces of demand and supply and are discovered during trading

hours. Prices of Futures are derived from the price of the underlying. For example, prices of

Satyam Futures will depend upon the price of Satyam in the cash market. You can expect Futures

prices to rise when Satyam price rises and vice-verses of Futures should be equal to Spot Prices

(i.e. Cash market prices) plus Interest (also called Cost of Carry). If this price is not actually

found in the market, arbitrageurs will step in and make profits.

Hedging with Options

Options offer additional flexibility for hedging and investing. Calls can be purchased tocap prices, if the expectation is for rising prices. Conversely, a floor can be established bythe purchase of puts if there is a likelihood of a market decline. Calls and puts can be combined

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in a single strategy to effectively put a collar on prices, limiting the upward and downwardmoves.

Futures contracts have been used to manage cash market price risk for more than acentury. Hedging allows a market participant to lock in prices and margins in advance andreduces the potential for unanticipated loss.

Hedging reduces exposure to price risk by shifting that risk to those with oppositeprofiles or to investors who are willing to accept the risk in exchange for profit opportunity.

Hedging with futures eliminates the risk of fluctuating prices, but also means limiting theopportunity for future profits should prices move favorably.

A hedge involves establishing a position in the futures or options market that is equal andopposite of a position at risk in the physical market. For instance, a metals dealer who holds (islong) 50 ounces of platinum can hedge by selling (going short) platinum futures contract.The principle behind establishing equal and opposite positions in the cash and futures or optionsmarkets is that a loss in one market should offset by a gain in the other market.

Hedges work because cash prices and futures prices tend to move in tandem, convergingas each delivery month contract reaches expiration. Even though the difference between the cashand futures prices may widen or narrow as cash and futures prices fluctuate independently, therisk of an adverse change in this relationship known as basis risk) is generally much less than the

risk of going un hedged and, the larger a group of participants in the market, the greater thelikelihood that the futures. Price will reflect widely held industry consensus on the value of thecommodity.

Because futures are traded on exchanges that are anonymous public auctions with pricesdisplayed for all to see, the markets perform the important function of price discovery. Theprices displayed on the trading floor of the Exchange, and disseminated to information vendorsand news services worldwide, reflect the marketplaces collective valuation of how much buyersare willing to pay and how much sellers are willing to accept.

The purpose of a hedge is to avoid the risk of an adverse market movement resulting inmajor losses. Because the cash and futures markets do not have a perfect relationship, there is nosuch thing as a perfect hedge, so there will almost always be some profit or loss. However, an

imperfect hedge can be a much better alternative than no hedge at all in a potentially volatilemarket.

OPTIONS

Options on futures offer additional flexibility in managing price risk. There are two typesof options, calls and puts. A call gives the holder or buyer of the option the right, but not theobligation, to buy the underlying futures contract at a specific price up to a certain date. A putgives the holder the right, but not the obligation, to sell the underlying futures contract at aspecific price up to a certain date. A call is purchased when the expectation is for rising prices; aput is bought when the expectation is forNeutral or falling prices.

The target price at which a buyer or seller purchases the right to buy or sell the option isthe exercise price or strike price. The buyer pays a premium, or the price of the option, to theseller for the right to hold the option at that strike price.

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An options seller, or writer, incurs an obligation to perform should the option beexercised by the purchaser. The writer of a call incurs an obligation to sell a futures contract andthe writer of a put has an obligation to buy a futures contract.

An option is a wasting asset. The premium declines as time passes. Depending upon themovement of an options price, the buyer will choose one of three alternatives to terminate anoptions position: Exercise the option, liquidate it by selling it back on the Exchange, or let it

expire without market value.

Options give hedgers the ability to protect themselves from adverse price moves whileparticipating in favorable price moves. If the options expire worthless, the only cost is thepremium. Many people think of buying options like buying insurance.

By using options alone, or in combination with futures contracts, strategies can beDevised to cover virtually any risk profile, time horizon, or cost consideration.

Determinants of an Options Premium

In return for the rights they are granted, options buyers pay options sellers a premium.The four major factors affecting the premium are:

Futures price relative to options strike price.

Time remaining before options expiration.

Volatility of underlying futures price.

Interest rates.

As in the futures market, options trading takes place in an open outcry auction market on thefloor of the Exchange. While the value of futures is tied to the underlying cash commoditythrough the delivery process, the value of an option is related to the underlying futures contractthrough the ability to exercise the option.

Options Rights and Obligations

CallBuyer

Has the right to buy a futures contract at a predetermined price on or before a defineddate.

Expectation: Rising prices

Seller Grants right to buyer, so has obligation to sell futures at predetermined price atbuyers sole option.

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Expectation: Neutral or falling prices

PutBuyer

Has right to sell futures contract at a predetermined price on or before a defined date.

Expectation: Falling prices

Seller

Grants right to buyer, so has obligation to buy futures at a predetermined price atbuyers sole option.

Expectation: Neutral or rising prices

Strike Price vs. Futures Price

Strike prices are listed in various increments, depending upon the contract. The mostimportant influence on an options price is the relationship between the underlying futures priceand the options strike price.

Depending upon futures prices relative to a given strike price, an option is said to be at-the-money, in-the-money, or out-of-the-money. An option is at-the-money when the strike priceequals the price of the underlying futures contract.

An option is considered in-the-money when the price of the futures contract is above acalls strike price, or when the futures price is below a puts strike price. An option which is notan in-the-money option has no intrinsic value.

A call is out-of-the-money when the futures price is less than the options strike price.For example, when the March gold futures price is $300 per ounce, the March $310 call grantsthe holder of the options contract the right to buy a March futures contract at $310 even thoughthe market is at $300.

A put is out-of-the-money when the underlying futures price is higher than the putsstrike price, such as when the March futures are $300 and the strike price of the March put is$290.

An options premium will usually equal or exceed whatever intrinsic value the option has,if any. Intrinsic value is the amount by which an option is in-the-money.

Time Value

An options time value is the amount buyers are willing to pay for the option above itsintrinsic value. Out-of-the-money options carry all time premiums since their intrinsic value iszero, as do at-the-money options. As an option becomes deeply in- or out-of-the-money, the timepremium shrinks. As an option approaches expiration, or volatility decreases, time valuedecreases. It is important to note that time value is equal for the same strike and same expirationfor both calls and puts.

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The time value of an option shrinks as the expiration date approaches, all other factors beingequal. The reason is that there is less and less time for a major change in market behavior and adecreasing likelihood that the option will increase in value.

Call/Put Parity

Options prices are linked to futures prices through the exercise feature. If, at the call

options expiration, futures are trading at 100, a 90-call is worth 10, intrinsically thedifference between the futures price and the strike price. This is because the holder of a 90-callcan exercise his option, receive a long futures position at 90, immediately turn around and sellthe futures contract for $1.00, and make 10. This is known as trading at parity. If the call is onlytrading at, say, 5, then a trader can buy 90-calls, exercise them into long futures at 90, sellthem for $1.00 and make a risk-free 5, exclusive of transaction costs; market forces ensure thatan opportunity like this cannot last long.

The option cannot have a negative value, so if the risk does not occur, that is, if futuresprices do not exceed the strike price, the option will be worth zero. An option will not beexercised to buy futures at 90 when the futures can be purchased at 70.

For a put option, the risk is the possibility that the futures price will be below the strikeprice. When this occurs, the option will be worth precisely the difference between the strike priceand the futures price. Since a put gives its holder the right to sell futures, if futures are at 70, theholder of a 90 put could exercise the put into a short futures position at 90 and immediatelybuy it back for 70, making 20, exclusive of transaction costs. At expiration, the put will beworth 20.

If futures prices are not below the strike price, the option will be worth zero. Metalsoptions are automatically exercised if, on expiration day, they are one tick or more in-the-money,unless the holder of the option notifies the Exchange that he wants to abandon them.

Volatility

Volatility is a measure of the amount by which an underlying futures contract is expectedto fluctuate in a given period of time. Markets which move up or down very quickly are highlyvolatile: markets which move up or down only slowly are non-volatile, which is why volatility isan important factor in the pricing of options. As prices fluctuate more widely and frequently, thepremiums for options on futures increase, since the probability of the option attaining intrinsicvalue or moving deeper into the money increases. If market volatility declines, premiums forputs and calls decline correspondingly.

Historical volatility will be calculated from the past movement of commodity futuresprices over a specified time period. Technically, historical volatility is the annual standarddeviation of the changes in the futures price, expressed in percentage terms. Or, to put it anotherway, 50% volatility, for example, means that there is a 68.3% chance (one standard deviation)that, a year from now, prices will be 50% higher or lower.

Historical volatility is useful because it provides a basis for anticipating future volatility,which is what options traders really want to know. Implied volatility is also the most importantaspect of options trading.

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Implied volatility reflects current sentiment of volatility as reflected by todays optionsprice. It is the unknown embedded component in an options premium. Since the past is notnecessarily a good forecaster of the future, at any point in time, implied volatility may be higheror lower than historical volatility.

Implied volatility is the key component to options pricing. It is, in fact, the only unknownin an options pricing model. Given an options market price and knowing the other variables inthe pricing model the futures price, the strike price, the time to expiration, and interest rates

the options pricing model is adjusted to derive the volatility implied by the options price.

Interest Rates

Interest rates have a small bearing on options prices because they represent the profit orcost that could result from an alternate use of the funds used for the premium. The interest rate ofthe 90-day U.S. Treasury bills is often used as a guide. In practice, though, isolating the effect ofinterest rates on futures options premiums is difficult, if not impossible. A change in interestrates influences the net present value calculation of a premium, the cost of buying and storing acommodity, and even the commoditys price. Most of the interest rate effect will already beincorporated in the futures price through the cost of carrying the physical commodity.

Call Option

The purchase of a call option gives the holder the right to buy the stock at a specific strikeprice at or before expiration.

This is a Bullish strategy, meaning you make money as the stock rises. Think of buying

call options the same as buying stock. Let's say you are bullish on ABC company, which iscurrently trading at $60. You think this stock will go up to $80 in 2 months, and it's currentlyAugust. Rather than purchasing the stock, you can purchase call options. Now, let's say forexample, you bought 1 ABC Dec 60 strike call @ $4.00. Your initial cost of investment is $400.

A month later, ABC stock is now at $75 and you decide to lock in your profit. Youexercise your option, meaning you get to buy 100 shares of ABC stock for $60. You then turnaround and sell those 100 shares at market price for $75. This gives you a gross profit of$15/share or $1500. Now, minus your initial cost of investment of $400, your net profit is $1100,not including commission. You just made a 275% return on your $400 investment!!! As long asyou exercise your option above the breakeven point (strike price + initial cost), $64 in ourexample, you would make money.

Compare this to actually buying stock. The purchase of 100 shares of ABC stock at $60will cost you $6000. If you sold at the same price of $75, you made $15/share or $1500. Buthere's the difference, you made a 25% return on your investment. Your initial cost of the stockwas $6000 compared to $400 for the purchase of a call option. That's the beauty of leverage: touse as less money as possible to make as much as possible. Here's another thing, by spending$6000 to purchase the stock, you are exposed to that much risk. If ABC happens to drop to $1,

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you would lose $5999. But, with the call option, the most you would lose is your initial cost, andin this example that would be $400, regardless of how low the stock drops.

Another thing about options is that you do not have to exercise them to make money.You can trade options just like a stock. Call options rise in value when the stock rises. So if youpurchased a call option for $4.00 and now it is worth $5.00 due to a rise in stock price, thismeans you made $100 for every contract you have.

Now, there are definitely more variables associated with buying options. The aboveexample shows how a call option works. Other things to consider when buying options are whichstrike price to pick, which month, time decay, volatility, and the Greeks. All of these topics arediscussed in the members section of the trading community

How Do Call Options Work

Call Options are financial contracts between a buyer and a seller for the purchase of aparticular stock (or whatever other underlying asset it is based on). The seller or "writer" isgiving the Buyer of those Call Options the right to buy his stocks at a fixed price. The buyer or"holder" of these Call Options can now hold on to them, hoping that the stocks will rise in priceover time, before the Call Options contract expires, and then either sell the Call Options on toanother buyer at a higher price orexercise the right vested in the Call Options to buy the stockfrom the seller at the lower agreed price, turning around for a profit by selling those stocks in theopen market.

Call Options Sellers

Clearly, the seller or "writer" of Call Options is expecting his stocks to stay stagnant or togo down. Since the seller expects his stocks to go down, selling Call Options on those stocks

actually results in additional income, offsetting the expected drop in the stocks if he is right. Thishedges the risk of owning those stocks without having to sell the stocks. This is known asa Covered Call.

For instance, you sold a call option on GOOG at the fixed price of $300 when GOOG istrading at $300 and receive a $20 premium. By expiration of those call options, GOOG drops to$280 but your account value remains the same as the loss of $20 is hedged by the $20 premiumthat you received from selling (or known as writing) the call options.Call Options Buyers

The buyer of those Call Options is clearly expecting those same stocks to go up and is

willing to pay a small price to speculate on such a move. This expectation is also captured in thepopular investor sentiment indicator known as Put Call Ratio. Put Call Ratio is the ratio of theamount of put options traded versus call options traded.

For instance, you bought a call option to buy AAPL at the fixed price (known asthe strike price) of $180 when AAPL is trading at $180 per share for $10. By expiration of thosecall options, AAPL rises to $200. Because the call option allows you to buy AAPL at $180, ithas now a value of $20 per share built into it, making a $10 profit ($20 less the $10 premium you

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paid to own the call options). You can now simply sell the call options for that $20 value orexercise your right to buy AAPL at $180 and then sell it in the open market for its present marketprice of $200.

Call Options - Terminology

Strike Price: The price at which you can buy shares of the company no matter how far it has

moved in the future.

Holder: Owners of Call Options. You are the holder of your Call Options.

Writer: Sellers of Call Options. You are a writer when you initiate a position by selling CallOptions. This is called Sell to Open. Learn More About The Types Of Options Orders.

Exercise: To initiate the right to buy the underlying stock at the strike price.

Expiration date: The date by which you must exercise the right to buy shares of the companyor let the Call Options lapse worthless.

In The Money: When the shares of the company is higher than the strike price. Read moreabout In the Money Options.

At The Money: When the shares of the company is the same as the strike price. Read moreabout At the Money Options.

Out Of the Money: When the shares of the company is lower than the strike price, makingthe Call Options worthless upon expiration. Read more about Out Of the Money Options.

Put Options

The purchase of a put option gives the holder the right to sell the stock at a specific strikeprice at or before expiration.

Put options are typically a little more difficult to understand. Unlike buying a call optionwhich is bullish, the purchase of a put option is a Bearish strategy, meaning you make money asthe stock declines. Think of buying puts as shorting stock. Using a similar example, lets say you

are bearish on ABC company, which is currently trading at $80. You think this stock will godown to $50 in 2 months, and it's currently September. Rather than shorting the stock, you canpurchase put options. Now, let's say for example, you bought 1 ABC Jan 80 strike put@ $5.00.You initial cost of investment is $500. Similar to the call option, this is most you can lose if thestock moves against you.

A month later, ABC stock is now at $50 and you decide to lock in your profit. You exerciseyour option, meaning you get to sell 100 shares of ABC stock for $80. Now, you normally wouldnot have these shares in your account. This means you have to buy it back from the market to

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cover the shortage. The good thing is that the stock is now worth $50. This means you get to sell100 shares at $80 and buy it back at $50, giving you a gross profit of $30/share or $3000. Now,minus your initial cost of investment of $500, your net profit is $2500, not includingcommission. You just made a 500% return on your $500 investment!!! As long as you exerciseyour option below the breakeven point (strike price - initial cost), $75 in our example, you wouldmake money.

Similar to calls, buying puts will give you the same buying power and minimal risk that

makes trading options so attractive. And just like calls, puts are under the same variables thataffect options.

ITM, ATM & OTM

These terms stand for in-the-money, at-the-money, and out-of-the-money. All of whichdescribes the relationship between an option strike price to its underlying stock.

Lets start with call options. Describing these terms are pretty dry and straight forward. Using thecurrent stock price of $80, any strike prices that are above the stock price are called OTM calloptions. Its called out-of-the-money because when you exercise, for example, the 85 strikeoption, you would not be making any money. An ATM call option means that the strike andstock price are the same. An ITM call option refers to any strike prices that are below the stockprice. Its called in-the-money because when you exercise, for example, the 75 strike option, youwould make $5: you have the right to buy at $75 and sell at $80

stock price strike price description

75 ITM

$80 80 ATM

85 OTM

Now, lets turn our attention to put options. Using the current stock price of $80, anystrike prices that are below the stock price are called OTM put options. Its called out-of-the-money because when you exercise the 75 strike option, you would not be making any money. AnATM put option means that the strike and stock price are the same. An ITM put option refers toany strike prices that are above the stock price. Its called in-the-money because when youexercise the 85 strike option, you would make $5: you have the right to sell at $85 and buy backat $80.

stock price strike price description

75 OTM

$80 80 ATM

85 ITM

Take some time to understand these terminologies. If you are ever confused, just askyourself "if I exercise my option now, would I be making any money?" If you say yes, then youroption is ITM, if no, then your option is OTM.

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Premium

Premium is how much a particular option is worth. It is made of two main components:intrinsic value and time value.

Premium = intrinsic value + time value

Starting with intrinsic value, it equals to how much an option is in-the-money. Bydefinition, only ITM options will have intrinsic value, and both ATM and OTM will not. If anoption is ITM by $2, then that is the intrinsic value of that option. Intrinsic value is only affectedby price movement; it is immune to time decay. This is an important concept to understand.

The other part is time value. Since options are time dependent, you are paying a portionof the premium to time. Time decays the fastest within the last 30 days. We usually do notrecommend anybody to trade the front (current) month for this reason alone.

Here's an example, if an option costs $5.00 and is ITM by $3.00, then what portion of thepremium is time value. Answer: $2.00.This means of the $5.00 that you paid; only $2.00 of itwill be affected by time decay.

Lets say that your stock does not move at all, the most you can lose from time is $2.00.The other $3.00 is not affected since that is the actual value and is only affected by pricemovement.

If an option costs $5.00 and is OTM, then what portion of the premium is time value.Answer: $5.00. Remember, only ITM options have intrinsic value, by definition. All ATM andOTM options only have time value. This means that the entire $5.00 is exposed to time decay.Lets say that your stock does not move at all, this means you can lose your entire $5.00premium to time decay.

Options Trading Basics - What Stock Options Are

The most important thing to learn before you can even consider Options Trading is

exactly what Stock Options are. In Options Trading, we are not trading the stocks itself. Instead,

we are merely trading the right to own or sell those stocks and these contracts to buy or sell the

underlying stocks are known as stock options. Stock Options are derivative instruments just like

stock futures. Stock Options cost only very little money to buy while allowing you to control the

profits on the underlying stocks as if you owned those stocks! It is very similar to the Option toPurchase you signed when you bought your house. If the price of the stock rallies strongly after

you purchase its stock options, you would make those same profits without buying the stocks at

all! This creates the explosive profits that you read about in Options Trading all the time.

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Options Trading Basics - Call Options

Call Options are stock options that grant you the right, but not the obligation, to buy the

underlying stock at a fixed price in the future. You buy Call Options when you are of the opinion

that the stock is going to rise. If you buy call options with the right to buy the stock at its price

right now, you could turn it around for a good profit should the stock rally because you own the

right to buy it at a lower price! Call options effectively allows you to control those same profitsas if you bought the stock at only a small fraction of the price.

Options Trading Basics - Put Options

Put Options are stock options that grants you the right, but not the obligation, to sell the

underlying stock at a fixed price in the future. You buy Put Options when you are of the opinion

that the stock is going to fall. If you buy put options with the right to sell the stock at its price

right now, you could turn it around for a good profit should the stock fall because you own the

right to sell it at a higher price! Put options effectively allows you to control those same profits

as if you have shorted the stock at only a small fraction of the price without needing any margin.

Options Trading Basics - Risks of Options Trading

Options Trading can be extremely risky in many ways and the biggest reason of all is the

fact that stock options could expireworthless along with all your money put into buying them if

your opinion on the stock is wrong. This is what we call "expiring out of the money". This is

why understanding Options Moneyness is so important to anyone who wish to start Options

Trading.

What Are Option Greeks

The mathematical characteristics of theBlack-Scholes modelare named after the Greek

letters used to represent them in equations. These are known as the Option Greeks. The 5 Option

Greeks measure the sensitivity of the price ofstock optionsin relation to 4 different factors;

Changes in the underlying stock price, interest rate, volatility, time decay.

Option Greeks allow option traders to objectively calculate changes in the value of the

option contracts in their portfolio with changes in the factors that affects the value of stock

options. The ability to mathematically calculate these changes gives option traders the ability

tohedgetheir portfolio or to construct positions with specific risk/reward profiles. This alone

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makes knowing the Option Greeks priceless in options trading.

For the amateur trader, knowing the delta (Greek Symbol ) of your options position is

the most important as it gives you an indication of how your option's value will change with

movements in the underlying stock price - all other variables remaining the same. Knowing your

time decay (theta ) gives you an indication of how much time value your options tradingposition is losing each day - all other variables remaining the s Trading options without an

understanding of the Greeks the essential risk measures and profit/loss guideposts in options

strategies is synonymous to flying a plane without the ability to read instruments on

instruments panel on cockpit.

Unfortunately, many traders not know how to read the Greeks when trading. This puts

them at risk of a fatal error, much like a pilot would experience flying in bad weather without the

benefit of a panel of instruments at his or her disposal.

When taking an option position or setting up an options strategy, there will be risk and

potential reward from the following areas:

Price change

Changes in volatility

Time value decay

If you are an option buyer, then risk resides in a wrong-way price move, a fall in impliedvolatility (IV) and decline in value on the option due to passage of time. A seller of that option,

on the other hand, faces risk with a wrong-way price move in the opposite direction or a rise in

IV, but not from time value decay.

Interest rates, while used in option pricing models, generally dont play a role in typical

strategy designs and outcomes, so they will remain left out of the discussion at this point.

Professionals use the Option Greeks to measure exactly how much they need to hedge their

portfolio and to surgically remove specificrisk factorsfrom their portfolio. The Option Greeks

also enable the measurement of how much risk the portfolio is exposed to, and where that risk

lies (with movements in interest rates or volatility, for example). Having a comprehensive

knowledge of options Greeks is essential to long term success in options trading.

The 5 Option Greeks are:

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Delta (Greek Symbol ) - a measure of an option's sensitivity to changes in the price of the

underlying asset

Gamma (Greek Symbol ) - a measure of delta's sensitivity to changes in the price of the

underlying asset

Vega - a measure of an option's sensitivity to changes in the volatility of the underlying asset

Theta (Greek Symbol ) - a measure of an option's sensitivity to time decay

Rho (Greek Symbol ) - a measure of an option's sensitivity to changes in the risk free

interest rate .

Delta:

Delta for individual options, and position Delta for strategies involving combinations of

positions, are measures of risk from a move of the underlying price. For example, if you buy an

at-the-money call or put, it will have a Delta of approximately 0.5, meaning that if the underlying

stock price moves 1 point, the option price will change by 0.5 points (all other things remaining

the same). If the price moves up, the call will increase by 0.5 points and the put will decrease by

0.5 points. While a 0.5 Delta is for options at-the-money, the range of Delta values will run from

0 to 1.0 (1.0 being a long stock equivalent position) and from -1.0 to 0 for puts.

Vega:

When any position is taken in options, not only is there risk from changes in the underlying but

there is risk from changes in implied volatility. Vega is the measure of that risk. When the

underlying changes, or even if it does not in some cases, implied volatility levels may change.

Whether large or small, any change in the levels of implied volatility will have an impact on

unrealized profit/loss in a strategy. Some strategies are long volatility and others are short

volatility, while some can be constructed to be neutral volatility. For example, a put that is

purchased is long volatility, which means the value increases when volatility increases and falls

when volatility drops (assuming the underlying price remains the same). Conversely, a put that is

sold (naked) is short volatility (the position loses value if the volatility increases). When a

strategy is long volatility, it has a positive position Vega value and when short volatility, its

position Vega is negative. When the volatility risk has been neutralized, position Vega will be

neither positive nor negative.

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Theta

Theta is a measure of the rate of time premium decay and it is always negative (leaving position

Theta aside for now). Anybody who has purchased an option knows what Theta is, since it is one

of the most difficult hurdles to surmount for buyers. As soon as you own an option (a wasting

asset), the clock starts ticking, and with each tick the amount of time value remaining on the

option decreases, other things remaining the same. Owners of these wasting assets take theposition because they believe the underlying stock or futures will make a move quick enough to

put a profit on the option position before the clock has ticked too long. In other words, Delta

beats Theta and the trade can be closed profitably. When Theta beats Delta, the seller of the

option would show gains. This tug of war between Delta and Theta characterizes the experience

of many traders, whether long (purchasers) or short (sellers) of options.

Gamma

Delta measures the change in price of an option resulting from the change in the underlying

price. However, Delta is not a constant. When the underlying moves so does the Delta value on

any option. This rate of change of Delta resulting from movement of the underlying is known as

Gamma. And Gamma is largest for options that are at-the-money, while smallest for those

options that are deepest in- and out-of-the-money. Gammas that get too big are risky for traders,

but they also hold potential for large-size gains. Gammas can get very large as expiration nears,

particularly on the last trading day for near-the-money options.

Rho:

Rho is a risk measure related to changes in interest rates. Since the interest rate risk is generally

of a trivial nature for most strategists (the risk free interest rate does not make large enough

changes in the time frame of most options strategies).

Hedging with Options

Options offer additional flexibility for hedging and investing. Calls can be purchased tocap prices, if the expectation is for rising prices. Conversely, a floor can be established bythe purchase of puts if there is a likelihood of a market decline. Calls and puts can be combinedin a single strategy to effectively put a collar on prices, limiting the upward and downwardmoves.

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Futures contracts have been used to manage cash market price risk for more than acentury. Hedging allows a market participant to lock in prices and margins in advance andreduces the potential for unanticipated loss.

Hedging reduces exposure to price risk by shifting that risk to those with oppositeprofiles or to investors who are willing to accept the risk in exchange for profit opportunity.Hedging with futures eliminates the risk of fluctuating prices, but also means limiting theopportunity for future profits should prices move favorably.

A hedge involves establishing a position in the futures or options market that is equal andopposite of a position at risk in the physical market. For instance, a metals dealer who holds (islong) 50 ounces of platinum can hedge by selling (going short) platinum futures contract.The principle behind establishing equal and opposite positions in the cash and futures or optionsmarkets is that a loss in one market should offset by a gain in the other market.

Hedges work because cash prices and futures prices tend to move in tandem, convergingas each delivery month contract reaches expiration. Even though the difference between the cashand futures prices may widen or narrow as cash and futures prices fluctuate independently, therisk of an adverse change in this relationship known as basis risk) is generally much less than therisk of going un hedged and, the larger a group of participants in the market, the greater thelikelihood that the futures. Price will reflect widely held industry consensus on the value of the

commodity.

Because futures are traded on exchanges that are anonymous public auctions with pricesdisplayed for all to see, the markets perform the important function of price discovery. Theprices displayed on the trading floor of the Exchange, and disseminated to information vendorsand news services worldwide, reflect the marketplaces collective valuation of how much buyersare willing to pay and how much sellers are willing to accept.

The purpose of a hedge is to avoid the risk of an adverse market movement resulting inmajor losses. Because the cash and futures markets do not have a perfect relationship, there is nosuch thing as a perfect hedge, so there will almost always be some profit or loss. However, animperfect hedge can be a much better alternative than no hedge at all in a potentially volatile

market.

PLATT'S FUTURES AND OPTIONS GLOSSARY

Glossary Futures and Options Terminology Category

American optionAn option that may be exercised on any day ahead ofexpiry. These trade on the futures exchanges.

options

ArbitrageThe simultaneous purchase and sale of an instrument intwo separate markets, when the price is out of line.

futures/options/ swaps

Asian option An option that is exercised against an average over aperiod.

Options

At the money option(ATM)

An option with an exercise price at the current marketlevel of the underlying.

Options

BasisThe gap between the active futures price and theimplied forward price of the underlying commodity.

Futures

Basis swap Basis swaps are used to hedge exposure to basis risks, Swaps

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such as locational risk or time exposure risk. Forexample, a natural gas basis swap could be used tohedge a locational price risk: the seller receives fromthe buyer a Nymex settlement value (usually theaverage of the last three days closing prices) plus anegotiated fixed basis, and pays the buyer the publishedindex value of gas sold at a specified location (Source:

Risk Publications)

Black-ScholesOptions pricing theory derived by Fisher Black andMyron Scholes, based on the theory that price volatilityis random around a given trend.

Options

CallThe right, but not the obligation, to buy something, forinstance, a future.

Options

Combination hedgingA risk management strategy that uses a combination ofhedges using different derivative instruments (Source:Risk Publications)

futures/options/swaps

Contracts for difference

This term is used as an alternative to the term swap.

The term is often applied to hedging instruments usedin the UK electricity market, and in the Brent 'CFD'market. (Source: Risk Publications)

Swaps

Covered option An option written against an underlying position Options

Curve-lock swap

Swap which "locks" the counterparty into an existingprice relationship in the forward curve, with the aim ofbenefiting from any shifts in the forward curve e.g.between backwardation and contango (Source: RiskPublications)

Swaps

DeltaThe rate of change of the value of an option withrespect to changes in the price of the underlyingcommodity

options

Diff swaps

Contract to exchange the difference between 1) thedifferential between the price of two products (fixed),and 2) the actual differential over time (floating)(Source: Risk Publications)

Swaps

Double-up swap

This instrument grants the swap provider an option todouble the swap volume before the pricing periodstarts; granting this option, swap users can achieve aswap price which is better than the actual market price.The mechanism by which this is achieved involves

consumers 0,vho are buying fixed) selling a putswaption, or producers (who are selling fixed) selling acall swaption; in either case, the premium earned fromthe sale is used to subsidize the swap price. (Source:Risk Publications)

Swaps

European option Option that can only be exercised on the date of expiry.These typically trade in the OTC markets. For metals,expiry is the third to last day of the month since

Options

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settlement. In crude oil, options expire OTC six daysprior to the 25th of the month or three days before theunderlying future expires.

Exchange-tradedFutures or options that are traded on an exchange suchas NYMEX or IPE, with standard contracts and rules.

futures/options

ExerciseThe conversion of the option into the underlying

commodity

Options

Extendable swap

The extendable swap is constructed on the sameprinciple as the double-up swap , except that instead ofdoubling the swap, the provider has the right to extendthe swap, at the end of the agreed period, for a furtherpredetermined period (Source: Risk Publications)

Swaps

FuturesA forward contract that trades on an organizedexchange allowing traders to take position in themarket at a future date

Futures

GammaThe rate of change in delta per unit change in theunderlying instrument.

Options

Historic volatility

The change in the absolute value of a commodity orinstrument over a certain period, expressed as apercentage of the LOWEST price recorded in thatperiod.


Implied volatility The volatility implied by a certain option price. Options

In the money option(ITM)

An option with an exercise price higher than the currentvalue of the underlying commodity.

options

Index swap

Iin the natural gas market in North America, indexswaps are often used to hedge against location pricerisk (a form of basis risk). The seller receives a fixed,

or otherwise determined, price and pays the buyer thepublished index value for natural gas from a specifiedlocation (Source: Risk Publications)

Swaps

Inter-month spreadSimultaneous purchase and sale of a future in twoseparate trading periods


Long positionA trader buys something, in the hope that its value willgo up


Long-liquidation Selling of a long position futures/options/swaps

Margin swap Refining margin swaps (Source: Risk Publications) Swaps

Margins

A deposit paid on a futures transaction. Initial margin is

paid, followed by top-ups as the position develops.Margins are paid to the exchange. Futures

Naked optionA short option position in which the writer does nothave the underlying commodity

Options

Off-market swap In this type of swap, a premium is built into the swapprice to fund the purchase of options or to allow for therestructuring of a hedge portfolio. Off-market swapsare generally used to restructure or cancel old

Swaps

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swap/hedge deals: essentially, they simulate arefinancing pack-age (Source: Risk Publications)

Options

A system of trading under which the writer of theoption gives someone the right but not the obligation tobuy or sell an underlying commodity, for instance, afutures contract. Options can be over-the-counter orexchange-traded. Because the writer of the option facesmore risk than the buyer, he charges a premium for hisservices.

Options

Out of the money option(OTM)

An option with an exercise prices lower than thecurrent market level of the underlying instrument. Suchan option has no intrinsic value, but has got time value,as price changes in the underlying might bring it backinto the money.

Options

Over the counter (OTC)Bilateral markets in which contracts for futures, optionsand swaps are written on a tailor-made basis.


Participation swap

Similar to a regular swap in that the fixed price payer is

fully protected when prices rise above the agreed(fixed) price, with the difference that the client-participates" in any price decrease. For example, aparticipation swap agreed at a level of $80/mt for highsulfur fuel oil, with a 50% participation, would offerfull protection against prices above $80/mt. But tilebuyer would retain 50% of the savings generated whenprices fell below $80/mt. (Source: Risk Publications)

swaps

PremiumThe price of an option, as determined by an optionspricing model.

Options

Pre-paid swap

By means of a pre-paid swap, the fixed payments that

form one side of the cash-flows generated by a standardswap, and which are normally paid over the life of theswap, arc discounted hack to their net pre-sent valueand paid as an immediate cash sum to one of the swapcounterparties. That counterparty will then makefloating price pay-merits over the life of the swap, justas in a standard swap. Pre-paid swaps are often used asa source of project finance or pre-export financing.(Source: Risk Publications)

Swaps

Profit-takingLong liquidation or short-covering set off by the desireto realize the profits in a position.


PutThe right, but no the obligation, to sell something, forinstance, a future.

Options

Refining margin swaps Swaps that simultaneously hedge the price of theproducts (or output) of a refinery, and the price of thecrude oil feedstock (or input). That is, the products aresold, and the crude is bought, for equivalent for-wardperiods. Refinery margin swaps effectively "lock-in"

Swaps

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the profitability of a refinery. (Source: RiskPublications)

RhoThe rate of change of the value of an option withrespect to the risk-free rate of interest.

Options

Short positionA trader sells something he doesn't have, with a view tobuying it cheaper at a later date.


Short-covering Buying back of short sell positions. futures/options/swaps

SpreadThe difference between two futures contract months (orcontracts for different commodities).

Stop-loss ordersBuy or sell orders put in through a broker, which areautomatically triggered if the price moves above orbelow a certain level.

Futures

Straddle (long)

Simultaneous purchase of a put and a call option withdifferent maturities. This is a bet that volatility willincrease; the rise in the value of one option will offsetthe non-productive premium paid by the other option.

Options

Straddle (short)Simultaneous sale of a put and a call with differentmaturities, with a view that volatility will go down. options

Strangle Buying call and buying put with the same maturity.

Strike price

The price which the buyer of an option decides to lockin. For instance, at $13.00 spot, WTI puts and calls canbe written at strike prices at ...$14.00, $13.50, $13.00,$12.50, 12.00...

Options

SwaptionOption to purchase (call swaption) or sell (putswaption) a swap at some future date. (Source: RiskPublications)

swaps/options

Theta

The rate of change of the value of an option with

respect to time. Options

VegaThe rate of change of the value of an option withrespect to the volatility of the underlying instrument(also sometimes called kappa).

Options

fm-principal of trading & hedging with option

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