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Introduction to Options

Since 1987, the New York Mercantile Exchange has introduced options contracts on all of the Energy Futures. The flexibility of these contracts has ensured their continued success in years to come.

Options Benefits

The value of the options market to both hedgers and speculators can not be understated. For example:

  • Options provide hedgers with the ability to hedge cash and futures positions against adverse price fluctuations, while still allowing for profit on favorable price swings.
  • Options offer the availability of hedging insurance at many different levels of cost and degrees of protection.
  • Options provide a host of complex strategies that can be used alone, or in combination with futures contracts. They can be tailored to fit any risk profile, time horizon, or cost consideration.
  • In contrast to futures, there are no margin calls for option buyers. If the market moves against a position, and a trader holds on to his option, the maximum loss is the amount he paid for the option. Conversely, if the market moves in a traders favor, the unlimited profit potential of an option can ultimately parallel that of a futures position.
  • With the exception of the spot month, futures contracts are subject to limits on daily price movements. However, there are no restrictions on how much fluctuation there can be on an options contract. Therefore, options may be traded during times of extreme volatility when futures contracts are locked limit and unable to trade.

Options Defined

Simply stated, a participant who buys an option is given the right, but not the obligation, to require the seller (writer) to perform according to the provisions stated in the contract. Options are segregated by calls and puts, contract month, and strike price.

Calls and Puts

There are two types of options: calls and puts. Both are traded in the first six months of the underlying futures contract.

  • A call option is a contract that gives the buyer the right but not the obligation to buy a fixed number of futures contracts at a fixed price at any time on or before a fixed date.
  • A put option is a contract that gives the buyer the right but not the obligation to sell a fixed number of futures contracts at a fixed price at any time on or before a fixed date.
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Introduction to the Spread Market

The Concept of Spreading

The purchase or sale of a futures contract is considered to be an outright long or short position. Another strategy known as spread trading is also available to the hedger and speculator. Spread trading involves the simultaneous purchase of one commodity contract against the sale of another related contract. Natural spread opportunities are available in the energy market between different months of the same commodity contract, as well as between different products and grades. Some players confine themselves to trading outright futures and options contracts, leaving the enormous potential of the spread markets untapped. This is primarily due to the misconception that spreads are inherently more complex than outright positions. While there can be additional risk holding both long and short positions in different commodity contracts, it is generally accepted that having a position off-set by an equal but opposite position in another commodity contract should lessen one's risk. This is reflected by the fact that spread positions are less costly to margin than outright positions. The hedger can benefit from the spread market as well. If spread values are closely monitored, they can provide valuable information as to when and where a hedge should be placed.

Types of Spreads

There are four basic types of spreads. Though the most commonly traded is the intramarket spread, they are all consistently played in the oil market.

Intramarket Spreads

This spread consists of a long position in one contract month against a short position in another contract month in the same commodity.

For example: Buy April Crude Oil - Sell May Crude Oil on the NYMEX

Intermarket Spread

These spreads feature similar or related commodities on different exchanges.

For example: Buy April IPE Gas oil -- Sell April NYMEX Heating oil or Buy April IPE Brent -- Sell April NYMEX Crude oil

Strictly interpreted, this definition is confusing when applied to the oil market, because spreads between different commodities on the same exchange are sometimes thought of as intermarket spreads.

Intercommodity Spreads

These spreads are comprised of a long position in one commodity, and a short position in a different but economically related commodity.

For example: Buy April Gasoline -- Sell April Heating oil

Commodity-Product Spreads

This can be defined as the purchase of a commodity against the sale of an equivalent amount of the product derived from it (or vice versa). In the oil market, this is referred to as a "crack spread."

For example: Buy 3 September Crude oil -- Sell 2 September Gasoline + Sell 1 September Heating oil (* Crude oil - dollars per barrel, heat and gas - cents per gallon)

Spreading in Theory

A spread transaction is established in expectation that the differential between contacts will widen or narrow. Each side of the spread is referred to as a "leg." If the trader buys the higher, more valuable leg of the spread, he anticipates that the differential will widen. Conversely, if he sells the higher leg, he believes it will narrow. Whether the trader is long or short the spread depends upon what he has done to the more valuable (premium) leg. This holds true regardless of whether the market is at a carry or a discount.

For example: Assume November Crude oil is trading at $14.00, and December Crude oil is at $14.25. The trader buys the premium leg - December, in belief that the .25 cent spread will widen (while simultaneously selling the November).

As the market gains in strength, November moves to $14.75, and December to $15.50. To calculate the profit or loss, simply examine the profit or loss on each leg, and then the net result. In this example, the trader has lost 75 cents on the short leg- but has made $1.25 on the long leg. The result is a 50 cent net profit. Stated another way, the spread has widened from 25 cents to a 75 cent differential. It is important to note that the movement of the spread value is dependent upon the movement of the individual legs.

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Advanced Options Concepts

Before one can explore the application of various options strategies, one must first be able to analyze the degree of risk they impose. This brochure examines several advanced concepts which must be understood before specific strategies can be discussed.

Risk Analysis of Options

Theoretical Value

Theoretical value and premium are related concepts. The theoretical value of an option is determined by inputs such as time, volatility, interest rates, futures price and strike price. The premium, which is the total price of an option, is determined by supply and demand in the marketplace. It will usually be close to its theoretical value. (see brochure #3)


The delta indicates the rate of change in the options premium in relation to the underlying futures price. Deltas are positive for bullish positions and negative for bearish positions. When an option is deeply "in-the-money", its premium changes at a rate that is approximately equal to the underlying futures price change (delta = 1.0). When an option is "at-the-money", its premium changes at a rate that is approximately one half (delta = .50) of the underlying futures price change. As an option moves further "out-of-the-money", the rate at which its value changes approaches zero (delta = 0.0).


The gamma is sometimes thought of as the "curvature" of an options delta. It is the rate at which an option gains or loses "deltas" as the underlying contract moves up or down. The gamma is shown in deltas per point change in the underlying futures contract.

For example: The crude oil March 20.00 calls have a delta of .34, and a gamma of .23. If crude settled the day with a 1.00 gain, the new delta would be .57 (.34 +.23). If the crude declined 1.00, the delta would be .11 (.34 - .23).

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The Basics of Hedging

Necessity for Hedging

The world oil markets have experienced dramatic volatility in recent years. The consistent supply and demand relationships that pervaded the oil market for decades can no longer be relied upon. Changing economic patterns, military conflict, and the nationalization of crude supplies by Middle Eastern producers, have sent oil prices on a treacherous path. Since 1985, crude prices have moved erratically between $41.15 and $9.60. Some companies whose profitability was dependent upon the value of oil, turned to hedging to offset the risks associated with unpredictable prices. Many of those who declined this opportunity suffered the consequences.

Hedging: The Concept

For those unfamiliar with the term, hedging is simply the transfer of risk from a commercial interest, (anyone who buys or sells physical fuel) to the speculator. The central theory of hedging is that if the price of the actual commodity changes, either up or down, the price of the futures should change an equal amount. A hedge is accomplished when the commercial interest assumes a position in the futures market that is equal in size, but opposite to his cash position. The purpose of this maneuver is to establish a temporary substitute for a cash market transaction that will be made at a future date. The paradox of hedging is that before risk can be minimized, additional risk must be undertaken. The key is that the second risk effectively negates the first. Therefore, a loss in the cash market will be offset by an equivalent profit in the futures. This allows producers, retailers, and consumers to shift their focus away from unpredictable price changes that could have disastrous effects on the profitability of their company. Moreover, while hedging acts as price insurance to the end user, it also helps lock in profit margins for producers and retailers as well.


Even a cursory explanation of hedging would be difficult without discussing the term "basis." Simply stated, basis can be defined as the difference in price between cash and futures. It can be expressed numerically by subtracting the futures from the cash price. Understanding this relationship is an integral part of the hedging process. Hedging would be far simpler if basis relationships always remained the same. Unfortunately, this is not the case. Sometimes futures prices change at a rate that do not exactly coincide with the cash market. Consequently, basis must be closely monitored. While basis risk can make some hedges imperfect, it can also create new opportunities for profit if managed correctly. Basis can be expressed either positively or negatively. The basis is negative, if cash is trading at a discount to futures. It would be regarded as positive if cash were at a premium to futures.

Long vs Short Hedges

Hedging can be approached from two sides -- as a long (buying) hedge, or as a short (selling) hedge. The determination of whether a hedger will sell futures or buy futures is dependent upon his position in the cash market. If a company has the physical fuel in inventory, they would sell (short) the futures in an effort to mitigate a potential loss in the value of that inventory. If they are in need of the physical fuel for delivery or eventual consumption, they would buy (long) the futures to protect themselves from rising prices. Remember, the position taken in the futures market is always opposite to the position in cash.

Practical Examples of Hedging

A strong candidate for a short futures hedge would be a producer, a party to a fixed priced contract, or a holder of physical inventory. One would advocate using this strategy when prices are perceived to be high, and the principal is concerned about protecting his interests in a declining market.

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