In this lesson, we're going to talk about some of the more advanced financial derivatives. Now, you'll find some pretty extensive notes in the actual lesson content page, so I'm going to do a summary here with these slides. And the first financial derivative that we're going to talk about is a swap.

Now, a swap is an exchange of payments between two parties. It can be a form of hedging, it can also be used for outright trading, so speculative traders can use swaps to try and make some revenue. These are generally known as over-the-counter. That is, they're not traded on an official exchange, such as NYMEX, but you do find them on electronic platforms, such as NYMEX's clear port or the Intercontinental Exchange. And then, also, swaps can be had by dealing with the so-called Voice Brokers-- literally a broker that you call up and arrange for a swap transaction. Now, these are strictly financial. In most cases, there is no physical commodity involved. You're strictly swapping out price.

Now, there are two pieces in a swap agreement. One is a fixed price and the other is a floating price. So, we refer to swaps as fixed for floating. One party will pay a fixed price at the time that the swap is actually entered into. And the other pays the floating price, and that's the price that is not known at the time. You have to wait till settlement of the respective underlying contract.

Now, we talk about the NYMEX look-alike because it's the most commonly used swap. It's a Henry Hub financial swap, and one party buys or sells at the current market, which would be the fixed or known price, in other words, whatever the NYMEX is currently trading at. And then the counterparty buys or sells, so the opposite party is going to take the opposite position. They'll buy or sell based on the NYMEX settlement. Now, this is your floating price, and it's unknown at the time of the swap transaction. So, in other words, the price floats as we know every day as NYMEX changes.

So, you set a price on the day that you enter into the swap for the specific month and the commodity that you are interested in. And then, in essence, the two counterparties, you and your counterparty, are going to wait until the NYMEX contract settles. And then, you're going to go ahead and true up, see who owes who money. And again, it's financially settled every month.

And then, we've also addressed the basis swaps. Again, there's more detail and specific examples in the lesson content. But really, in the case of a basis swap, we're looking at the current market value.

Now, the current market value you can find on NYMEX's clear port system. Or, if you have access to the Intercontinental Exchange, you will see natural gas basis swaps quotes for the various cash locations that we have reviewed in the publications, such as Platt's. And then, we have to come up with the second part of this, in other words, the floating price. We can fix the price based on the values on those electronic platforms I mentioned. But then, to settle with our counterparty, we have to wait until the settlement of the basis. Now, we know when a NYMEX final settlement occurs, and so we'll have that piece of the basis swaps settlement, but then we're waiting for the cash prices to come out. So, in other words, Platt's has their monthly price guide, or as I noted, it's more commonly known as the Inside FERC postings. So, those are the first-of-month cash prices for the respective location. And when you take the NYMEX settlement, and you find that cash location, that difference becomes what we call actual basis. It is the settlement price for the basis swap for that particular location.

Moving on to the next part of our discussion of advanced financial derivatives, we're talking about spreads. Again, I've got some extensive notes and some examples in the lesson content, but we'll review these concepts here in these slides.

OK, Spread trading itself-- here we're talking about trading-- it's a technique that takes advantage of the relative price movement between futures contracts. Arbitrage, that's a simultaneous purchase and sale of similar or identical commodities in two different markets in hopes of gaining a profit from the price differential. Now again, with spread, we're not dealing so much with price as we are dealing with the price differences. Margin requirements are considerably lower than the requirements on single futures contracts, because again, the exposure is the spread difference-- the difference between the price is not one singular price. So that also makes them less risky than outright futures positions. You're exposed to this movement in the spread, either the spread widens or the spread gets tighter, as opposed to the price of the futures contracts themselves.

Here are some simple rules. This is for trading spreads for speculative purposes. Rule 1 is, if you think spreads are going to narrow, you buy low, and you sell high currently. So, you buy the lower price, and you sell the higher price to set a spread. And then, when the prices do, in fact, narrow based on your expectations, you'll be able to go ahead and liquidate that spread at some profit. Otherwise, if the spreads are expected to widen, you expect the price difference to get greater, you will buy the high contract now and sell the lower of the two.

Different types of spreads-- one is the Inter-market. Now, this is the simultaneous purchase and sale of different, but related, commodities that have a reasonably stable relationship to each other. So, inter-market, keep in mind, inter-market means different commodities, not the same commodity. So, we have some different types of spreads and these are the commonly used terms for these spreads.

We have what's known as a Crack Spread. OK, this would be crude oil versus unleaded or heating oil. Now, if you think back to the lesson on crude refining, you have a process by which you are actually cracking the hydrocarbon molecules and then reforming them into these other products, so that's why you get this name here. Crude being the feedstock, and the refined products being unleaded and heating oil. And all three of these trade on the New York Mercantile Exchange. Therefore, these can be used to hedge the spread that refiners are exposed to.

A Spark Spread, it's natural gas versus electricity. Again, this would pertain strictly to natural gas fired power plants. Heating oil versus gas oil-- again, this one can be broken down into another, so we can use this spread. NYMEX versus ICE. Now, this is on crude oil spreads. Here, we have a situation where we're actually using inter-markets. The markets are the different trading platforms. So, savvy traders can sit there and look at NYMEX prices and Intercontinental Exchange Prices for crude oil, and they can take advantage by buying one and selling another, or selling one and buying another electronically.

And then we have a Frac Spread, and this is not to be confused with fracking, which is a completion method for oil and gas wells. What we're talking about here is, again, if you think back to the lecture on processing, the processing plants take natural gas and convert it to natural gas liquids or the so-called fractions using a fractionation tower. And so, that's where we break down and get the ethane, propane, butane, isobutane, natural gasoline, and condensate. So, since natural gas is the feedstock for a processing plant, and the natural gas liquids are the output from that plant, we can put on a frac spread to hedge those differences.

The other type of spread is Intra-market, and this is also known as an intra-commodity spread. The idea here is we are using the same commodity, but we are trading things like time or location. So, a time spread is the simultaneous purchase and sale of futures contracts on the same commodity for different delivery months. So, for example, we could buy August 2015 natural gas contracts and sell the January 2016 natural gas contracts. This would be a storage spread, because the idea would be we would buy the August contracts, put that gas in the ground in August, and then turn around and sell the January contracts, and take the gas out then. So, that difference in price between August and January represents our storage spread.

Then we also have Locational Spreads. This would be the simultaneous purchase and sale of futures contracts for different locations. So, for instance, in terms of crude, we could use the WTI versus the Brent crude pricing. And for natural gas, we could use Henry Hub versus, say for instance, New York City. And here's an example of an intra-market spread for natural gas. Again, as I've mentioned right here, in this example, we're going to talk about August 2015 versus January 2016 at these respective prices.

So, if you think spread's are going to narrow, in other words, we start up $2.90 versus $3.25, so we have a $0.35 spread, if you think that that spread is going to become less, you're going to buy the low, which is the $2.90 and sell the $3.25, which is the high. And then, if you think spread's is going to widen, that is that the price difference between these two months is going to end up being greater than for $0.35, you're going to sell the lower priced, $2.90, and you'll buy back the $3.25. Now, again, keep in mind this is for speculative trading, trading for pure profit. This is not a hedging type of plan or scenario.

The last advanced financial derivative we're going to talk about are options. And again, I've given you pretty extensive notes and some good examples of what options are and how they're utilized and how they're valued. So, these slides just represent pretty much an overview of the notes from the lesson content. Well actually, we'll talk about the definition, the types of options, some of the terminology, the benefits and risks of using options, what happens when options expire, how options are valued, and then we'll just have a summary of the key learning points.

Options are another type of financial instrument used to manage risk and/or to speculate. An option contract gives the holder the right but not the obligation to buy or sell futures contracts at a specified price at any time in the future prior to the expiration of the option contract. Now keep this in mind, this is an important point. If you're buying an option-- in other words, you're the holder of the option-- you have the right but not the obligation to either buy the underlying contracts or sell them. You do not have to.

Types of options contracts-- there are two types, the Call, and the Put. A Call is an option to buy. In other words within the option, you have a designated commodity and the number of contracts and a specified price. Your option position is long. So, once you buy a call option, since you have the right to buy the contracts, your option position is considered long.

So, many times the holder is short the underlying commodity. In other words, let's say a crude-oil refiner would want to buy a call option for crude-oil contracts, thus having the right to buy the crude-oil contracts at a certain price-- again, not the obligation. So. while their physical position is short, their options position is long.

On the flip side, we have the Put option. This is an option to sell the underlying contracts. Again, the option position here is short. Why? Because they have the right to sell. Many times the holder is long the underlying commodity.

So, for example, a crude-oil producer may want the right to sell their crude or to sell contracts in the financial marketplace at a predetermined price which is stated in their option. So, again, to the extent that they exercise, they have the right to sell. We consider their option position to be short because their physical commodity position is, in fact, long.

The most popular type of option is the Futures option or the Commodity option. It is an exchange-traded option calling for the delivery of futures contracts. However, options can be traded in the over-the-counter market and, at times, can call for physical delivery.

And then note my footnote. Having the options contract means you have the right-- you have contracts or can sell contracts. The Premium, this is the price of the option. The premium value reflects the risk of the underlying commodity, and its value is made up of two components. In other words, this is the price you'll have to pay. Just as in the lesson notes, I talked about car insurance and you have a premium. The premium is what it will cost you to have this type of risk insurance.

And there are two pieces, the Intrinsic and the Extrinsic. When you think of the intrinsic, think of the embedded value. As soon as you execute the option, you're going to have a strike price, and there's going to be a market price or what we call the asset price. So, it's the positive difference between the strike price and the price of the underlying commodity.

So, for example, if you, in your contract, you set a strike price of $52 and the current market is $50, the intrinsic value of that is $2.00. So, we know that the premium would be at least $2.00. At $2.00, the writer or seller of the option you're dealing with isn't going to make any money.

Part two of the premium then is what we call extrinsic, which is the time value of money. So, think about it this way. You enter into an options contract on a particular day, but that particular underlying contract won't expire until some point in time in the future. Well, every single day with market changes in price, volatility, and those types of things as well as the time that gets closer and closer to expiration, the value of that option changes. So, in other words, the premium that the writer of that option would then charge you is going to change every day, and this is reflected in what we know as the Greeks, the theoretical models that calculate the various differences in the extrinsic value.

So, when you have the premium and you know what the intrinsic is, all remaining value other than the intrinsic is the extrinsic, and it consists of the components that we talk about as the Greek values. So, for the example above, if the premium for this particular option of $52 was $2.50, we know, based on the fact that the intrinsic is $2.00, that the extrinsic part of the premium or the time value of that premium is $0.50.

The Strike Price, that's the buy or sell price as detailed in the options contract, also known as the exercise price. Expiration, which again, it's the date by which the outcome of the options contract, whether it's sold, exercised, or just abandoned, has to be determined. Now, the options expire typically one to three days prior to the expiration of the underlying futures contract. So, for natural-gas options, as an example, it's one day prior to the expiration of the underlying contract. And we know that the underlying contract for natural gas on NYMEX expires three working days prior to the first of the month. Therefore natural-gas options expire four working days prior. So, they have to be executed or they just go ahead and settle.

And the Greeks, these are the theoretical values projected from mathematical models that are used to measure the sensitivity of an options price to quantifiable factors. When we refer to the Greeks, we're talking about delta, gamma, theta, vega, and rho. And again, I'm not going to hold you responsible for these, but these are the definitions of the Greeks themselves.

Benefits of an option-- the option premium is a fraction of the cost of the underlying commodity. So, think about the fact that, say again, you're a crude refiner and you want to go out and you need to secure some crude supplies in the future. You could buy the contracts outright or you could buy a call option where you have the right to purchase those at a certain price level if, in fact, you need to exercise it, but it's only costing you the premium upfront. You're not buying the contracts unless the price exceeds your option price and then you want to enter into those contracts.

And because of that, you can potentially control a large number of futures contracts for a relatively small cost. So, you could hold several contracts of crude oil, and rather than buy them outright, you're paying the premium on a call option. This gives you a considerable amount of leverage in the marketplace. Now the option buyer's risk is known and limited to the amount paid for the option premium. So, again, your exposure as someone who buys the option is strictly what you paid. You can't lose any more than the premium.

Now the Risk-- the risk is that these are time-sensitive investments. Basically, the value of the options can tend to deteriorate from the time at which they're exercised until the actual expiration date. Now the Option Seller is the writer of the option. That's the other term we use for them, and they are at risk to unlimited potential losses. If you're buying a call option, you're buying a ceiling price. You will never pay more than the strike price in your agreement. Well, the seller of that option or the writer of that option has that exposure if the price runs right through that.

When options expire, they can expire worthless. In other words, you never executed the option. They can be sold for the intrinsic value if one is in an option-buyer position where the option is purchased for its intrinsic value if one is in an option-seller position. So, in other words, as we talked about the intrinsic value, as the options come up anytime between the time they're executed and the time that it expires, if there's value in that, someone trading options could, in fact, cash that in or settle it and make some money on it, or the option gets exercised sometime before expiration, or it automatically is exercised on expiration.

How do they come up with premiums? Well, options are generally valued using pricing theory and/or pricing models.

One of the more popular models used for option evaluation is the Black Scholes model. Now, some of the large firms that actually buy and sell options or they'll write options, they may have some proprietary models that were developed by some quantitative analysts.

Here is what the inputs look like on a Black Scholes model. 

As an example, one can evaluate an option's value at contract expiration. As previously stated, at expiration, the contract has no time value and one would expect the options value to be solely intrinsic.

So, if you have a model-- and I've put a spreadsheet, Excel spreadsheet, out in Canvas under the lesson resources. It's an example of the Black Scholes model. And these will be the inputs.

The asset price-- that's the current market price. In this scenario, the current market price for crude oil was $50, the desired strike price for the option was $55. So, in this particular case, this would be a call option. The time to expiration-- in the spreadsheet, you enter in the number of days to expiration in the one cell, and it automatically calculates this fraction.

The risk-free rate-- you have to put in an interest rate because the idea is, you are paying the premium at the time that you execute the options contract. So, there's cash sitting out there, which could be drawing interest as an alternative. So, this is your so-called opportunity cost. And then, the volatility-- you're going to get that from the marketplace-- the daily implied volatility.

D1 and D2-- those are deltas. Do not worry about those.

But you can see what it spits out are call values and put values. So, a call value-- it's going to cost you $0.72 to get a $55 call in a $50 market with those other parameters that you've entered into it.

From the put side-- and again, remember, the put allows you to sell at a certain price level. Well, if we look at this, if you want to sell at $55 and the market is $50, well, obviously the intrinsic value is $5. So, at a minimum, it's going to cost you $5. And in this scenario, though, the extrinsic value of it is $0.72 as well.

One could also anticipate the value utilizing basic understandings. The purchaser of a call option is anticipating the price of the underlying security to increase. So, one would expect the call option's value to increase with an increase in commodity prices. If the strike price were higher than the actual commodity price, the option should have little to no value.

So, some of the learning points of these things-- the purchaser of a call option expects the price of the future contract to increase. OK. So, their sentiment or their outlook is that they're bullish on the underlying commodity. If they think prices are going to go up, they would enter into a call option.

The purchaser of a put option expects the price of the future contract to decrease. So, their sentiment is bearish on the underlying commodity. They expect prices to fall. And as a result, they want to establish a floor price. OK.

Options are referred to as being asymmetrical. It's a right, but not an obligation for the buyer of the option.

Options are financial in nature. Delivery of the physicals is relatively rare. And options premium typically moves in concert with an option's valuation. That only makes sense because you're going to put a value on the option and the premium should be the result of those calculations.

At expiration, the time value portion of the premium is equal to zero. So, in other words, on the day of expiration, all you've got left is intrinsic value. What's the strike price in the options contract versus the asset or market value at that time?

And then, options trading is a zero-sum game. We talked about this with the underlying futures and forwards contracts. For every buyer, there's a seller and vise versa. Same thing here-- if you want to buy an option, there has to be a seller in the marketplace.

Options rights and obligations-- so, let's break this down a little bit. In terms of call options, the actual buyer has the right to buy a futures contract at a predetermined price on or before a defined date. They expect prices to rise. They want to establish a ceiling price, a price at which they're guaranteed to purchase the underlying contracts.

The seller, on the other side, they're granting that right to the buyer. So, they have the obligation to sell futures at the predetermined price at the buyer's sole option. In other words, the seller of the option can't call up the buyer and say, hey, I would really like you to go ahead and exercise these. It is up to the buyer.

In terms of a put option, this gives the buyer the right to sell futures contracts at a predetermined price on or before a defined date. Why? Because their expectation is that prices will fall and they want to establish a floor price, a guaranteed minimum price.

The seller then grants the right to the buyer. So, they've got the obligation to potentially have to buy futures at a predetermined price, which is the price stated in the contract, the strike price, at the buyer's sole expectation.

The seller, in this case, they're expecting neutral or rising prices. So, in other words, if they sell a put option, their hope is that the prices don't ever fall. If they stay the same, they're going to collect the premium and they won't have to pay anything out. But if prices rise, the same thing happens as well. They're not going to have to purchase contracts in a falling marketplace.

OK. Again, here is just the determinant of options prices themselves.

If there's an increase in the underlying price, that's going to increase the value of the call and it'll decrease the value of the put. OK. If there's an increase in the strike price, that's going to lower the call value and increase the put value.

If volatility increases, both the value of the call and the put are going to increase. I mean, as you can imagine, if there's volatility in the marketplace, then those models, like the Black Scholes and others, are going to reflect that added volatility. So, the risk or the exposure by the writers of the options is going to increase.

Time to expiration-- the further the time out from the time you enter into the options contract until expiration, both the put value and the call value could also increase. And then, interest rates-- if there's an increase in the interest rate, both the call value and the put value are going to decline.