How Put Options Work in Energy Trading

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How Put Options Work in Energy Trading

The volatility in the energy markets means you should seek ways to protect your budget. Put options offer a solution, and while it might sound complex at first the core concept is rather straightforward.

The building blocks

Here is a break-down of the key elements using oil trading as an example:

Strike Price: This is the price at which you can sell. If you buy a put option with a $80 per barrel strike price, you have the right to sell oil at $80 per barrel, regardless of how low market prices go.

Premium: This is what you pay for the put option. Say the premium is $1 per barrel – that’s your maximum possible loss. It’s like an insurance premium: you pay it whether you use the insurance or not.

Expiry Date: Put options have an expiry date. You might buy a three-month put option, meaning you have the right to sell at your strike price at any time during those three months.

How it works in practice

Suppose you’re trading oil and the current prices are $85 per barrel. You’re worried prices might fall, so you buy a put option:

Strike price: $80 per barrel
Premium: $1 per barrel
Duration: Three months

If prices drop to $75 per barrel, your put option lets you sell at $80 per barrel instead. If prices rise to $90 per barrel, you can let the option expire and sell at market price.