Python Model for Call Options on Crude Oil - Intrinsic & Extrinsic Values
Modelling and Interpretation for Crude Oil Option Contracts
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What Are the Options Contracts?
An option is a contract between two parties: an option seller and an option buyer.
The option buyer pays a fee (the premium) to the option seller. In return, the option buyer receives the right to purchase or sell an asset (like crude oil) at a specific price. This price is called the strike price.
Every option has an expiration date on which it ceases to exist. The option buyer must decide whether to exercise the option before this date passes.
What Is Crude Oil?
Crude oil is unrefined petroleum extracted from the ground. It’s a fossil fuel formed over millions of years from the remains of ancient marine organisms. Crude oil isn’t useful in itself. Refineries process it into products that are useful: gasoline, diesel, jet fuel, heating oil, and plastics.
Crude oil is one of the most actively traded commodities in the world. Its price affects everything from transportation costs to electricity bills.
The Option Premium
The price at which an option is traded is called ‘option premium’. Let’s say a company that has refineries wants to buy an option on crude oil. And it pays $8.74/barrel to buy this option.
It is an American Call option on 1000 barrels of crude oil, at strike price of $70/barrel. This means that the company can exercise the option at any time before it expires, and will buy 1000 barrels of crude oil at $70/barrel.
The Option Intrinsic Value
So the company exercises the option and buys the crude oil for $70/barrel. Let’s say the spot price of crude oil is $78.5/barrel. This means that the company can immediately sell the crude oil it just bought to the spot market for $78.5/barrel, making a profit of $8.5/barrel. This immediate profit is called the Intrinsic Value of the option.
Intrinsic Value = Spot Price of Crude oil - Strike Price of Option = $78.5/barrel - $70/barrel= $8.5/barrel.
However, the company paid $8.74/barrel to buy this option. So overall, it has a negative profit if we consider also the amount it paid to buy the option.
