Strangles
Assume a utility, having just updated its compliance plan, projects that it will be able
to meet compliance requirements for several years out into the future. The utility does
not have a need to go into the market to purchase allowances to meet compliance
targets, and it does not anticipate having excess allowances to sell. Nonetheless, the
utility's projections can change over time if, for example, it experiences an abnormally hot or
mild summer. This situation would leave the utility with a surplus or deficit of allowances
and the corresponding risk of price changes.
In order to hedge against this risk, the utility could execute a strangle. The strangle is another combination of a call and a put. It involves buying both call and put options at different strike prices. To protect against the risk of rising allowance prices in case the utility needs to buy allowances in the future, it can purchase a call option with a strike price higher than the current allowance market spot price. This is called an out-of-the-money call option. At the same time, the utility can protect itself from the risk of decreasing allowance prices in the event it finds itself long on allowances. This can be done by purchasing a put option with a strike price lower than the current allowance market spot price. This is known as an out-of-the-money put option. The out-of-the-money options typically sell for premiums that are lower than the premiums for options with strike prices closer to actual market price. Like a collar, the strangle allows the utility to protect against unforeseen price risks, but also enables it to save money on options.
Selling Covered Call Options
Market participants with excess allowances can use the market to maximize the value
of their portfolio while hedging the risk that a drop in price will diminish the value of
their holdings. For example, a utility holding excess allowances could start by selling
out-of-the-money call options, which give it the right to purchase a set of allowances at a
price currently above the market price. This allows the utility to collect a premium against
its excess allowance inventory.
If prices stay stagnant or decrease, the buyer of the call option will simply go the market to purchase allowances, while the utility collects the premium and retains ownership of the allowances. On the other hand, if the market price rises above the call strike price, the option buyer will likely exercise the option and purchase the contracted allowances. The utility has collected the premium and transferred allowances. Typically, the utility does not sell options for all of its allowances and so it can then sell additional allowances into the market at the higher market price. Or, the utility can sell another call option, going through the same process.