German power options volatility flattens as underlying upside risk eases

Hopes that the German power options market would break out of a recent narrow range on the front year have been frustrated, according to one trader.

And data indicates the risk of the outright German power front year baseload product trading above €32.00/MWh by mid-December has eased significantly in the eyes of options traders over the last five days.

Upside risk

While the underlying Calendar Year 2018 electricity product hit a record high at the brokered over-the-counter market on 19 July, it has since fallen back which has subdued the exchange-traded options market on the product.

Settlement prices for call contracts strengthened over the past month in response to gains in the underlying power product, which was in turn lifted by bullish coal prices.

The call, or buy, settlement for a strike price of €32.00/MWh expiring at 14 December soared to €1.407/MWh on 20 July at the EEX exchange, using the German-only product as a reference as opposed to the German-Austrian product. This was the day after the underlying power contract hit a high as front-year of €31.75/MWh.

The options settlement price had been just €1.035/MWh on 30 June (see explanatory box out).

“The recent high in the Calendar ’18 power product had raised hopes that the contract would break through the €32.00/MWh ceiling,” said one trader.

The put, or sell, settlement price had been €1.577/MWh on 20 July but this had climbed to €1.938/MWh by 24 July.

Increased volatility in underlying contracts has a bullish impact on settlement prices because either positive or negative movements are factored into participants’ calculations.

However, the underlying front year product eased, and call settlement prices fell to €1.098/MWh by 24 July, a 22% decline.

This fall, in just four days, means that fewer participants now expect the front year to be trading above €32.00/MWh by mid-December. The decline in the underlying OTC product was around €0.60/MWh between 19-25 July.

Carbon

Looking forward, the trader said the options market would continue to look to the coal market and clean dark spreads – a measure of the profitability of coal fired power stations taking carbon emissions allowances (EUAs) into account – for guidance.

As such, traders will also follow the EUA market, which been slowly recovering losses made from 18-21 July.

Options liquidity has been muted over the past month because of the holiday season which has hit the efficiency of the market.

“Volatility analysis is very difficult at the moment because liquidity is so low,” said one trader. “There are so few trades that just one can skew the whole picture.” jon.stibbs@icis.com

Power options: a brief explanation

Options contracts allow participants to hedge the risk of volatility on the underlying power market, insulating long or short positions from sharp price movements over a period of time, or speculate based on assumptions of those price movements.

The most common form in the European markets are known, appropriately, as European options. These contracts give the right but not the obligation to buy or sell a product at an agreed price at the set expiry date of the option.

Options generally expire before the underlying contract and, in terms of European power, options liquidity is unsurprisingly focused on the biggest markets such as Germany.

Participants tend to be utilities, banks, trading houses and hedge funds.

The buyer of the contract is known as the holder, while the seller is the writer.

There are two forms of options, which apply if a product is the particular side of a strike price at expiry:

• Call options: give the holder the right to buy which would require the writer to sell

• Put options: give the holder the right to sell which would require the writer to buy

Decisions whether to trade an option tend to be based on:

• The current price of the contract, which is called the underlying, in relation to the strike price

• The amount of time until expiry

• The implied volatility, which is a measure of volatility used in option pricing models, such as the Black-Scholes formula