What Is a Swing Option?
A swing option is a type of contract used by investors in energy markets that lets the option holder buy a predetermined quantity of energy at a predetermined price while retaining a certain degree of flexibility in the amount purchased and the price paid.
A swing option contract delineates the least and most energy an option holder can buy (or "take") per day and per month, how much that energy will cost (known as its strike price), and how many times during the month the option holder can change or "swing" the daily quantity of energy purchased.
How Swing Options Work
Swing options (also known as “swing contracts,” “take-and-pay options” or “variable base-load factor contracts”) are most commonly used for the purchase of oil, natural gas, and electricity. They may be used as hedging instruments by the option holder, to protect against price changes in these commodities.
- "Take-and-pay options” or “variable base-load factor contracts,” or “swing contracts" are other names for swing options.
- The difference between the contract price and the market price is typically smaller and less volatile, which consequently depresses arbitrage trading opportunities in the market, and hence reduces the option's value.
- If one engages a contract primarily to acquire the commodity—and not for trading purposes—the indexed contract ensures that a price close to the market will be paid.
For example, a power company might use a swing option to manage changes in customer demand for electricity that occur throughout the month as temperatures rise and fall. These contracts are more intricate than they appear to be. Consequently, they tend to make their valuation challenging. An oil company might also do the same with fuel for customer demand for heat during winter months.
Swing options are most commonly used for the purchase of oil, natural gas, and electricity.
The typical constraints of swing options are minimum and maximum daily contract quantities (DCQ), annual contract quantities (ACQ), and total contract quantities (TCQ). But in addition to these chief examples, there are copious others that, if violated, can trigger a penalty with the option holder. The price paid for the commodity can either be fixed or floating. A floating or “indexed” price essentially means that it is linked to the price in the market. In contrast to a fixed price contract, an indexed price contract is less flexible.