What is a swing option?

A swing option is a contract which provides flexibility as to when and how much of a commodity is taken. The offtaker of the commodity can “swing” (change) the quantity each hour or day. It is most commonly used in natural gas markets, but also in electricity, oil and other commodity markets.

Another name for a swing option is take-or-pay, or take-and-pay contract. This name refers to the minimum quantity that should be taken, or if not taken, should still be paid for. Such a minimum is one of the many volumetric constraints that are possible. Typical constraints are minimum and maximum daily contract quantities (DCQ), annual contract quantities (ACQ) and total contract quantities (TCQ). But essentially, there can be any type of constraint. When a constraint is violated, the option holder pays a penalty.

The price paid for the commodity can be fixed or floating. A floating price or indexed price means that it is the linked to the price or prices in the market. Compared to a fixed price contract, an indexed price contract contains less optionality: the difference between the contract price and the market price is generally smaller and less volatile. This reduces the arbitrage trading opportunities in the market, and hence the option value. On the other hand, if the contract is primarily entered into for acquiring the commodity, not for trading purposes, then an indexed contract ensures that a price close to the market is paid.

Swing contracts offer multiple interdependent exercise moments: they belong to the class of American-style path-dependent options. This means that most of the swing contracts cannot be broken down into plain-vanilla options and hence not be priced with standard solutions, such as the Black-Scholes formula. The market standard methodologies for valuing swing contracts are least-squares Monte Carlo and rolling intrinsic. Both methodologies are embedded in KySwing, a software product dedicated to swing contracts. It calculates the market value, value distributions, delta hedges and a range of other option Greeks.

Do you want to know more about swing options, read our monthly gas market report or check the KySwing web page.

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