Weather Options Overview

  • 15 Nov 2016
  • By CME Group
  • Topics: Weather

CME Group received approval from the Commodity Futures Trading Commission (CFTC) to list Heating and Cooling Degree Day (HDD and CDD) futures in August 1999. The very first weather futures contracts listed in September 1999 were based upon HDDs to the extent that this coinciding with the commencement of the heating season. CDD based contracts were subsequently introduced in January 2000.

At the outset, the two most popular instruments to emerge included option contracts based on heating degree days (HDD) and cooling degree days (CDD) options. HDD & CDD represent energy industry standard measures of the extent to which average temperatures during a particular day deviate from a (benchmark) of 65 degrees Fahrenheit.

The concept of a heating degree day (HDD) index was developed by engineers who observed that commercial buildings were frequently heated to maintain an indoor temperature of 70° Fahrenheit whenever daily mean (average) outdoor temperatures fell below 65° Fahrenheit. Each degree of mean temperature below 65° Fahrenheit is counted as "one heating degree day."

Conversely, air conditioning may be employed when temperature rise much above the 65° Fahrenheit standard. Thus, each degree of mean temperature above 65° Fahrenheit is counted as "one cooling degree day." These concepts are expressed mathematically as follows.

HDD = Max(0, 65°F - daily average temperature)

CDD = Max(0, daily average temperature - 65°F)

For example, if the average of a day’s maximum and minimum temperature on a midnight-to-midnight basis is 35° F, that day’s HDD is 30 and the CDD is zero (0).

The original HDD and CDD futures are based on the cumulative value of HDDs or CDDs throughout a specific subject month. To illustrate, an average daily temperature of 45°F degrees is associated with an HDD of 20 (= 65°F - 45°F). If the average daily temperature were in excess of 65°F, the HDD for that day would be zero. A monthly contract is cash settled at the cumulative value of HDDs recorded on each day of the month.

For example, assume that the month had 31 days and the average daily temperature for all of those days was 45°F. Accordingly, the cumulative monthly HDD would equal 620 (= 31 days x 20). The futures contract value would be identified by multiplying that figure by $20. In this example, the cash value of the contract would be $12,400 (= $20 x 620).

A seasonal strip contract is based on the cumulative HDD or CDD values during a five-month period within the season. The traditional heating season runs from November through March while the traditional cooling season runs from May through September.

Seasonal strip contracts provide the same type of risk exposure as monthly HDD and CDD contracts but offer the convenience of being able to trade a bundled package of months during the heating or cooling season.

The concept of temperature linked futures also includes international coverage in Europe (Amsterdam and London).

These contracts are based upon cumulative average monthly temperatures during the cooling season and HDD readings during the heating season.

These contracts further depart from the U.S. standards in the sense that temperature readings are recorded on the Celsius rather than Fahrenheit scale. Rather than reference a base of 65°F, these indexes reference a base of 18°C. The European cooling contracts are based upon a so-called Cumulative Average Temperature (CAT) index rather than a CDD to the extent that the term CDD is not in use in the context of European OTC weather markets.

Weather products offered by CME consist of both futures and options. In the following section of this paper we would like to describe a few examples of how options on weather futures can be utilized as a hedging mechanism in the energy sector.

Let’s examine how a utility would use a CDD option strategy to account for a forecasted mild summer in the Northeast and how the strategy would change as the forecast changes. (The pricing of all option strategies is based strictly on historical averages and may not accurately reflect the cost of the hedge).

1. The utility receives its summer forecast and elects to BUY a 1250 CDD Put option (capped with a 1050 PUT) @ 30 ticks per contract to protect $5,780,000 in revenue.

Parameters

  • Timeframe: May – September (5-month “summer” seasonal strip)
  • Seasonal 10-year average for New York: 1352
  • Strike prices: 1250 (cap is 1050)
  • Option premium: $600 per contract
  • Cost of “The Hedge”: $1,020,000 (max potential loss)
  • Max potential payout: $6,800,000

Strategy calculation:

  • $5,780,000/170 = 34K per CDD
  • 34K per CDD/$20 = 1,700 contracts
  • 30 ticks*$20/tick*1,700 contracts = $1,020,000

"The Hedge": The utility would pay a premium of $1,020,000 for $5,780,000 in protection.

2. The utility received an updated forecast from their meteorological source that projects a warmer than average for the start to summer. The risk manager negotiates to SELL 500 of the 60 PUT option (no cap) @ 10 ticks/contract.

Parameters

  • The forecast for May: 90
  • New York 10-year avg. for May: 71
  • Strike price: 60
  • Option premium: $200 per contract
  • Max potential payout: $100,000
  • Max potential loss: $600,000 (max net loss: $500,000)

Strategy calculation:

  • 10 ticks*$20/tick*500 contracts = $100,000

"The Hedge": The utility would receive a premium of $100,000

3. The utility received a forecast from their meteorological source that projects a cooler outlook for June. The risk manager negotiates to SELL 500 of the 270 CALL option (capped with a 370 CALL) @ 17 ticks/contract.

Parameters

  • The forecast for June: 225
  • Location: New York (10-year avg. for June: 259)
  • Strike price: 270 (capped at 370)
  • Option premium: $340 per contract
  • Max potential payout: $170,000
  • Max potential loss: $1,000,000 (max net loss: $830,000)

Strategy calculation:

  • 17 ticks*$20/tick*500 contracts = $170,000

"The Hedge": The utility would receive a premium of $170,000

4. The utility receives an updated forecast that projects a warmer outlook for July. The utility elects to SELL 500 of the 430 PUT option (capped at 380 PUT) @ 15 ticks/contract.

Parameters

  • The Forecast for July: 487
  • Location: New York (10-year avg. for July: 444)
  • Strike price: 430 (capped at 380)
  • Option premium: $300 per contract
  • Max potential payout: $150,000
  • Max potential loss: $500,000 (max net loss: $350,000)

Strategy calculation:

  • 15 ticks*$20/tick*500 contracts = $150,000

"The Hedge": The utility would receive a premium of $150,000

There are many strategies and instances where both futures and options can be utilized for hedging various temperature related risks. CME Group offers both futures and options products in 10 cities to help better serve our customers and the market places’ needs.

If you have any questions regarding CME Group weather products, please contract Charles Piszczor at +1 312 930 4536, Charles.Piszczor@cmegroup.com or Michael Marano at +1 312 454 8338, Michael.Marano@cmegroup.com.

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