Finance Case Study
ph95
Chapter10-Mechanicsofoptionsmarkets.pdf
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Week 10
Mechanics of Options Market
Mechanics of options markets
• Some of the topics covered in this chapter
• Types of options • Organization of options markets • Terminology used • How the contracts are traded, • How margin requirements are set,
• We will mostly discuss about stock options
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Types of options
• A call is an option to BUY a certain asset by a certain date for a certain price that is fixed today
• A put is an option to SELL a certain asset by a certain date for a certain price that is fixed today
• The date specified in the contract is known as the expiration date or the maturity date .
• The price specified in the contract is known as the exercise price or the strike price.
Types of options
• American options can be exercised at any time up to the expiration date,
• European options can be exercised only on the expiration date itself.
• Most of the options that are traded on exchanges are American.
• European options are generally easier to analyze than American options, and some of the properties of an American option are frequently deduced from those of its European counterpart.
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Call option
• An investor buys a European call option with a strike price of $100 to purchase 100 shares of a certain stock (the buyer of a put option hopes that the price of the stock will increase). • Suppose that the current stock price is $98, the expiration date of the option is in four months, and the price of an option to purchase one share is $5. • The initial investment is $500. Suppose that at expiration the stock price is $115. • Will the option be exercised? If yes, what will the profit be? • Yes, it will be exercised since the price is greater than the strike price. • The profit will be (115-105)x100=$1000.
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Put option
• An investor buys a European put option with a strike price of $70 to sell 100 shares of a certain stock (hoping that the price of the stock will decrease). • Suppose that the current stock price is $65, the expiration date of the option is in three months, and the price of an option to sell one share is $7. • The initial investment is $700. Because the option is European, it will be exercised only if the stock price is below $70 on the expiration date. • Suppose that the stock price is $55 on this date. The investor can buy 100 shares for $55 per share and, under the terms of the put option, sell the same shares for $70 to realize a gain of $15 per share, or $1,500 or a net of $800 if we take into account the transaction costs.
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Options positions
• There are two sides to every option contract.
• On one side is the investor who has taken the long position (i.e., has bought the option).
• On the other side is the investor who has taken a short position (i.e., has sold or written the option).
• The writer of an option receives cash up front, but has potential liabilities later.
• The writer’s profit or loss is the reverse of that for the purchaser of the option
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Options positions
• There are four types of option position:
1. A long position in a call option 2. A long position in a put option 3. A short position in a call option 4. A short position in a put option.
Payoffs of European Call Options
• Payoff long position = ! 𝑆$ − 𝐾, 𝑖𝑓 𝑆$ > 𝐾 0, 𝑖𝑓 𝑆$ ≤ 𝐾
= 𝑚𝑎𝑥 𝑆$ − 𝐾,0
• The payoff to the short position will be −𝑚𝑎𝑥 𝑆$ − 𝐾,0 or
• Payoff short position = ! 𝐾 − 𝑆$, 𝑖𝑓 𝑆$ > 𝐾 0, 𝑖𝑓 𝑆$ ≤ 𝐾
= 𝑚𝑖𝑛 𝐾 − 𝑆$,0
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Payoffs of European Put Options
• Payoff long position = ! 𝐾 − 𝑆$, 𝑖𝑓 𝑆$ ≤ 𝐾 0, 𝑖𝑓 𝑆$ > 𝐾
= 𝑚𝑎𝑥 𝐾 − 𝑆$,0
• The payoff to the short position will be −𝑚𝑎𝑥 𝐾 − 𝑆$,0 or 𝑚𝑖𝑛 𝑆$ − 𝐾,0
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Underlying assets
• ETP Options • The CBOE trades options on many exchange-traded products (ETPs). • ETPs are listed on an exchange and traded like a share of a company’s stock. • They are designed to replicate the performance of a particular market, often by tracking an underlying benchmark index.
• SPDR S&P 500 ETF trust is designed to provide investors with the return they would earn if they invested in the 500 stocks that constitute the S&P 500 index
• Stock Options • Exchanges in the US: Chicago Board Options Exchange, NYSE Euronext, International Security Exchange, Boston Optics Exchange. • Options trade on several thousand different stocks. One contract gives the holder the right to buy or sell 100 shares at the specified strike price. This contract size is convenient because the shares themselves are normally traded in lots of 100.
Underlying assets
• Foreign Currency Options • Most currency options trading is now in the over-the-counter market, but there is some exchange trading
• It offers European-style contracts on a variety of different currencies. One contract is to buy or sell 10,000 units of a foreign currency (1,000,000 units in the case of the Japanese yen) for U.S. dollars exchange trading
• Index Options • The most popular exchange traded contracts in the United States are those on the S&P 500 Index (SPX), the S&P 100 Index (OEX), the NASDAQ-100 Index (NDX), and the Dow Jones Industrial Index (DJX).
• Futures Options • When an exchange trades a particular futures contract, it often also trades American options on that futures contract.
• The life of a futures option normally ends a short period of time before the expiration of trading in the underlying futures contract.
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Specifications of Stock Options
• Expiration Dates • One of the items used to describe a stock option is the month in which the expiration date occurs.
• In 1973, in the U.S.: January ( January, April, July, and October) , February ( February, May, August, and November) , or March ( March, June, September, and December) cycles
• For example, at the beginning of January, options are traded with expiration dates in January, February, April, and July; at the end of January, they are traded with expiration dates in February, March, April, and July;
• For example, expiration months available from September 2008 for three different stocks:
• Microsoft: Sept 2008, Oct 2008, Jan 2009, April 2009, Jan 2010 and Jan 2011.
• Progressive: Sept 2008, Oct 2008, Nov 2008 and Feb 2009.
• CitiGroup: Sept 2008, Oct 2008, Dec 2008, Jan 2009, Mar 2009, Jan 2010 and Jan 2011.
Expiration dates
• Unlike purchasing shares of stock, purchasing an option contract is generally used as a shorter-mid term investment.
• When you buy or sell an option contract (controlling 100 shares of stock), you must agree to an expiration date, as part of that contract.
• It is not vital to learn why expiration cycles occur in the weeks/months that they do, but rather what is more important is understanding what expiration is and how to choose an expiration date because it becomes pivotal in determining whether or not a trade was a success or failure.
• Expiration is important because it sets a timeframe for your trade. • Whether or not a trade is going in the right direction and how much time left until that option expires define what profit or loss you will incur as an investor.
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Expiration dates
• Most stock options have weekly, monthly, and quarterly cycles.
• Something to keep in mind when choosing an expiration date is what cycle the option is in, as this can have an impact on how liquid the underlying is.
• Weekly cycles tend to be less liquid than monthly/quarterly, so you may have a little trouble getting out of a trade in a weekly expiration cycle.
• Weekly expiration cycles are commonly used for earnings trades.
Specifications of Stock Options
• Strike Prices • The exchange normally chooses the strike prices at which options can be written so that they are spaced $2.50, $5, or $10 apart.
• Typically the spacing is $2.50 when the stock price is between $5 and $25, $5 when the stock price is between $25 and $200, and $10 for stock prices above $200.
• When a new expiration date is introduced, the two or three strike prices closest to the current stock price are usually selected by the exchange.
• If the stock price moves outside the range defined by the highest and lowest strike price, trading is usually introduced in an option with a new strike price
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Example
• Suppose that the stock price is $84 when trading begins in the October options. Call and put options would probably first be offered with strike prices of $80, $85, and $90.
• What if the stock price rose above $90? Or if it fell below $80?
• In the first case it is likely that a strike price of $95 would be offered; in the second case it is likely that a price of $75 would be offered; and so on.
Specifications of Stock Options • Terminology • For any given asset at any given time, many different option contracts may be trading.
• Suppose there are four expiration dates and five strike prices for options on a particular stock. If call and put options trade with every expiration date and every strike price, there are a total of 40 different contracts.
• All options of the same type (calls or puts) on a stock are referred to as an option class.
• An option series consists of all the options of a given class with the same expiration date and strike price.
• Options are referred to as in the money , at the money , or out of the money .
• A call option is in the money when S > K , at the money when S=K , and out of the money when S < K .
• The intrinsic value of an option is defined as the maximum of zero and the payoff from the option if it were exercised immediately. For a call option, the intrinsic value is max{S-K; 0}.
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Dividends and Stock Splits
• The early over-the-counter options were dividend protected • If a company declared a cash dividend, the strike price for options on the company’s stock was reduced on the ex-dividend day by the amount of the dividend.
• Exchange-traded options are not usually adjusted for cash dividends. • In other words, when a cash dividend occurs, there are no adjustments to the terms of the option contract. An exception is sometimes made for large cash dividends
• Exchange-traded options are adjusted for stock splits. • For example, in a 3-for-1 stock split, three new shares are issued to replace each existing share and should cause the stock price to go down to one-third of its previous value.
• After an 3-for-1 stock split, the strike price is reduced to 1/3 of its previous value, and the number of shares covered by one contract is increased to 3/1 of its previous value.
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Position Limits and Exercise Limits
• Position limit for option contracts defines the maximum number of option contracts that an investor can hold on one side of the market. • For this purpose, long calls and short puts are considered to be on the same side of the market
• Also, short calls and long puts are considered to be on the same side of the market
• The exercise limit usually equals the position limit. • It defines the maximum number of contracts that can be exercised by any individual (or group of individuals acting together) in any period of five consecutive business days.
Trading
• Over 95% of the orders at the Chicago Board Options Exchange are handled electronically.
• Market Makers • Most options exchanges use market makers to facilitate trading. A market maker for a certain option is an individual who, when asked to do so, will quote both a bid and an offer price on the option.
• The exchange sets upper limits for the bid–offer spread
• Offsetting Orders • An investor who has purchased an option can close out the position by issuing an offsetting order to sell the same option and vice versa
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Commissions
• For a retail investor, commissions vary significantly from broker to broker. • Discount brokers generally charge lower commissions than full- service brokers. • The purchase of eight contracts when the option price is $3 would cost $20+(0.02x$2,400)= $68 in commissions.
Margin Requirements
• When call or put options with maturities less than nine months are purchased, the option price must be paid in full.
• For options with maturities greater than nine months, investors can buy on margin, borrowing up to 25% of the option value. • A trader who writes options is required to maintain funds in a margin account.
• Both the trader’s broker and the exchange want to be satisfied that the trader will not default if the option is exercised.
• The amount of margin required depends on the trader’s position.
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Writing Naked Options
• A naked option is an option that is not combined with an off setting position in the underlying stock.
• The initial and maintenance margin for a written naked call option is the greater of the following two calculations (for brokers):
1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount if any by which the option is out of the money
2. A total of 100% of the option proceeds plus 10% of the underlying share price.
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Options Clearing Corporation • The Options Clearing Corporation (OCC) performs much the same function for options markets as the clearinghouse does for futures markets
• It guarantees that options writers will fulfill their obligations under the terms of options contracts and keeps a record of all long and short positions
• The OCC has a number of members (brokers), and all options trades must be cleared through a member
• The OCC member in turn maintains a margin account with the OCC.
• When an investor notifies a broker to exercise an option, the broker in turn notifies the OCC member that clears its trades. • This member then places an exercise order with the OCC. • The OCC randomly selects a member with an outstanding short position in the same option.
Regulation
• Exchange-traded options markets are regulated in a number of different ways.
• Both the exchange and its Options Clearing Corporation have rules governing the behavior of traders.
• In addition, there are both federal and state regulatory authorities.
• In general, options markets have demonstrated a willingness to regulate themselves.
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Taxation
• Determining the tax implications of option trading strategies can be tricky, and an investor who is in doubt about this should consult a tax specialist.
• In the United States, the general rule is that (unless the taxpayer is a professional trader) gains and losses from the trading of stock options are taxed as capital gains or losses.
• For both the holder and the writer of a stock option, a gain or loss is recognized when (a) the option expires unexercised, or (b) the option position is closed out.
