Chapter 9. Mechanics of Options Markets. I. Overview. A. Definitions. 1. Option - contract that entitles holder to buy/sell a certain asset at or before a certain time at a specified price . Gives holder the right, but not the obligation, to do something. - PowerPoint PPT Presentation
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1. Option - contract that entitles holder to buy/sell a certain asset
at or before a certain time at a specified price.
Gives holder the right, but not the obligation, to do something.Call - ... buy ...Put - ... sell ...European Option - ... at a certain time (not before) ...American Option - ... at or before a certain time ...Expiration / Maturity - the certain time.Exercise Price / Strike Price - the specified price (K).
A Call is in-the-money (itm) if S > K ;A Call is at-the-money (atm) if S = K ;A Call is out-of-the-money (otm) if S < K ;
Premium - value or cost of optionTrade in round lots - 1 option is the right to buy 100 shares.
a. Underlying asset is a futures contract.i. Let F = current futures price; K = strike price of option.ii. Call holder has right to buy futures at K.iii. Put holder has right to sell futures at K.
b. Futures contract normally matures shortly after expiration of option.
c. Available for most assets for which futures are traded.
d. Normally trade on same exchange as futures.
e. When call is exercised (by buying for K), Holder of call becomes holder of long position in futures; Can close out (sell) futures for F, and keep cash (F - K).
f. When put is exercised (by selling for K), Holder of put becomes holder of short position in futures; Can close out (buy back) futures for F, and keep cash (K - F).
g. Just like payoff for stock option, with F replacing S.
1. Expiration Date - 10:59 p.m. Central Time on Saturday following 3rd Friday of expiration month.
a. Last day traded - 3rd Friday of expiration month. Can exercise until 4:30 C.S.T. Your broker then has until 10:59 p.m. next day to do paperwork.
b. Expiration Month - Traded on a Jan, Feb, or March cycle. January Cycle - Jan, Apr, July, & Oct. February Cycle - Feb, May, Aug, & Nov. March Cycle - Mar, Je, Sept, & Dec.
i. If exp. date for current month is ahead, options trade with exp. in current month, next month, and next 2 months in cycle.
ii. If exp. date for current month is behind, options trade with exp. in next month, next-plus-one month, and next 2 months in cycle.
iii. Example: IBM is on Jan. cycle. - Early in Jan, options traded that expire in Jan, Feb, Apr, & July.- Late in Jan, options traded that expire in Feb, Mar, Apr, & July.- At beginning of May, options expire in May, June, July, & Oct.- When one option expires, trading in another begins.
c. LEAPs: trade on some stocks; expirations up to 3 years; mature in January.
d. ITM options are exercised automatically (if ITM ≥ $.05).
b. Weeklys: Created on a Thursday and expire on Friday of following wk.
c. Binary Options: Provide fixed payoff of $100 if K is reached.
Binary Call pays $100 if S ≥ K at expiration;
Binary Put pays $100 if S ≤ K at expiration.
Price is market estimate of P(event will happen); Prediction mkts.
d. CEBOs: Credit Event Binary Options Pay fixed payoff if certain company suffers ‘credit event’ by expiration. Credit event = { bankruptcy, failure to pay on debt, restructuring, … }. Similar to Credit Default Swaps (CDS). More in Chapter 23.
e. DOOM Options: Deep–Out–Of–the–Money put options. Cost very little. Cheap insurance against major price decline. Similar protection to CEBOs or CDS. More in Chapter 23.
a. Option terms are adjusted when there is a stock split or stock dividend.
b. Valuation of European call is simple (Black/Scholes). What about American call on stock that will change value? Exercise early?
i. Suppose company makes 2 for 1 stock split. Should make S by 1/2; and affect value of option.
ii. m for n stock split should make S by (n/m). e.g. 3 for 1 split; (new S) = (1/3)(old S).
iv. Stock dividends are similar.
e.g. 20% stock dividend like a 6 for 5 stock split; (new S) = (5/6) (old S)
c. Most exchange-traded options are protected by automatic adjustments in the number of shares to be exchanged (N) and the exercise price (K).
i. K is adjusted by (n / m), to match expected change in S. N is adjusted by (m / n), to match dilution in value of S.
ii. Consider call option to buy 100 shares at K; 3 for 1 split; new option is for 300 shares @ new K = (1 / 3) (old K). 20% stk.div; new option is for 120 shares @ new K = (5 / 6) (old K).
7. Cash Dividends.a. Suppose company declares a $1 dividend. What happens to S on ex-date?
b. Early OTC options were protected against dividends. K was reduced by amount of dividend.
c. Exchange traded options are NOT dividend-protected. This means an American call loses value on ex-date. (European call too?)
8. Position Limit.a. Exchange specifies maximum number of option contracts an investor can hold on one side of market; same side = (long calls & short puts) or (short calls & long puts).
9. Exercise Limit = Position Limit.a. Defines maximum number of contracts that can be exercised by an individual in a period of 5 consecutive business days.
b. 8 - 9; to prevent individual from influencing market.
WSJ - Today’s paper lists yesterday’s quotes. See next slide.
1. First Column – company name.
2. Second Column - expiration month.
3. Third Column – strike price.
4. Fourth Column – nothing? call; p? put.
5. Fifth Column – volume; total number of contracts traded.
6. Sixth Column – the exchange.
7. Seventh Column – option price on last trade that day.Quoted price is for option to buy 1 share.Since one contract is for 100 shares, multiply by 100.
8. Eighth Column – net change in option price.
9. Ninth Column – closing share price for underlying stock.
3. Floor Brokers (members).a. Execute trades for public.
b. Trade with other floor brokers or market makers.
c. May be on commission or salary from brokerage firm.
4. Order Book Official (for exchange).a. Executes limit orders for public.
b. Floor broker passes limit orders to Order Book Official.
c. Enters limit orders into computer; Manages information on all outstanding limit orders; Makes information available to all traders.
d. c. above distinguishes mkt-maker / order book official system from specialist system (used by AMEX, PHLX, most stock exchanges). Under specialist system, specialists are responsible for being market-maker and keeping record of limit orders. But specialist does not make info on limit orders available to others.
6. Same example, but investor writes 4 naked puts ( $2 ITM ).
Initial Margin: a. 400 x [ 5 + .2(38) - 0 ] = $5,040.
This is always greater than other calculation (b.), for ITM options.
Thus, investor puts up $5,040 for this short position.
7. In both cases (5 & 6), the sale proceeds ($2,000)
can be used to form part of the margin account.
a. The further the option is OTM, the less likely it is that the option will be exercised, and the less will be the required margin for selling. Alternatively, ITM options are more likely to be exercised, and their initial margin will be greater.
b. Maintenance margin is the same calculation,
with option’s current market value replacing sale proceeds.
1. Like the clearinghouse for futures markets.Guarantees option writer will honor obligations.
Keeps record of all long & short positions.
2. OCC has members; all option trades must clear thru member.a. If a brokerage house is not a member of OCC, must arrange to clear its trades through a member.
b. Members required to have minimum capital, and to to contribute to fund used to honor obligations if a member defaults.
3. When an option is purchased,a. buyer must pay in full by morning of next business day;
b. funds are deposited with OCC;
c. writer maintains margin account with broker;
d. broker maintains margin account with OCC member;
1. Exchanges & OCC’s have rules of behavior for traders.
2. State & Federal regulators also oversee markets.a. Federal Level: i. SEC - options on stocks, stock indexes, bonds, & currencies. ii. CFTC - options on futures.
b. State Level: i. New York & Illinois have biggest options markets in U.S. These states enforce their own laws.
3. Option markets have been willing to regulate themselves.a. In U.S. there have been no major defaults by OCC members.
b. Recent scandal involved traders conspiring to skin investors; not executing best trade, to pad own account.
c. Overall investors have confidence.
4. OTC option markets have less regulatory scrutiny.Players resist more oversight - especially banks; this is their business!