CBOE

1. CBOE Products and Option Trading Amit Agarwal Lu Fang Wenbo Hu

2. Contents • Introduction to CBOE • People involved • Types of orders • Trading system/ process • Technology • Products

3. Introduction • The world's largest options marketplace. • Located on the corner of LaSalle and Van Buren streets in Chicago, IL. • Lists options on approximately 1500 equities and forty indexes.

4. Brief History • Founded by CBOT in 1973, trading call options on 16 underlying stocks then. • Put options were introduced in 1977. • The first index option, OEX was introduced on March 11, 1983. • Moved into its own building in 1984 due to increased volume. • Options on Interest Rates were introduced in June 1989. • Innovations made a lot of options available every year in the early 90’s.

5. 5 types of person involved 5 types of person involved • Investors • Broker • Floor Broker • Market Maker • DPM’s

6. Investor • Investors realize that options give more investment alternatives, and add diversity to their investment portfolio. • Investors give broker and the trading details via phone or website.

7. Broker • The broker takes order over the phone or through an online brokerage website and this information is relayed via computer to be filled at CBOE. • The broker may receive different types of orders.

8. Floor Broker • The floor broker is an agent for the investor. • He trades for the investor and has the investor’s best interest in mind at all times. • He cannot trade for himself because of a possible conflict of interest with the investor. • Those representing a firm are called Firm Floor Broker. • Independent traders are called Crowd Floor Brokers.

9. Market-Maker • Market-makers are entrepreneurs who risk their own capital in order to compete with other market-makers for options orders. • They are not allowed to to represent public investors and traders. • They earn money by making tiny profits on each trade, and, thus, are interested in trading as many options as possible. • Market makers are necessary for a liquid trading market.

10. The DPM (Designated Primary Market Maker) is an exchange appointed organization, who acts a specialist for an option. This combines the strengths of the market-maker with those of the specialist in one entity. DPM

11. Function of OCC • The Options Clearing Corporation (OCC) is approved by SEC as the central clearing corporation for exchange-listed options. • By acting as guarantor, OCC ensures that the obligations of the contracts are fulfilled. • OCC is equally owned by 5 participant exchanges that trade options: CBOE, ASE, ISE, PE and PSE. • OCC operates as an industry utility and obtains most of it’s revenues from clearing fees charged to its members.

12. Types of Orders • Market Order • Limit Order • Spread Order • Contingency orders • Request for Quote (RFQ)

13. Market Order • A customer order for immediate execution at the best price available when the order reaches the marketplace. • This is the most common type of order, it has the advantage of nearly always being filled, since no price is specified.

14. Limit Order • Executes a transaction only at a specified price (the limit) or better . • If the prices do not match, the system will store the order in the book in the appropriate price/time sequence. • If the prices match, the orders are executed against each other. Any remaining quantity will stay in the book.

15. Spread Order • A Spread order is in fact 2 option orders in 1. • A spread ticket instructs the floor broker to execute the order only when the combined prices of the two options are equal to or better than the spread order’s stated prices. • Both sides of the spread are to be executed simultaneously.

16. Contingency Orders • Contingency orders, except IOC, are put last in execution priority, regardless of their position in time. • A contingency order received ahead of a limit order at the same price will be treated as though it was received behind the limit order.

17. Types of Contingency Orders • AON - All or none • FOK - Fill or kill • IOC - Immediate or Cancel

18. AON - All or none • Orders of this type instruct the floor broker to either trade the entire order (e.g., 50 contracts) at one price or do not trade at all. • This strategy is used to keep an order from being split up and filled at, for example, 10 contracts at a time at different prices.

19. FOK - Fill or kill • An order that is sent to the floor for immediate execution. • If it cannot be filled immediately, it is automatically cancelled. • This strategy is also used to avoid a partial fill, by canceling the entire order unless all 200 options requested trade right now, so as to avoid several different trade times.

20. IOC - Immediate or Cancel • Time contingent • Must be filled within 5 seconds • remainder is automatically cancelled • Accepted only during the Open state • price and quantity disseminated to OPRA as part of the best bid/ask • Execution priority same as limit order

21. Request for Quote (RFQ) • Any trader --- market maker, retail firm broker, or non-market maker professional trader may initiate an RFQ for a series. • Sizemay be specified • The interest (to buy or sell) is not specified • Sent to the market makers-- assigned to that class and those who subscribed to receiving RFQs for that class. • 30 second expiration period

22. Trading System

23. Trading System- History • CBOE Trading System was the best when it started operating in 1973. • There were two main types of trading systems at that time, ‘specialist’ and NASDAQ. • Chicago Board Options Exchange started as a blend of both, specialist, and NASDAQ.

24. Specialist Trading System • Each stock is assigned to a member firm known as a specialist which uses its own money to trade. • The specialist is required to provide a two-sided market in the stock. • He also maintains the customer order book for that stock. • The specialist is responsible for providing a fair and orderly market for the stock.

25. Disadvantages • The specialist has monopoly power –can easily control trading in a stock. • Advantage of trading on the bid-ask spread. • The specialist is also a broker--combination of the agency and principal function. • Can use the customer order book to his own advantage.

26. The NASDAQ System • It relies on a computer system linking a vast network of dealers. • No physical exchange, no building. • A dealer makes market in one or more stocks listed on the system.

27. Disadvantages • A stock often did not open at a single price. • A broker was under no obligation to trade at the best price. • Difficulty in executing a market order • Did not completely solve the Principal and agent problem.

28. CBOE Trading System • A combination of both the systems • Physical Exchange • Competing members, not one specialist • Statutory separation of principal and agent • A central order book for customer orders • Central clearing house eased settlement and almost eliminated default risk.

29. Classic Trading Process • Open Outcry

30. Open Outcry Process • The order is telephoned from the broker's office to its booth at the exchange. • A runner delivers the order to the floor broker. • The broker runs to the pit where the option is being traded.

31. Open Outcry Process • Through the use of hand signals, he offers the position to the crowd. • Market makers answer with a price at which they will buy and sell. • The floor broker trades with the one who offers the best price.

32. CBOE Today • The pit-trading method is supplemented by an electronic screen-based trading system. • Even though floor brokers still use hand signals to communicate information of orders, technical innovation has changed option trading.

33. Technology at CBOE

34. Technology at CBOE • ORS (Order Routing System) replaces the telephone call. • BART (Booth Automated Routing Terminal) replaces the runner. • PAR (Public Automated Routing ) replaces hand signals. • RAES (Retail Automated Execution System) automatically executes orders. • EBOOK

35. ORS (Order Routing System) • It is a network of communication lines from retail member firms computers to the exchange. • It collects and routes orders to either booth, crowd, Electronic Book or RAES. • Handles orders of up to 20,000 contracts.

36. BART (Booth Automated Routing Terminal) • It is a dynamic, PC based, touch screen workstation located in the firm’s booth at the exchange where the orders are displayed. • BART allows each firm to customize order-flow to the booth. • BART allows the customer orders to be electronically forwarded to a destination of the firm's choice.

37. PAR (Public Automated Routing ) • PAR is a PC based, touch screen, order routing and execution system used by floor brokers. • Floor brokers can also carry mobile PAR. • The Mobile PAR enables a Floor Broker to receive the orders, move to the appropriate trading crowd, and execute the order from a Mobile PAR order screen.

38. RAES • RAES (Retail Automated Execution System) executes smaller transactions. • The price of the order should be marketable. • The routing system premium and quantity limitations are determined by the DPM for that option .

39. EBOOK (Electronic Book) • EBOOK is the automated public customer order book at CBOE. • A depository for public customer orders away from the market. • It automatically sorts and files orders in price and time sequence. • Most orders received during pre-opening period are routed to EBOOK for efficient price discovery. • Floor brokers can also send all orders from their PAR workstation to EBOOK.

40. Order Flow Summary Brokerage sends the order to Order Routing System (ORS) Sent to floor broker ….otherwise (Depending on the price and volume parameters set by the brokerage and CBOE) Order meets volume & price criterion Gets printed at the firm’s booth Sent to Electronic Book (EBOOK) Executed thru Retail Automatic Execution System (RAES)

41. An Example PAR

42. CBOE Products • Equity Options • Index Options • Options on Exchange Traded Funds and HOLDRssm • Exchange Traded Funds • Interest Rate Options • Structured Products • Equity & Index LEAPS® • Equity & Index FLEX® Options

43. Equity Options? • CBOE lists equity options on approximately 1,500 stocks and ADRs. An equity option is a securities contract which conveys to its owner the right to buy or sell a particular stock at a specified price on or before a given date.

44. More about Equity Option • The Options ToolBox v5.0 You can download it from http://www.cboe.com/LearnCenter/RCMain.asp

45. Index Options • Just as stock options are defined as contracts that give the buyer the right to buy or sell a stock at a stated price, so do cash-settled index options give buyers similar rights. However, the underlying asset covered by index options is not shares in a company but rather an underlying dollar value equal to the index level multiplied by $100.

46. Options on Exchange Traded Funds • Exchange Traded Funds, or ETFs, are index-based investment products that allow investors to buy or sell shares of entire portfolios of stock in a single security

47. Options on Exchange Traded Funds(continued) ETF: baskets of securities that are traded, like individual stocks, on an exchange There are a number of different ETFs on the market currently, including Qubes, SPDRs, sector SPDRs, MidCap SPDRs, HOLDRs, iShares, and Diamonds. All of them are passively managed, tracking a wide variety of sector-specific, country-specific, and broad-market indexes.

48. Options on Exchange Traded Funds and HOLDRssm • HOLDRs(holding company depository receipts) are trust-issued receipts that represent an investor's beneficial ownership of a specified group of stocks. HOLDRs allow investors to benefit from the ownership of stocks in a particular industry, sector or group.

49. Interest Rate Options • Interest rate Options are European-style, cash-settled options on the yield of U.S. Treasury securities. Available to meet your needs are options on short-, medium-, and long-term rates. These options give you an opportunity to invest based upon your views of the direction of interest rates.

50. Interest option example: IRX • Underlying: 13-Week Treasury Bill discount rate • Multiplier: $100 • Strike Price Intervals:2 1/2 points. A 1-point interval represents 10 basis points. • Expiration Months: Three near-term months plus two additional months from the March quarterly cycle