OPTIONS MARKETS (More on Derivative Securities)

1. OPTIONS MARKETS(More on Derivative Securities) CHAPTER 14 Dr David P Echevarria

2. Options • Two Types of Options • Calls • Puts • Buyer Expectations • Calls: stock prices will rise • Puts: stock prices will fall • Seller Expectations (Writer) • Calls: prices will fall or stay level • Puts: prices will rise or stay level Dr David P Echevarria

3. Option Writers • Option Writers may be attempting to generate additional income in sideways market. • Call Writer Positions • Covered writer; owns stock to deliver if option is exercised. • Naked writer; does not own stock (very risky position) • Highest margin requirement. • Put Option Writers • Must deposit margin equal to 50% of current value. Dr David P Echevarria

4. GENERAL TERMINOLOGY • Premium: the price paid per option; one option per share, contract = 100 options. • Exercise Price (XP): the fixed [share] price for future transaction. • Expiration date: the date the option expires. Dr David P Echevarria

5. GENERAL TERMINOLOGY • Profit (Loss) Definitions: In- At- or Out-of-the-Money • In-the-Money Call: The stock price is greater than the exercise price • At-the-Money Call: The stock price is equal to the exercise price • Out-of the Money Call: The stock price is less than the exercise price • In-the-Money Put: The stock price is less than the exercise price • At-the-Money Put: The stock price is equal to the exercise price • Out-of-the-MoneyPut: The stock price is greater than the exercise price Dr David P Echevarria

6. GENERAL TERMINOLOGY • Contract Specifics (CBOE) • Contract Size is for 100 shares. For indexes, a multiple of the index • Expiration Dates: current month, next month , next two months in the cycle. • Several stocks have weekly options • Position Limits: max # of options held by one player on same side • Exercise Limits: max # of options exercised in a 5-day period. Dr David P Echevarria

7. GENERAL TERMINOLOGY • Players in the Options Market • Market Makers: Provide liquidity, Imposes spread as charge for liquidity services • Scalpers: near simultaneous buy at bid, sell at ask to lock in the spread. • Floor Broker: executes trades for public traders. • Order Book Official: Exchange official who oversees execution of limit orders entered into the computer. • AMEX, PHLX: Specialists, Registered Option Traders (ROT): G. Open Interest: number of option contracts Opened on a [stock]. F. Exercising an Option; making or taking delivery at the request of the option buyer. Dr David P Echevarria

8. TYPES OF OPTIONS • Stock Options; 2009 > 1500 different issues (CBOE) • Exercise (settlement involves stock delivery). • Exercise also involves paying a commission on the purchase of stock. • Index Options: settlement in CASH • "OEX" S&P 100: Value is index value times 100 • Options available on all major market indexes • Advantages of Index Option Trading • Cash settlement permits trading w/o necessity to make/take delivery. • Options cover the market as a whole. Dr David P Echevarria

9. OPTIONS CLEARING CORPORATION (OCC) • Guarantees writer performance and as such is an important intermediary • Handles the assignment on exercises • All firms trading or brokering in options have accounts with OCC • Sets capital requirements for members of the OCC • Hold funds deposited for margin requirements Dr David P Echevarria

10. MARGIN REQUIREMENTS • Stocks • 50% initial for long and short positions. • 25% maintenance • Options • 100% of the price of the contract (already leveraged). • Naked Calls • 20-50% of current stock price plus/minus maintenance if option is in/out of the money. • Index options have lower margin requirements (15% due to lower volatility). • Covered Calls: Stock is usually in street name (held in margin account ) Dr David P Echevarria

11. REGULATION OF OPTIONS MARKETS • SEC is primary regulator for options on stocks, foreign currencies, and indexes. • CFTC is primary regulator for futures options. • Exchanges also have rules, particularly in regards to capital requirements. • OCC also has certain rules for member firms to follow. Dr David P Echevarria

12. HOMEWORK QUESTIONS • What is a derivative security and how is it valued? • What functions do derivative securities play? • What is a call option? a put option? • What bet is a call buyer making? A put buyer? • What is a naked writer? • Understand what is meant by the following terms: • Option premium • Strike (or Exercise) price • Option Contract • Naked call writing • Covered call writing • In- and out-of-the-money for calls, puts • What are index options? • How index options settled? Dr David P Echevarria