Chapter 9. Mechanics of Options Markets

Chapter 9. Mechanics of Options Markets I. Overview. A. Definitions. 1.Option - contract that entitlesholder to buy/sell a certain asset at or beforea certain timeat 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 option Trade in round lots - 1 option is the right to buy 100 shares.

I. Overview of Options B. Combinations. 1. Synthetic Call (Put-Call Parity). 2. Writing a Covered Call. 3. Straddle, Strangle. 4. Spreads (Bull, Bear, Butterfly). C. Uses. 1. Options can be combined to create any payoff pattern desired; Possible variations are only limited by imagination. 2. Options have substantial "inherent leverage." 3. These characteristics make options powerful and useful tools for speculation or hedging.

II. Mechanics of Options A. Strategy. Value 1. If you think S will , buy a call; │ a. If right (S), S > K, exercise. │ (buy @ K, sell @ S, worth (S-K)). ________________________ S b. If wrong (S), S < K, │ lose price of call. │ │ Value 2. If you think S will , sell a call; │ a. If right(S), S < K, │ keep price of call. ________________________ S b. If wrong (S), S > K, │ will be exercised. │ (must sell @ K, buy @ S, lose (S-K)). │

II.A. Strategy - Mechanics of Options Value 3. If you think S will , buy a put; │ a. If right(S), S < K, exercise. │ (sell @ K, buy @ S, worth (K-S)). ________________________S b. If wrong (S), S > K, │ lose price of put. │ │ Value 4. If you think S will , sell a put; │ a. If right(S), S > K, │ keep price of put.________________________S b. If wrong (S), S < K, │ will be exercised. │ (must buy @ K, sell @ S, lose (K-S)). │

II.A. Strategy - Mechanics of Options 5. Summary: StocksCallsPuts Think S will ? Buy Buy Sell Think S will ? Sell Sell Buy Buy if you think: S SSUnlimited upside Sell if you think: S S SUnlimited downside

II.B. Warrants, Intrinsic Value, & OTC Markets 1.Optiontrade is like a side bet; has no effect on value of the firm (S). a. Warrant is different; issued by parent corp. or bank. i. When issued, firm receives cash flow (price of warrant). ii. When exercised, affects cash flow & ownership interest: - New shares issued - Firm receives cash flow (K); iii. Warrant issuance & exercise affects firm value (S) - More difficult to value warrants.

II.B. Warrants, Intrinsic Value, & OTC Markets 2. Call option is:itmatmotm if: S > K S = K S < K if: (S-K) > 0(S-K) = 0(S-K) < 0 a. Intrinsic value of call = Max { S-K, 0 }. (payoff if exercised now). b. Intrinsic value of put = Max { K-S, 0 }. c. An itm option will always be exercised @ expiration (if not early). i. It may be optimal for holder to wait or sell, rather than exercise early. ii. In this case, option also has Extrinsic value (time value). Total value of option = (Intrinsic value) + (Extrinsic value).

II.B. Warrants, Intrinsic Value, & OTC Markets 0 < dc/dS < 1 Total Value If σ↑ dc/dS = 1 S K dc/dS = 0 Intrinsic Value S K Extrinsic Value S K

II.B. Warrants, Intrinsic Value, & OTC Markets 3.OTC Markets. a. Not all options trade on exchange. b. FC options also trade on OTC Interbank mkt between banks, Or between bank & its corporate clients. c. Interest rate options traded in many forms OTC through banks. e.g., caps, floors, collars, swaps, … More later.

II.C. Underlying Assets 1.Stockoptions. a. Options trade on > 500 stocks in U.S. b. Exchanges trading options in U.S. include: i. CBOE, PHLX, AMEX, PE. ii. Options on a given company trade on all exchanges. c. One option gives right to buy or sell 100 shares (1 round lot). 2.Foreign Currencyoptions. a. PHLX is major exchange for FC options. b. Offers both European & American options on: British £, Canadian $, €, Swiss Francs, Yen, Australian $, … c. There is also a well-developed OTC market in FC options. i. Interbank OTC mkttrades large denominations (> $1 MM).

II.C. Underlying Assets 3.Stock Index Options. a. CBOE options: i. S&P 500 (SPX) - European; ii. S&P 100 (OEX) - American; iii. Nasdaq 100 (NDX); iv. Dow Jones (DJX). b. Example: 1 contract is to buy ($100 x Index) @ strike price, K. c. Settlement is in cash. Example: 1 call on S&P100 with K = 980; while Index = 992; Can be exercised for (S - K) x ($100) = (992 - 980) x ($100) = $1,200. d. Payment based on index value at day’s close, when exercised. e. Hull discusses Index options more in Ch. 15.

II.C. Underlying Assets 4.FuturesOptions. (More in Hull, Chapter 16.) 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 sellfutures 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 putis 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.

II.C. Underlying Assets 5.Bond options. a. CBOE trades options on T. Bonds (> 10 years) & T. Notes (1-10 years). b. Underlying assets are specific bonds. Not like futures on T. Bonds! No implied delivery option here. So no complications from finding cheapest to deliver bond. c. Not so popular. Options on T.BondFutures are more popular; T.BondFuturesare more liquid; easier to trade & deliver.

II.D. Specifications of Stock Options 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).

II.D. Specifications of Stock Options 2.Strike Price (K). a. Exchange chooses strike prices traded. b. For stock options, strike prices normally spaced $2½ , $5, or $10 apart. c. Typical Rule for exchanges: If S < $25, use $2½ spacing; If $25 < S < $200, use $5 spacing; If S > $200, use $10 spacing. d. When new expiration date introduced, the 2 K’s closest to S are traded. If one of these K’s is ≈ S, the 3rdK closest to S may also be traded. When S moves outside range of K’s traded, a new K is traded. e. Example 1: Suppose Bethlehem Steel trades @ $22¼ ; with options trading @ K = 17½ , 20, 22½ , and 25 (S rising). f. Example 2: Suppose IBM trades @ 109¾ ; with options trading @ K = 105, 110, 115, 120, & 125 (S falling).

II.D. Specifications of Stock Options 3. Terminology. a. Many options may trade on a given stock – many strikes & expirations. b. Example: If there are 4 expiration dates, & 5 strike prices, there are 40 different contracts (4x5 calls & 4x5 puts). c. Option Class– options of same type (calls or puts). d. Option series– all options of given class with same exp. & same K. Refers to a specific contract. 4. Flex Options. a. CBOEoffers these on equities & equity indexes. b. Nonstandard terms. c. Can involve a strike price or expiration date that is different from usual. d. Can involve European rather than American option. e. An attempt by option exchanges to regain business from OTC market.

II.D. Specifications of Stock Options 5. Other NonStandard Products offered by CBOE. a. Options on ETFs. 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.

II.D. Specifications of Stock Options 6. Stock Splits & Stock Dividends. 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).

II.D. Specifications of Stock Options 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 NOTdividend-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.

II.E. Newspaper Quotes 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. 10. Tenth Column – open interest.

II.E. Newspaper Quotes

II.F. Trading in Options 1. Open Outcry versus electronic trading. a. Traditionally exchanges have had to provide a large open area for individuals to meet and trade options. Options exchange has members, who have seats. Exchange membership entitles one to trade on exchange floor. This is changing. b. Eurex, the European derivatives exchange, is fully electronic. Traders do not physically meet. c. CBOE launched CBOEdirect in 2001. Initially used to trade certain options outside trading hours. Likely to eventually be used for all option trading.

II.F. Trading in Options 2.Market Makers. a. Most options exchanges have mkt-makers to facilitate trading. b. Individuals who are willing to quote both bid & ask for option. c. Willing to buy @ bid or sell @ ask. (Can keep the difference.) d. Doesn’t know whether you wish to buy or sell. e. Profits from the bid-ask spread. Hedges or unwinds positions. f. Exchange may set upper limits on bid-ask spread, such as: Spread must be: < $.25 for options priced < $.50; < $.50 for options priced $.50 to $10; < $.75 for options priced $10 to $20; < $1.00 for options priced > $20. g. Existence of market makers ensures liquidity.

II.F. Trading in Options 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.

II.F. Trading in Options 5.Offsetting Orders. a. Anyone who is long an option can close out position by issuing an offsetting order to sell the same option. b. Anyone who is short an option can close out position by issuing an offsetting order to buy the same option. c. What happens to open interest when a contract is traded? i. If neither party is offsetting an existing position, open interest increases by one. ii. If one party is offsetting an existing position, open interest stays the same. iii. If both parties are offsetting existing positions, open interest goes down by one.

II.G. Commissions 1. Vary greatly. Discount brokers generally charge less. 2. Might charge (fixed cost) , or (fixed cost) + (proportion of total $ amount). 3. Closing Out a position. a. If you close out a position by entering an offsetting trade, must pay commission again. b. If you exercise your option, must pay commission you’d pay if buying or selling the stock (may be 1-2% of stock’s value). 4. See example of option commission schedule in Hull.

II.H. Margin 1.When sharesare purchased, can pay cash or use margin. a. Initial margin is usually 50% of value of shares. Maintenance margin -- 25% of value of shares. Works like margin account for futures markets. 2.When short term call or put options are purchased, (< 9 months maturity), option price must be paid in full. a. Cannot buy these short term options on margin. b. Options already have a lot of leverage; Buying on margin would increase leverage further.

II.H. Margin 3.When long term call or put options are purchased, (> 9 months mat), may borrow up to 25% of option price. a. Longer term option acts more like the stock itself, especially if option is in-the-money. b. Hence, margin purchases are allowed on longer term options. 4.When optionsare sold, writer must maintain margin account. a. Broker & Exchange need assurance that writer will not default if option is exercised. b. Size of margin depends on circumstances.

II.H. Margin 4.Initial margin for writing naked options: the greater amount from two calculations: a. [(100% of sale proceeds) + (20% of S) - (amount OTM)]; (If further OTM, this is smaller.) b. [(100% of sale proceeds) + (10% of S)]. (If far OTM, will pay this.) 5.Example: Investor writes 4 naked calls. C = $5; K = $40; S = $38; ( OTM: S-K = -$2 ). Sale proceeds: $5 x 400 = $2,000 for calls. Initial Margin is greater of two calculations: a. 400 x [ 5 + .2 (38) - 2 ] = $4,240; b. 400 x [ 5 + .1 (38) ] = $3,520. c. Thus, investor puts up $4,240 for this short position.

II.H. Margin 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, ITMoptions 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.

II.H. Margin 8.Initial Margin for writingCovered Calls. a. Sell call but own the shares; not so risky; worst result, must deliver your shares. b. If covered call is OTM (less likely to be exercised), no initial margin is required. Shares can be bought on 50% margin, and call price can be used to help pay. c. If covered call is ITM (more likely to be exercised), again, no initial margin. However, to calculate investor’s equity position, S is reduced by the extent to which the option is ITM. This may limit amount investor can withdraw from margin account, if S further. d. Example: C = $7; S = $63; K = $60; (ITM; S-K = $3). Want to buy 200 shares and write 2 calls. Cost of shares = $63 x 200 = $12,600. - Margin allowed on stock purchase = - $6,300. - Price received for 2 calls = $7 x 200 = - $1,400. (Can use sale proceeds to pay.) Therefore, minimum initial investment is: $12,600 - $6,300 - $1,400 = $4,900. 9. Other option combinations have their own rules for margin. (Described in CBOE Margin Manual, available at www.cboe.com.)

II.I. The Options Clearing Corporation (OCC) 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; e. OCC member maintains margin account with OCC.

II.I. The Options Clearing Corporation (OCC) 4. To exercise an option: a. Investor notifies broker; b. broker notifies OCC member who clears her trades; c. OCC member places an exercise order with OCC; d. OCC randomly selects member with outstanding short position; e. This OCC member uses set procedure to select an investor who has written the option; f. If call, writer must sell @ K; If put, writer must buy @ K; g. This investor is said to be assigned. h. After an option is exercised, open interest declines by one. i. At expiration, all ITM options should be exercised (automatic).

II.J. Regulation 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.OTCoption markets have less regulatory scrutiny. Players resist more oversight - especially banks; this is their business!

II.K. Taxation 1. Unless a bona fide hedger, all gains taxed as capital gains. 2. Losses can be used to offset capital gains. 3. If losses > gains, up to $3,000 is deductible against income (for non-corporate taxpayer). 4. When are gains / losses realized, for tax purposes? a. If option position closed out with offsetting trade, realized then; b. If option position allowed to expire unexercised, realized then; c. If call is exercised, writer effectively sold stock @ (K + C); buyer effectively bought stock @ (K + C). This amount (K + C) is used as basis for later gains / losses. d. If put is exercised, buyer effectively sold stock @ (K – P); writer effectively boughtstock @ (K – P). 5. Commissions are always deductible.

II.K. Taxation 6. The Wash Sale Rule. a. Example: You buy stock @ S = $60 for long term investment. If S  to $40, may want to sell to realize tax loss, & then buy back @ S = $40. b. This is prevented by wash sale rule. If you sell a stock & then buy it back within 30 days, Deductions are disallowed. c. This rule is relevant for option traders, because a call on a stock is regarded like a purchase of the stock for the wash sale rule. That is, selling a stock & buying a call within 30 days means any loss on the stock sale is disallowed.

II.K. Taxation 7. Constructive sales. a. Prior to 1997, if a U.S. taxpayer shorted a security while holding long position in similar security, no gain or loss was recognized until the short position closed. Thus a short position could be used to defer recognition of gain. b. This situation changed with Tax Relief Act of 1997. Appreciated property is now treated as “constructively sold” if: i. owner enters into short sale of similar property; ii. owner enters a futures or fwdposition on similar property; iii. owner enters into position that eliminates loss or gain opport. c. Note: Transactions reducing only the risk of LOSS, or only the opportunity for GAIN are not constructive sales. Thus, investor holding long position in a stock can buy ITM puts without triggering a constructive sale. (put option -- only risk of loss)

Chapter 9. Mechanics of Options Markets