Mechanics of Options Markets

Chapter 9, 7th editionChapter 8, pre 7th edition

Types of Options• A call is an option to buy

• A put is an option to sell

• A European option can be exercised only at the end of its life

• An American option can be exercised at any time

• Expiration = Exercise = Maturity date

• Exercise = Strike price• http://www.m-x.ca/nego_cotes_en.php?symbol=ECA*&image.x=14&image.y=14

Types of Options

• A call is an option to buy (profit/payoff profile)

• A put is an option to sell (profit/payoff profile)

Payoff Payoff

ST STKK

Payoff Payoff

ST STKK

Option Positions• Two sides to every option contract

– long = buy position – short = sell position

• Four types of option positions

• Terminal payoff characterization– Long call = max (St – K, 0)– Short call = min (K – St, 0)– Long put = max (K – St, 0)– Short put = min (St – K, 0)

Assets Underlying Options

• Stocks

• Foreign Currency

• Stock Indices

• Futures

Stock Options• Most trading in stock options is on

exchanges

• US: Chicago Board Options Exchange, Philadelphia Stock Exchange, American Stock Exchange, Pacific Exchange

• Canada: Montreal Exchange

• One options contract = 100 shares

Foreign Currency Options• Most trading in foreign currency options is

on over-the-counter and some exchange trading

• US: Philadelphia Stock Exchange

• Canada: Montreal Exchange

• Size of contract depends on currency

Index Options• Trading in both over-the-counter and

exchange traded market• US: S&P 500 Index, Nasdaq 100 Index,

Dow Jones Industrial Index• Canada: TSX 60 (http://globeinvestor.com/)• One options contract = 100 * Index• Flex options: traders on the floor agree to

nonstandard terms on equities and indices (similar to over-the-counter contracts)

Specification ofExchange-Traded Options

• Expiration date

• Strike price

• European or American

• Numerous expiration dates and strike prices

• Option class (call or put)

• Option series (same class, expiration date and strike price)

Terminology Moneyness :

–At-the-money option

–In-the-money option

–Out-of-the-money option

Terminology(continued)

• Intrinsic value• Time value• What is the time value on the expiration

date?• Can intrinsic value be negative?• What is the intrinsic value for out-of-the

money calls?

Market Makers

• Most exchanges use market makers to facilitate options trading; they add liquidity

• A market maker quotes both bid and ask prices when requested

• The market maker does not know whether the individual requesting the quotes wants to buy or sell

• Offer is always higher than the bid (bid-offer spread); exchange sets the upper limits for the bid-offer spread

• http://www.m-x.ca/f_publications_en/mainteneurs_marche_en.pdf

Offsetting Orders

• An investor can close out a position by issuing an offsetting order

• Commission system on options will make investors to sell rather than exercise options; commission paid when you purchase and sell

Offsetting orders review

Source: http://www.cboe.com/LearnCenter/OptionCalculator.aspx

TodayT = 90 days

TomorrowT = 89 days

TomorrowT = 89 days, Equity Price = $60

Margins • Margins are required when options are sold without

a position in the underlying stock

Example on page 195 (read at home)

Regulation• US: Options Clearing Corporation (OCC)

• Canada: Canadian Derivatives Clearing Corporation (CDCC)

• http://www.m-x.ca/participants_liste_en.php?specifique=1• http://www.m-x.ca/nego_cotes_fr.php?symbol=LCE• http://www.m-x.ca/nego_liste_en.php• http://www.m-x.ca/produits_options_actions_en.php

5th and 6th edition: 8.1, 8.2, 8.9, 8.10, 8.125th edition only: 8.236th edition only: 8.22

7th edition only: 9.1, 9.2, 9.9, 9.10, 9.12, 9.22