Options and the Options Market

An Options contract is considered a derivative product as the contract has no intrinsic value other than that which can be derived from the cash value or income stream value of an underlying asset.

Standardized options traded on an exchange are available on underlying interests in equities (common stocks), equity indexes, government debt securities, foreign currencies and futures contracts on these same instruments.

An Options contract gives the purchaser of the contract the right, but not the obligation, to buy (call) or sell (put) a commodity/asset/futures contract (underlying) at a predetermined (strike / exercise) price prior to expiration or on a future date (maturity).

CALL Option is the right to BUY (remember CB)

PUT Option is the right to SELL (remember PS)

Example: The option to purchase 100 common shares of ABC Corp., on or before a certain date at a fixed certain price per common share would be referred to as an ABC call option.

The usage of Options can be for hedging purposes or entirely for a speculative investment position.

There are two parties to an options contract:

The buyer of the options contract purchases either a Call Option or a Put Option. They become the Holder of the options contract and they acquire the right to buy (Call) or sell (Put) the specified amount of the underlying interest.

The seller of the options contract sells either a Call Option or a Put Option. They become the Writer of the options contract and they now have a contractual obligation to buy or sell the specified amount of the underlying interest if the option is exercised by the Holder.

Every options contract is separate. When a Writer "sells" a Call Option to a buyer, that is all that transpires in the transaction, there is no opposite put option on the behalf of the Writer nor is any related to or involved with this one-time transaction. All the Writer does is sell either a Call option or Put option contract to a requesting counterparty.

In basic common equity share and commodity options:

The buyer ("Holder") acquires an option contract by paying an up-front fee ("Premium") to the seller ("Writer"). Option premiums are not a down payment, it is a non-refundable payment for the rights conveyed by the option. The premium paid for the option reflects two components of an option's value:

The difference between an option and a futures contract is that exercise of the option is entirely "optional" for the buyer (holder) of the option; however, the seller of the option must deliver into the contract if called upon to do so by the buyer.

The only risk for the purchaser is the price (premium) paid for the option. On the other hand, the option seller (writer or grantor) has unlimited liability same as in a futures contract as the option may be exercised.

Options can be traded on an exchange or in the over the counter (OTC) market between two parties.

Exchange traded options are standardized contracts with fixed maturity dates, prices and amounts; OTC options specifications vary and are negotiated between the parties before sale.

The credit risk associated with Exchange traded options is perceived as minimal, since the exchange serves as the clearing house and takes measures (such as margin call) to assure that contracts are honored.

As with futures, option positions can be closed out by offset - a transaction of equal size and on the other side of the market from the transaction that originated the position.

The variables to value an option are: market price of the underlying, option strike price, tenor of the option, price volatility of the underlying asset/index (the greater the volatility the more than chance the asset will move above/below the strike price), money market interest rates, and whether it is an American or European option.

Certain types of options may be exercised only during certain periods prior to the maturity of the contract:

American option: can be exercised anytime prior to the maturity date (expiration date of the contract).

European option: can only be exercised on the expiration date or during a specific period prior to expiration.

From the moment the options contract is entered into and until the moment the contract matures on the expiration date, the cash value of the underlying asset fluctuates constantly. The value of the option is in its relationship to a given cash value for the underlying asset:

 

intrinsic value is the amount an option's strike price is below (in the case of calls) or above (for puts) the relevant current futures price. If the intrinsic value of an option is positive, it is "In the Money." If negative, it is "Out of the money." If the strike price is the same as the relevant current futures price (underlying contract), it has no intrinsic value and is "At the Money."

time value is whatever amount of value an option has in addition to its intrinsic value. Time value reflects what a buyer would be willing to pay for the option in the hope that before or at expiration, it will develop intrinsic value and enable the buyer to exercise the option at a profit. Generally, the time value of an option declines as the maturity date approaches since there is less time for the option to develop any intrinsic value.

 

Example: If a Holder has an options contract to buy (Call) 100 common shares of ABC Corp., at $14.50 per share, and the market price on a specific day is $15.00 per share, then the options contract is "In the Money" because the Holder could exercise the options contract and buy 100 shares at $14.50 per share from the Writer of the contract, take delivery of the shares and turn around and sell them in the market for $15.00 per share and pocket the $.50 profit per share.

 

Conversely, if a Holder has an options contract to buy (Call) 100 common shares of ABC Corp., at $14.50 per share, and the market price on a specific day is $14.00 per share, then the options contract is "Out the Money" because it is of no value to the Holder to exercise the options contract and buy 100 shares at $14.50 per share, take delivery of the shares and turn around and sell them in the market for $14.00 per share, as that is a loss of $.50 per share.

 

However, if a Holder has an options contract to sell (Put) 100 common shares of ABC Corp., at $14.50 per share, and the market price on a specific day is $14.00 per share, then the options contract is "In the Money" because the Holder could exercise the options contract, go into the market and separately purchase the 100 share of ABC Cop. at $14.00 per share, and then sell 100 shares at $14.50 per share to the Writer of the Put option contract and pocket the $.50 profit per share.

Basically, the value of an option is the Maret Price minus the Strike Price.

The majority of most options contracts are never exercised. Rather, they are closed out by an offsetting contract once the original contract is either "In" or "Out" of the money.

Types of Options

Asian or Average Rate Option is the right, but not the obligation, to purchase (buy / call / long / receive) or sell (put / short / deliver) an underlying asset where the settlement is based on the difference between the exercise price and the average price of the underlying over a predetermined period, with the average price being dependant on predetermined fixing intervals which can be daily, weekly, monthly or a specific number of days.

A Currency Option is the right, but not the obligation, to purchase (buy / call / long / receive) or sell (put / short / deliver) a specified amount of foreign currency at a fixed price on a future date.

Currency Basket Options: combines all the different currencies a customer wants to hedge into a single basket, or index. This reduces the concern with a single currency move because the bank that sold the option pays out based on the moves in aggregate (lower risk).

An Interest Rate Option may be exchange listed or privately traded (OTC/over the counter), and they give the holder the right, not the obligation, to receive (call / long) a payment if the indexed interest rate exceeds a specified strike price or if the indexed interest rate is below (put / short) the specified strike price. Interest rate options also include Cap, Floor and Swaption transcations.

A Stock Option is the right, but not the obligation, to purchase (buy / call / long / receive) or sell (put / short / deliver) a specified amount of shares of the stock that underlie the stock option.

Characteristics of an Options Contract

Barriers: make an option vanish if rates go up above or down below a certain pre-arranged limit; are options that are activated or extinguished when the underlying spot hits a predetermined level.

A Bear Call Spread is constructed by the sale of a call option and the simultaneous purchase of another call option with the same expiration, whereby the short call has a lower strike price than the long call.

A Bear Put Spread is constructed by the sale of a put option and the simultaneous purchase of another put option with the same expiration, whereby the short put has a lower strike price than the long put.

A Straddle is an option position involving a put and a call option on the same underlying asset/security. To buy a straddle, one will buy both a put and a call that have the same expiration date and strike price. The straddle is a function of the currency price at expiration:

If the underlying asset/security price equals the exercise price at expiration, both the put and the call expire worthless, and the loss of the straddle is the entire premium price paid for the position.

Any movement in the currency price away from the exercise price at expiration gives a better result.

The straddle position breaks even if the price movement of the underlying asset/security either rises over or falls below the strike price the same amount of the purchase premium for the option position.

If the price of the underlying asset/security differs greatly from the exercise price, there is an opportunity for substantial profit.

One is covered against substantial volatility if the price movement at expiration is greater than the strike price plus/minus the premium for the option as the gain on one side of the straddle offsets the loss on the other side.

The seller of the straddle bets on low volatility), profits if the underlying asset/security price at expiration lies close to the strike price and somewhere between plus or minus the amount of the premium paid by the purchaser. If there is low volatility, and the price of the underlying asset/security is between the strike price plus or minus the premium paid by the purchaser, the loss/gain in either direction is offset by the corresponding loss/gain of the straddle, with the total loss to purchaser being the net loss/gain applied against the premium price.

A strangle is similar to a stradle. A long position (buys) consists of a long position in a call and a long position in a put on the same underlying asset/security with the same expiration date however, with the call having a higher exercise price than the put. One purchases the put and call for the total outlay of the premium for both positions.

The put and the call cannot both have value at expiration.

To be in the money, the price of the underlying asset/security must move over the price of the call strike price or below the put strike price.

For the long strangle to show a profit, the call or the put must be worth more than the total premium cost of the strangle.

The seller of the strangle, would profit if there is low volatility and the price of the underlying asset/security was between the two strike prices.

Knock-in and knock-out barrier options - are activated or deactivated when the price of the underlying index (usually a floating rate such as six month Libor) hits or goes beyond a fixed limit. The buyer receives a fixed value if the fixed limit is not broached and nothing if it is broached.

Options Exchanges

The Chicago Board Options Exchange maintains the VIX / Volatility Index. When equity fund managers become nervous about whether there may be a decline in the values of equities they purchase Puts on the S&P 500 Index (index puts function as a form of portfolio insurance), thus the VIX goes up.

NYSE Amex Equities has options on:

Domestic equities

American Depositary Receipts (ADRs) for foreign corporations

Broad-based, industry sector and international indexes

Exchange traded funds (ETFs)

HOLDRS

LEAPS (Long-term Equity AnticiPation Securities)

Equity and Index FLEX (Leaxible Exchange) options

NYSE Amex Equities (former American Stock Exchange / AMEX; former NYSE Alternext US)   www.nyse.com/equities/nysealternextus/1218155408912.html

NASDAQ OMX Group absorbed the options trading of the former Phildadelphia Exchange (PHX), now renamed the NASDAQ Options Market.

NASDAQ   www.nasdaq.com/

Settlement

Settlement is the actual transfer of funds between the payer’s financial institution and the payee’s financial institution. Settlement discharges the obligation of the payer financial institution to the payee financial institution with respect to the payment order.

In the United States, the cash purchase transaction for options must be settled within one (1) business day, which is also referred to as T + 1.

Information Sources

Options Clearing Corporation (OCC) Volume Reports.
www.optionsclearing.com/onn/volume/volume_information?action=gtsp&pkind=options

Options Clearing Corporation (OCC) Daily Contract Volume Report.
www.optionsclearing.com/market/vol_data/main/contract_volume.jsp