OPTIONS MARKETS (More on Derivative Securities) CHAPTER 14 ECN-324 All Rights Reserved Dr David P Echevarria

Options Two Types of Options Buyer Expectations 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 All Rights Reserved Dr David P Echevarria

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. All Rights Reserved Dr David P Echevarria

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. All Rights Reserved Dr David P Echevarria

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-Money Put: The stock price is greater than the exercise price All Rights Reserved Dr David P Echevarria

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. All Rights Reserved Dr David P Echevarria

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. All Rights Reserved Dr David P Echevarria

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. All Rights Reserved Dr David P Echevarria

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 All Rights Reserved Dr David P Echevarria

MARGIN REQUIREMENTS Stocks Options Naked Calls 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 ) All Rights Reserved Dr David P Echevarria

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. All Rights Reserved Dr David P Echevarria

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? All Rights Reserved Dr David P Echevarria

Covered Call Option Decisions Maximize Net Cash Flow Minimize Loss FIN 330: Fundamentals of Investments ECN-324: Financial markets and Institutions

Example Plays Buy Stock, Sell Covered Calls Option Strike Price such that: X > Sbuy