1. Structure of option markets
Chapter 2
Structure of option markets

2. Concept of option
Option is a contract that gives its buyer the right but not the obligation to buy or sell an asset at a fixed price on or before a given date.

3. The seller of the option grants the buyer of option the right to purchase from or to sell to the option seller something. There is no obligation to the buyer of the option to do this. The writer grants this right to the buyer in exchange for a certain sum of money which is called option price/ option premium.
The option holder will exercise the option in future if he is in benefit otherwise he will ignore it, that is, nobody can force him to exercise so it so just the option for the holder, not the obligation.

4. In terms of timing of exercise, the option may be American or European
In terms of timing of exercise, the option may be American or European. European option can be exercised only at the end of the given period but American option can be exercised anytime within the period.

5. Features of option Option price/ Option premium
The fee/ subscription price which is paid by the buyer to the seller for buying the option is called option premium or option price. It is non refundable and not a down payment. Option price refers to the current market price of the option. The option premium and option price are the same at the time of option contract. However the option price can be changed over the time with prevailing market condition.

6. Exercise price / Strike price
The fixed price specified in the option contract at which the holder can buy or sell the underlying assets is called exercise price.

7. Option buyer (Holder)
An option buyer is the purchaser of an option contract. Option buyer has the right to buy/sell the underlying assets at pre determined price.

8. Option seller(writer)
Option seller is the person from whom the option buyer purchases the option contract. Option seller takes the short position in the option. They are obligated to honor the terms of option contract if the buyer decides to exercise the option.

9. Expiration date
The expiration date of the option contract is the date on which the option expires.

10. Underlying assets
The underlying asset is the asset to be exchanged on or before expiration date in the option contract.

11. Exercising the option
Exercising the option is the act of actually buying or selling the underlying assets as per option contract.

12. Option position
Since option is a contract it involves it involves two parties taking two different positions. The buyer of the option takes long position and the seller of the option takes short position. The seller of the option receives cash up front but has potential liabilities later.

13. Moneyness
During its life span, an option is classified as either in the money, at the money or out of money.
In the money- Option is said to be in the money if it is worth exercising. If the price of underlying assets is higher than the exercise price, call option is in the money. If the price of the underlying assets is lower than the exercise price, put option is in the money. If there is substantial difference in price of the underlying assets and exercise price, it is said to be deep in the money.

14. Out of the money – Option is said to be out of the money, if it is not worth exercising. If the price of an underlying asset is lower than the exercise price, call option is out of money. If the price of an underlying asset is higher than the exercise price, put option is out of money.

15. At the money- Option is at the money when the market price of underlying assets is equal to the exercise price. The option holder may exercise the option or may ignore it which depends upon his perception.

16. At and after expiry, the option becomes worthless
At and after expiry, the option becomes worthless. When it is in the money, the difference between the exercise price and market price of the stock gives the intrinsic value. In other cases there is no intrinsic value. The intrinsic value is always less than the selling price of option. The positive difference is called time value. The time value is also referred to the premium over intrinsic value.

17. Naked option and covered option
If the seller of the option write the option on the stock which is not belong with him or if the seller write the option without any share, that is called naked option.
If the seller writes the option upon the stock which he has already purchased or if the seller writes the option with shares is called covered option.

18. Types of options
There are two basic types of option; Call option and put option
Call option
A call option is a contract that gives its holder the right but not the obligation to buy the specified assets at specified price on or before specified date. Call option holder (owner) on the stock has right to buy at fixed price at on or before given date no matter what happens in the market price of the stock.

19. As a call option buyer, if the stock price is lower than exercise price the holder would buy the stock from market price instead of exercising the option. On the other hand, if the stock price is higher than the exercise price, the holder would exercise the right and get the profit by reselling it back to the market- provided the difference is greater than cost of option. When an investor buys a call, he is anticipating a price upward movement in the stock before the expiry date, this is the bullish attitude.

20. The value of call option at expiration is as follows;
Value of call option (Vc) = Max [(Ps – E) or 0]
Where
Ps = Price of stock at expiration
E = Exercise price/ strike price
Profit/loss to the call option buyer
Investors that expect the price rise of a particular security in the future buy a call option and take a long position. If the stock price decreases the buyer loses only premium.
Profit/loss for call option buyer = Vc – P
Where, P = premium on call option

21. Breakeven price for call option buyer = E+ P
Profit/loss to the call option seller (writer)
Call option seller sells options in an expectation that the price will fall in the future. Therefore s/he holds a short position in the option. The profit for the call option writer is the proceeds or the premium received from writing the option. If the stock price increases, call seller’s profit decreases.
Profit/ loss for call option seller = P – Vc
Breakeven price for call option seller = E+ P

22. Put option
A put option is a contract that gives its holder the right but not the obligation to sell the specified assets at specified price on or before specified date. Put option holder (owner) on the stock has right to sell at fixed price at on or before given date no matter what happens in the market price of the stock.
For a put option holder, it is experienced when the stock price is lower. When an investor buys a put, he is anticipating a price downward movement in the stock before the expiry date, this is the bearish attitude.

23. The value of put option at expiration is as follows;
Value of call option (Vp) = Max [(E - Ps) or 0]
Where
Ps = Price of stock at expiration
E = Exercise price/ strike price

24. Profit/loss to the put option buyer
Investors who expect the price decreases of a particular security in the future buy a put option and take a short position. If the stock price decreases, the buyer gains and seller losses. The loss to the put option buyer will be limited to the amount of premium if the price of the stock rises. The put option writer will benefited from the premium.
Profit/loss for put option buyer = Vp - P
Where, P = premium on put option

25. Breakeven price for put option buyer = E- P
Profit/loss to the put option seller (writer)
A put option writer sells options in an expectation that the price will rise in the future. Therefore s/he holds a long position in the option. If the stock price increases in the future, put writer’s profit increases.
Profit/ loss for put option seller = P – Vp

26. Breakeven price for put option seller = E- P
Expected value of Call option =
Max [(Ps – E) or 0] X P
Expected value of Put option =
Max [(E - Ps) or 0] X P

27. Mechanics of option trading
Placing an order
An investor who wants to trade option must first open an account with a brokerage firm. The individual then instructs the broker to buy or sell a particular option. The broker sends the order to the firm’s floor broker on the exchange on which the option trades. An investor can place several order such as market order, limit order or top order etc.

28. Margin requirement
In stock market, investors have two options available to purchase the shares of stocks. An investor can either pay full cash or pay some portion in cash and borrows rests to purchase the shares of stock. Second option is called buying on margin.
In the option market, purchaser of call and put option must pay the price in full. Investors are not allowed to purchase option on margin. i.e margin requirement is 100%. But option with maturities of greater than nine months, can however, are margined. An investor who writes the option is required to maintain funds in margin account. The margin deposit from the writer of the option serves as a good faith security deposit. This deposit ensures the broker and the exchange that the investor will not default if the option is exercised.

29. Role of clearing house
After trade is completed, the clearing house enters the process. The clearing house, formally known as the option clearing corporation (OCC) is an independent corporation that guaranteed the writers performance. The OCC is the intermediary in each transaction. It keeps the records of all long position and short position. Thus a buyer of the option should not look to the writer but to the OCC. The writer of the option therefore, makes payment for or delivers underlying stocks to the clearing house (OCC). The OCC has number of members known as a clearing firm. All option trades must be cleared through a member. Thus the market makers and brokerage firms should clear option trade through a member. Although in some cases a brokerage firm is also a clearing firm. Member of OCC should open an account with a certain minimum amount of funds. This funds is used to offset the loss if any member defaults on an option obligations.

30. Exercising options
An American option can be exercised before or on the expiration date. European option on the other hand can be exercised only on expiration date. When the buyer of an option wishes to exercise the option should notify to his broker. The broker then notifies the OCC. The OCC then selects particular investor on random basis who has written the same option. The OCC member using a procedure established and made known to its customer in advance.
If call option is going to be exercised writer is required to sell the stock at given exercise price. If it is put option, writer of the put option is required to buy the stock at a given exercise price.

31. Placing an offsetting order
Suppose an investor holds a call option. The stock price recently has been increasing and the call’s price is now much higher than the original purchase price. Investor can get profit by selling the option in the market. This is called an offsetting order. Investor could open a position by buying a call and later close that position by selling the call option. Similarly, one could open a position by selling a put and close the position by buying the put option. So investor can offset the position by taking the opposite position for the existing position in the same option.

32. Transaction costs in option trading
Trading option in the option exchange is no free of cost. It entails two types of cost.
Market impact transaction cost
Bid ask spread is market impact transaction cost. Placing buying order will be executed at ask price (dealer’s selling price) whereas placing selling order will be done at the bid price (dealer’s purchase price). For traders buying price is always greater than selling price. This spread (Ask price minus bid price) represents the cost of immediacy (price paid for immediate trade).

33. Broker commission
There is range of commission for trading options. Trade occurs electronically over the internet usually involves lower commissions than trade that involve a broker. Full service brokers usually charge more than discount brokers. Traders are also ready to pay more because they receive personalize service on trading options.

34. Underlying assets in the option contracts
Options can be traded on a wide range of commodities and financial assets. The commodities include wool, corn, wheat, sugar, tin, petroleum product, gold etc and financial assets include stocks, currencies, treasury bonds.
Exchange traded options are actively traded on stocks, stock indices (index option), foreign currencies and future contract.

35. Stock option – Stock option is a contract that gives the holder right to buy or sell shares at specified exercise price. Shares are normally traded in a lot of 100 shares in USA. Thus an option contract consists of 100 shares.
Foreign exchange options – Foreign exchange option is a contract that gives the right to buy or sell stated amount of foreign currencies at a specified domestic rate in a given time. Currency options are primarily traded in over the counter market.

36. Index option – Index option is an option contract on a stock index
Index option – Index option is an option contract on a stock index. It gives right to buy or sell the index with the given multiplier at the specified exercise price. For example, one call option on the S&P 500 with the exercise price of 980. S&P 500 has implicit multiplier of 100 for each option contract. If the index option is exercised when the value of index is 992, the writer of the call option in index pays the holder ( )* 100 =Rs 1200.
Future options – An option on a future contract or a future option is an option that takes a future contract as its underlying assets.

37. Option prices are available daily in the Wall street journal and many news papers. The quotation provides the price of the last trade and the volume for the day along with the exercise price, expiration date, closing price etc. Example with interpretation of a quotation can be as follow-
Calls
Last sale
Bid
Ask
Net
Vol
Open int.
07April 80 10 12 13 2
150
15400

38. Interpretations;
Call option expires on 2007 April (col. 1)
Exercise price is Rs 80 (col.1)
Call option price was Rs 10 on quotation day (yesterday) (col.2)
Price of call option has gone up by Rs2 on that day (col.5)
Price of call option the day before yesterday was Rs8 (col.2 & 5)
Dealer is willing to pay Rs 12 for the call option (col.3)
Dealer is ready to sell call option at Rs 13(col.4)
On that day 150 call option had been traded (col. 6 )
Total numbers of options traded upto that day were They are outstanding call options as they have not yet exercised (col.7)
Bid ask spread is Re 1 (col.3&4) it is profit to the dealer.