Cha, ter
The Options—the Basics
after reading this chapter, students will be able to
> Understand the concept options and option markets,
> Be aware of the historical background of option contracts and markets.
> Know about the various terminologies used in option trading, such as parties to an option
contract, exercise price, expiration date, option premium theoretical and time value of option.
> Be aware of the types of option contracts, i.e., call option and put options, American and
European options, exchange-traded and OTC options, etc.
> Understand the concept of the valuation of an option and its mechanism
Distinguish between option and futures contracts.
> Understand the option positions, viz. four types of position {a) A long position in a call option
(b) A long position in a put option (c) A short position in call option (d) A short position in a put
option with their payoff profiles.
> Explain the eee and covered option, synthetic futures and options.
options, foreign currency options, index
Know about the exchange-traded options like stor
options, ae options, oe rate option, LEAPS options, FLEX options and Exotic options
v
161 INTRODUCTION
Uke futures and forward instruments, the opt ae
‘lover the world for the last three decades:
415
t derivative securities trading
cone also important
ions ae a js a security or contract or
tative security 476 — Financial Derivatives (Theory, Concepts and Problems)
instrument designed in such a way that its price is derived from the prim of aR A8Set, Ry,
example, the price of dollar currency futures will be derived from # p dolls f a tion to
currencies. Similarly, the value of January call option on gold depends on aoe old
the price of a derivative security is not arbitrary, rather it is linked to the en oO aa underlying
A price of a derivative security is affected by its features, Bh ia ealeitions! arisen
against the underlying parties. That is why, the price of a security would be it ae 8S Per relateg
derivatives features, For example, the primary difference between an option _ ‘i tures oF forw,
contract is that the options confer a right, rather than obligation, to buy or sel ‘i . underlying ass,
«As a result, payoff under options will be different to futures or forward, an ence, the Price of
underlying security. In this section, we will discuss the nature, features, types and mechanism of
options.
ce,
16.2 CONCEPT OF OPTIONS
An option is a particular type of a contract between two parties where one person gives the other
Person the right to buy or sell a specific asset at a specified price within a specific time Period. In
other words, the option is a specific derivative instrument under which one party gets the right, but
no obligation, to buy or sell a specific quantity of an asset at an agreed price, on or before a particular
date. For example, one Person buys an option contract to purchase 100 shares of State Bank of India
at 300 per share for a period of 3 months. It means that the said Person has the right to purchase the
share of State Bank of India at 300 per share within 3 months from the date of the contract. If the
Price of State Bank of India increases, he will exercise the option, and if the price falls below 3300,
then he will not exercise his option,
It is evident from the above that an option is the right, but not the obligation to buy or sell
Something at a specified date at a stated Price. It means the option buyer will exercise the optionally
when he is in profit. In case of loss, he will not exercise the option. Today, options are traded on a
variety of instruments like commodities, financial assets as diverse as foreign exchange, bank time
deposits, treasury securities, stocks, stock indexes, petroleum Products, food grains, metals, etc.
EXAMPLE: Assume that a stock is selling in the market the call Price Cr = €4.25 when the market price of
stock 5; = €50 and strike price is €46. The arbitrageur can sell the call on 100 shares, and thereby receives €425,
and buy the stock for €5,000. Since the option is in the money, the arbitrager will exercise the option and he will
deliver the shares and receives 4,600. The arbitrage profit is 425-(5,000 — 4,600) = %25.
16.3 HISTORICAL BACKGROUND
The history of options are as old as trading in the business world. The idea of Options has existed
from ancient Roman and Greek times. The teferences to options have also been found in the famous
‘Tulip Bulb Mania’ which had gripped Holland in the Seventeenth century. It was perhaps one of
major cause for the boom as well as its end as many of the option writers tefused to take delivery of
the tulip bulb when the bubble had burst,
Options on commodities have existed in different forms since 1860 in USA. First such trading
was on major grains but the options were met with immediate Opposition from the farmers, and as 2
result, such option trading was eliminated in 1869, Afterwards, by Passing the Commodity Exchange
Act in 1936, there was ban on' option trading in various commodities like wheat, cotton, rice, comm,
cats, barley, grain sorghums, milk feeds, butter, eggs, potato, ete Further, in 1940, more commodities The Options—The Basics 477
like wool, fats, oils, soya bean, ;
options disapeared nl iz ee or mal ee also added in ban. As a result, commodity
Pes ctatellesptneplaernt options were continued to prosper in London, and
; ge firm: inctioning in London options market for their American customers.
Options ven oe in London on cocoa, coffee, copper, silver, sugar, lead, tin, zinc, etc. As a
a y the early 1970s, London options market had become a popular market at the international
rating eran eae due to scandal in USA, and the result was the Commodity
a rad CRTCh Ts (CEA) of 1974, and the creation of the Commodity Futures Trading
om }), The CFTC responded by proposing regulations governing options traded
off-exchange by firms already engaged in such trading. In 1978, the Futures Trading Act reinforced
the ban on option trading but also directed the CFTC to develop regulatory structure for option trading.
In September 1981, the CFTC initiated an option pilot program for exchange-traded commodity
options. Eight futures exchanges subsequently applied to trade options on futures contracts, including
options on precious metals, agricultural products, financial instruments, etc.
"As observed earlier, the options as stocks have been traded actively for nearly a century in the
over-the-counter (OTC) market under the auspices of the Put and Call Dealers Association. The
first options were traded as individual stock on an organized exchange in 1973, when the Chicago
Board Options Exchange (CBOE) came into existence. The CBOE listed standardized call options
on 18 common stocks. Since then, several other exchanges like the American Stock Exchange, the
New York Exchange, the Pacific Stock Exchange, and Philadelphia Stock Exchange have introduced
trading options on individual stocks.
Te 1980s, stock exchanges expanded the scope of option trading by including options on other
financial assets. For example, in 1982, the Philadelphia Stock Exchange introduced options on
foreign exchange, and the American Stock Exchange on bills, T-notes, T-bonds and gold. In 1983,
the CBOE began trading options on the Standard and Poor's 100 Index. Several other exchanges also
followed such options and futures trading, A list of important options exchanges functioning in the
USA is given in Table 16.1.
TABLE 16.1 Option Exchanges and the Main Items they Trade in USA
Main items
Exchange
‘American Stock Exchange Stosks, options on individual stocks and options on stock indexes
Chicago Board of Trade Futures, options on futures for agricultural goods, precious metals,
stock, stock indexes and debt instruments
Chicago Board Options Exchange | Options on individual stocks, options on stock indexes and options on
treasury security
Chicago Mercantile Exchange Futures, options on futures for agricultural goods, stock indexes, debt
instruments and currencies,
Futures and options on agricultural futures
tures for metals
Coffee, Sugar and Cocoa Exchange
Commodity Exchange (COMEX) _| Futures and options on fut
»ptions on agricultural futures
Kanas City Board of Trade Futures and oj :
Mid America Commodity Futures and optioris on futures for agricultural goods and precious
metals
Futures and options on agricultural
futures
si;
Minneapolis Grain Exchange 478 Financial Derivatives (Theory, Concepts and Problems)
vain items
rrency and debt instrimen,
Exchange
New York Cotton Exchange Futu
futures
Fatures and options on stock indexes :
energy futures
res and options on agricultural, cu
New York Futures Exchange
New York Mercantile Exchange Futures and options on energy TUIUNT® ______
| New York Stock Exchange Stocks and options on individual stocks and a stock index |
Pacific Stock Exchange Options on individual stocks and a stock index
Philadelphia Stock Exchange Stocks, futures and options on individual stocks, currencies and stock
indexes.
In India, options have been traded on the over-the-counter (OTC) markets with names like Teji,
Mandi, Phatak, etc. Commodity options trading was banned in India in 1952 and it still continues,
Options on securities were banned in 1969. However, it has been allowed in financial markets in
1995. The Reserve Bank of India has allowed certain options to cooperate with high forex exposure
and also to all authorized dealers for option trading in rupee dollar exchange markets. The Bombay
Stock Exchange and National Stock Exchange have also started options trading in stock from 2001.
This has been discussed in other chapters in detail.
16.4 OPTIONS TERMINOLOGY
Following are the important terms which are frequently used in option trading:
Parties of the option contract: There are two parties to an option contract: the buyer (the holder)
and the writer (the seller). The writer grants the buyer a right to buy or sell a particular asset in
exchange for a certain sum of money for the obligation taken by him in the option contract.
Exercise price: The price at which the underlying asset may be sold or purchased by the option
buyer from the option writer is called exercise or strike price. At this price the buyer can exercise
his option.
Expiration date and exercise date: The date on which an option contract expires is called
expiration date or maturity date. The option holder has the right to exercise his option on any
date before the expiration date. In other words, the date after which an option is void is called the
expiration date. Exercise date is the date upon which the option is actually exercised, whereas the
expiration date is the last day upon which the option may be exercised.
Option premium: The price at which option holder buys the right from the option writer is called
option premium or option price. This is the consideration paid by the buyer to the seller and it
remained with the seller whether the option is exercised or not. In other words, the price or premium
is paid by the holder to the writer of the option against the obligation undertaken. This is fixed and
paid at the time of the formation or writing an option deal.
Option ‘In’, ‘Out’ and At-the-money: An option contract at a particular time, can be in-the-
money, out-of-the money and at-the-money. When the underlying futures price/stock price is greater
than the strike or exercise price, the call option will be in-the-money, and if the futures price is lesset
than the strike price, it will be called out-of-the money call option. Further, if the futures price is
equal to the strike price, it is said that call option is at-the-money. The reverse is the position in cas
of put options. This has been shown in Table 16.2. 479
Futures < strike
Futures = Stike
jt should be noted that some
instead of futures pri
options : S Price to determi tts have
. mi con
ine options are listed with the exchanges Me the option as ies the market price of the stock
“erlving asset, SO it can also be urea aa the market price chan 2 Of Ouof-the money. Since
ihat the European option cannot be exer ise pathether the option i epee eee
io determine the option in money ame ‘maturity, so theft ee
, : lutures price will be appropriate
Futures > §
Financial expe Sire]
The break-even-price: It is that Price of
ihe option premium. The break-even-price the stock where the
\ Zain on the option is just equal to
level j :
premium paid together. In other words, the ae determined by adding the strike price and the
option premium and yields a potentially unlimited net, sufficiently deep in-the-money to cover the
- . Fi : imited net
from selling a call is the mirror image of the profit fom en nana
all.
EXAMPLE: Suppose that a call with a strike
Price of K = % 150 is selling for C,%20 at when the
siock is selling for S,—% 180. To arbitrage, an individual trader could buy the call on Tooshares of sock ‘otza00
(ie, 100 x 20) and acquires the 100 shares of stock for %15,000. Finally, he will sell the shares in the ‘pot
market for 218,000. The arbitrage profit is (15,000 + 2,000 — 18,000) = 21,000, however subject to present value
of option expiration period.
16.5 TYPES OF OPTIONS
Options can be classified into different categories:
1. Call and Put options
2. American and European options
3. Exchange-traded and OTC-traded options
16.5.1 Call and Put Options
as ing asseU/stock from the
sght to purchase the underlying asse
When an option grant the buyer (oli pee ai thin a specified expiration date, its called
nite (Seller) a particular quantity a! Spe purchase: its holder has the privilege of purchasing or
. 0 s :
a option or simply a call. It is of it buy an asset. The call option holder pays the premium to
calling from a second party (i.e
i ion. i s the right to sell
the writer for the right taken 19 the ae tion contract where the option a ea ton t
. jon’s _ iS
A put option, on the other hands ‘ specified price at oF prior aoe teaia stock, you have gained
the underlying asset to the writer, a put option on State Ba 0 , nat “ke ora ds
also called, simply a put. Thus if YOu uy & Pat a specified price on OF
the right to sell the shares of SBI (0 "© buys a European call option to
stor WhO
° rice of %320 per share. Further
at an inv
a strike pt
der t
Example of a call option: Let US Ph gig (SBD WI
Purchase 100 shares of State Ban 480 Financial Derivatives (Theory, Concepts and Problems)
assume that the current market price of the share (SBD. is ae oa eas coton i
i tion to purchase one share . 1 inv 000. si
thespten is ‘Bier sany Penes, he investor can exercise only onthe expiration date. I the SB
price on that date is less than €320 then the investor will not exercise 1 es option. ere is no poin,
in buying SBI share for £320 if the same is available from the market at ster price than 2399,
In this position, the investor will lose the whole of his initial investment of €2,000. Let us as
that the share price of SBI is above %320 on the expiration date then the option will be exercise,
Assume that the SBI share price is 350. By exercising the options, the investor is able to buy 109
shares of SBI for £320 per share and if the share is sold immediately, the investor makes a gain of
3,000 [(€350 - €320) x 100] ignoring transaction costs. When the initial cost of the option is taken,
into account, the net profit to the investor is 1,000 (i.e., 73,000 — %2,000). Table 16.3 summarizes
the earlier example.
ince
TABLE 16.3 Profit from Call Option (European)
‘An investor buys a call option to purchase 100 SBI shares
Strike price %320 per share
Current stock price %310 per share
Price of an option to buy one share | %20
The initial investment is 100 x 820 = %2,000
The outcome: Assume at the expiration of the option, SBI share price is £350. At this time, the
option is exercised for a gain of (8350 — %320) x 100 = 3,000. When the initial cost is taken into
account, then the net gain is $3,000 — 2,000 = 71,000.
Figure 16.1 shows the way in which investor’s net profit/loss on an option contract to purchase
one share of SBI which varies with terminal share price in the earlier example. It is important to note
that the investor will incur loss ‘till the market price of the share does not increase more than strike
+30 Break-Even-Price
Exercise Price
0 } 1 } \ n n n }
260 280 = 300 30 40 360 «380 «400 «= 420
Stock Price
Loss
FIGURE 16.1 Profit from buying a call option (European). . + oe The Options—1
price, and in the above example ees beics a,
e More than %341
if the market price of the share rises above the he Ree Lewes
he , Le, 0
the market price of the share is €330
he will exercise the option,
Per share because some loss
As dis i i i
: eae in Carlier section, the buyer of the put option gets the right o sell the
above example of the SBI shares. The i oe Specified price within the particular time. Let us consider the
price of €320 per share. Suppose thatthe uhm usatie an Put option to sell 100 SBI shares with a strike
is in three months and the price of a put option to sell one
31,500 15 x 100). Since the option i iwi ,
strike price of £320. ption is European, it will be exercised only if the share price falls below the
Let us assume that the market price on the expiration date is £300. In this situati i
can purchase 100 shares of SBI from the market at %300 and will sell to He ea ei Ce
party) at €320, and hence, making a gain of €2,000 [i.e., 100 x (320 - 300)]. After deducting the
initial cost of 71,500 on the purchase of option, the net gain will be 7500 (ie., %2,000 - 21,500).
However, if the market price is ¥320 or more than 320, the put option expires worthless and the
investor loses % 1,500. Table 16.4 and Figure 16.2 show the summary of this option transaction and
the way in which the investor's profit/loss on an option to sell one share varies with the terminal
stock price in this example of SBI share.
The outcome: At the expiration of the option, the SBI share price is €300. At this time, the investor
buy 100 SBI shares at £300 and then sells at €320 to the option buyer to realize %20 per share, being
2,000 in total. When the initial cost is taken into account, the net gain %2,000 - €1,500 = 2500 in
this option.
TABLE 16.4 Profit from Put Option (European)
‘An investor purchases a put option to sell 100 SBI shares
Strike price 320 per share
Current share price 2300
Price of put option to sell one share | @15
Initial investment on the option ZS x 100 = 71,500
Figure 16.2 shows the way in which investor’s net profit/loss on a put European option contract
to si share of State Bank of India which varies with terminal stock price, as shown in the
sabe should be noted that the investor will incur loss till the market price of the shave does
not fall below the strike price, i.e., 7320. The maximum loss to the investor will be 71,5
100 x 15. However, he will exercise the option if the market price is below %320 at the expiration
date, ie., after three months. Assuming the price is 2300, then the net gain to the investor wil
%500 (see Table 16.4). : 482 — Financial Derivatives (Theory, Concepts and Problems) ee
+40-
Profit
+30:
Break-Even Price
4207-
Exercise Price
+10:
0
FIGURE 16.2 Profit/loss from buying a put option.
16.5.2 American and European Options
On the basis of the timing of the possible exercise, the option contracts can also be classified into
two categories: American options and European options. A European option can be exercised only
at the expiration date, whereas the American option can be exercised at any time up to and including
the expiration date. Thus, the definitions given above relating to ‘call’ and ‘put’ options apply to the
American style options. Most of the options traded in the world today are the American style options.
There is nothing particularly geographical about the names, it is just a convention.
16.5.3 Exchange-traded and OTC-traded Options
The options can be traded like other financial assets either on an organized exchange or on the over-
the-counter (OTC) market. Exchange-traded option contracts, like futures contracts are standardized
and are traded on the recognized exchanges. On the other hand, over-the-counter (OTC) options are
customer-tailored agreements sold directly by the dealer rather than through an organized exchange.
The terms and conditions of these contracts are negotiated by the parties to the contract. Both the
options have different mechanism of functioning which is discussed here as under:
1. Exchange-traded options, such as futures contracts, are standardized and are traded on
organized (or government designated) exchanges. On the other hand, the OTC options are
written on the counters of the large commercial and investment bankers.
2. Exchange-traded options have certain Specified norms relating to quantity, maturity dates,
underlying assets, etc. which are determined by the exchanges. However, in case of OTC
options, all such terms are subject to negotiation and mutually determined by the buyer and
the seller of the option contract. _ The Options—The Basics 483
3, Being standardized in natu ,
uniform underlying asset, limited number cf ecieeea reece dei end 60 bee
But in casv'of opdiGhs through OTC have: of strike prices, limited expiration dates and so on.
designed normally as per desire of th © not such limitations. They are tailor-made contracts
expiration dates, etc. 1e buyers. So, there are no boundation on strike prices,
4, Exchange-traded options
which interposes Heres acess oe cleared through a clearing house corporation
guaranteed by the exchanges, hence. default is " options contacts. Since ae ef OTC
traded options, the degtee of the default risk risk is almost eliminated. But in case of OTC-
if the optiods writer comrnite'defant, i is higher because there are only two parties, and
5, On buying’ th option contrict froni a recogaized ex Set aereaeeis ae
‘one of the three ways which are mentioned Sone gation cast Be "
y ned as follows:
(a) The option buyer may not exercise the contract, allowing the option to expire. All the
premium is retained by the seller and the seller's obligation is discharged.
(b) e case pepe the buyer can exercise his fight on or before the expiration
, and then, fer adhere to fulfil all the terms of contract. The writer keeps all of
the premium underlying the contract.
Either of the parties to the option contract can execute an offsetting transaction in
the option market to eliminate the future obligations. For example, the buyer sells or
the seller buys another option with the identical terms. In such situation, the rights or
obligations under the original option contract are transferred to a new option holder. It
means the option contracts can be offset even before the expiration.
In contrast, the OTC-traded options have no such facilities, as mentioned above, like
exchange-traded options. Being tailor-made and unstandardized in nature, the OTC-
traded option writers may face difficulties in offsetting the options before the maturity.
6. Incase of exchange-traded options, the writers are required to deposit the margin funds since
they are exposed to considerable risk. However, in case of the OTC options, the writers
deposit no such margins.
7. It has been observed that the transaction costs are Jower in exchange-traded options in
comparison to the OTC-traded options, ‘which depends usually on the creditworthiness of the
buyers of the options.
8. In OTC-traded options, market large investment banking firms and commercial banks normally
operate as principals as well as ‘brokers, that is why, they are less liquid in compariso® to the
exchange-traded options. Further, they take them as @ part of an asset-liability management
in which they intend to hold them to expiration.
«©
16.6 DISTINCTION BETWEEN OPTIONS AND FUTURES CONTRACTS
After going through the basic concept of the options and futures contracts, ‘one can visualize the basic
difference between these two, and that is to obligation. In the option contracts, one party (the buyer)
is not obligated to transact the contract ata later date, only the other party (seller) is under obligation
to perform the option contract, and only if the buyer desires so. On the other hand, in case of futures
contract, both the parties, the buyers and the sellers, are under obligation to perform the contract.
In case of options contracts, one party (the buyer) has to pay in cash the option price (premium) to
the other party (seller) and this is not returned to the buyer whether he insists for actual performance 484 Financial Derivatives (Theory, Concepts and Problems)
is transferred to either party at the time of
of the contract or not. In case of futures contract, no cash i
the formation of the i
The risk and rowan characteris of these two contracts oe ere fot tts
Contract, the buyer of the contract realizes the gains in cash when th Bric aed
increases and incurs losses in case of fall in the prices. The position 1 DUTT? 1” ete of
seller of the futures conract, However, inthe case of options conzacs, et Nutra: sk
Telationship doesnot arise. The most thatthe buyer of an option can 8s OF
which he possesses all the potential benefits. The maximum profit ee tidersk a
‘may realize is the options price. This is to offset against substantial Sar ended dh na
In case of option contracts, they are brought into existence by set tare ri is trad
None exists; conversely, there is no limit to the number of option contract ei ne existe ,
at any time. However, in the case of futures contracts, there is process of cl losing ou Position
cause contracts to cease to exist, hence, diminishing the total number in comparison to options,
16.7 BASIC PROPERTIES OF OPTIONS
There are certain properties of options whatever the distribution of the underlying the as
specifically in case of financial assets. A financial asset is an instrument that paysoff in cash or in
a form which can be converted into cash. So, stocks and bonds are financial assets. Currency is nop
a financial asset, since it eams a convenience yield. Before discussing the properties of the option,
following are the symbols used which are as under:
= Call Price of an Option
= Put Price of an Option
= Stock Price
= Strike or Exercise Price
= Rate of Return
Time to Maturity of Option
= Current Period
Present Value
New Strike Price
New Call Price
= New Put Price
In option trading there exists upper and lower bounds on option prices which hold whatever
the underlying of the option and its return distribution. As discussed earlier, a call option allows the
holder to buy the underlying asset at a fixed price. The upper bound on a call option price is the
Prige of the underlying asset, and in a put option, the upper bound on the price of put option isthe
exercise price.
A call option cannot have negative price. To get a higher lower bound for a call option, its
value cannot be less than (SK), where ‘Sis the price of the underlying asset and K is the exercise
Price. If the price of the option lower than ($ ~ K), one can buy the option, exercise it, and make
profit which will be equal to ($— X) minus the call price. However, this result cannot be applied 10
‘he European call option since it cannot be exercised before the maturity period,
There will be arbitrage opportunity if the call price Plus the present value of the exercise price
is lower than the stock price, which is if C(S, K, T, 1) + PH(T) K’< S, where Pt(T) is the price at!”
"
RAAB IVA a.
\ <
5 eyh't promes of call and Put options.
16.11 THE UNDERLYING ASSETS IN EXCHANGE
Various assets, which are active!
foreign c
“TRADED OPTions
Bes, are stocks, stock indices
ntracts. These have been explained in brief here as under: ‘
: Ptions on equity shares started in 1973 on CBOE, whereas on put options j
in 1977. Stock options on a number of over-the-counter stocks are also available." While sa ie
are not because of cash dividends paid to common stock holders, the strike Price is adjusted for ce
pis. stock dividends, reorganization, recapitalizations, etc. which affect the value of the underlying
stock, _.
Stock options are most Popular assets, which are traded on various exchanges all over the world.
For example, more than 500 stocks are traded in United States. One contract gives the holder the
ight to buy or sell 100 shares at the specified strike price. In India, the National Stock Exchange and
3ombay Stock Exchange have started option trading in certain stocks from the year 2001.
‘oreign currency options
‘oreign currency is another important asset, which is traded on various exchanges. One among these
s the Philadelphia Stock Exchange. It offers both European as well as American option Contracts.
Aajor currencies which are traded in the option markets are US dollar, Australian dollar, British
ound, Canadian dollar, German mark, French franc, Japanese yen, Swiss franc, etc. The size of spe contract differs: currene
nreney option, Y (0 cure
493
The Option
ney.
Mis has been explained
index options in more detail in the chapter on
Many different index options
‘or example, the S, NS ate curre
Ea fod mark EP 100 index a CHOY aM dite
US op ets, Similarly ia OB and Major M rent exchanges in different countries.
exchange and Bombay Stock Each India, such index F larket Index at AMEX are traded in the
salue at which the buyer ofthe option atte Sek ations have been sated on National tock
Sonverted into dollar (rupee) vate yn ct DAY OF sll the und ex option’s strike price s the index
ihe buyer of the stock index option on tPing the strike el yag stock inden. The ahs index is
ttwvould be complicated to x PLON intends to exercise th index by the multiple for the contract. If
vvriculat index, Hence, j settle stock index oi fe option then the stock must be delivered.
Pe enc 2, instead, stock index options y by delivering all the stocks that make up that
the option is exercised, the exchange assigned ions are cash settlement contracts. In other words, if
will be no delivery of any share, ‘option writer pays cash to the option buyer, and there
The money value of the stock i
a index i i ca
value multiplied by the contracts cane Ta eee option is equal to the current cash index
s calculated as:
Rupee value ing i
Pe of the underlying index = Cash index value x Contract multiples
__ For example, the contract multiple for the S&P 100 is $100. So, assume, the cash index value
for the S&P 100 is 750 then the dollar value ofthe S&P 100 contracts is 750 x 100 = $75,000. Index
Options are very much useful in speculating the future direction of the stock market. Some investors
have better timing skills than stock selection skills. They may be in better position to predict the stock
market when it will rise or fall, and thus, accordingly take the position in stocks or stock options.
Further, the index option after a low cost stock trading when a large cash inflow is not currently
av aie. Further they can be used to hedge an existing portfolio against a systematic decease in
stock.
Futures options
In a futures option (or options on futures), the underlying asset is a futures contract. An option
contract on futures contract gives the buyer the rights to buy from or sell to the writer a specified
future contract at a designated price at a time during the life of the options. If the futures option is
a call option, the buyer has the right to acquire a Jong futures position. Similarly, a put option on a
futures contract grants the buyer the right to sell one particular futures contracts to the writer at the
exercise price. It is observed that the futures contract normally matures shortly after the expiration
of the option. Futures options are now available for most of the assets on which futures contracts are
on the Euro dollar at CME and the Treasury bond at the CBOT.
Interest rate options 7 ar in the i ‘onal financial market
, . ons contract, which are popular in the internation’ financi: ts.
2 eagle en on cash instruments or futures. ‘There are various debt instruments,
Which are used as underlYiNg instruments for interest rate options on different exchanges. ne
contracts are referred to as options oF physicals. Recently, these ie! rate options ee gain
popularity on the over-the-counter markets like on treasury bonds, agency oe : saoeuates
backed-securities. There are governments, large banking firms and mortgage” acked-securiti
dealers who make a market in such options on specific securities. 494 Financial Derivatives (Theory, Concepts and Problems)
LEAPS options
These options contracts are created for a longer period. The longest time before expiration for a
standard exchange traded option is six-months. However, Long Term Equity Anticipated Securities
(LEAPS) are option contracts designed to offer with longer period maturities even up to 39 months.
These LEAPS options are available on individual stocks and some indexes. Usually, they are designed
for a particular purpose.
FLEX options
It is a specific type of option contract where some terms of the option have been customized. The
basic objective of customization of some terms to meet the wide range of portfolio strategy needs of
the institutional investors that cannot be satisfied through the standard exchange-traded options. FLEX
options can be created for individual stocks, stock indexes, treasury securities, etc. They are traded on
an option exchange and cleared and guaranteed by the clearing house of that exchange. The value of
FLEX option depends upon the ability to customize the terms on four dimensions, such as underlying
asset, strike price, expiration date and settlement style (ie., American vs European). Moreover, the
exchange also provides a secondary market to offset or alter positions and an independent daily
marking of prices.
Exotic options
The option contracts through the OTC market can be customized in any manner desired by an
institutional investor. For example, if a dealer can reasonably hedge the risk associated with opposite
side of the option sought, it will design an option as desired by the customer. OTC options are not
limited to only European or American type of options, rather a particular option can be created with
different exercise dates as well as the expiration date of the option. Such options are also referred
to as limited exercise options, Bermuda options, Atlantic options, etc. Thus, more complex options
created as per the needs of the customers are called exotic options which may be with different
expiration dates, exercise prices, underlying assets, expiration date and so on. 7 MA
16.14 MARGIN REQUIREMENTS IN OPTION CONTRACTS
Some of the option transactions requi se
of the options must post margin t quire {o maintain a margin. It means investors specifically sellers
and can be made by depositin, re an option position. This is analogous to posting collateral
example, if one party writes 8 of cash or other specified securities into the brokerage account. For
mice can betrcotmicht ss Re option, the loss associated with an unfavourable movement in stock
ble to fulfill their obliggticg net S¥Stem is to reduce the likelihood that option writers will be
unable oa eS igations under the option terms. Further, when an investor sells an option but
does not Writing of wane ane Said underlying stock, this practice is known as selling naked options.
we rare of naked options is too risky, because losses are theoretically unlimited in both the
options—call or put contracts. In such case, the brokers, the exchanges and the regulatory authority
want assurance that the writers of naked opt
: i i tions will fulfill their obligations. Consequently, a
substantial margin requirements are imposed by the exchanges on written naked positions. Further,
it is also observed that some brokers do not handle Tequests
i c ; to write naked options of the investors/
clients without having substantial equity in their accounts. For example, in 2001 Chicago Board
of Exchange (CBOE),
the formula for determining the margin required to write a naked call on a
common stock was; but subject to change:
Max {c + 0.1(s), c + 0.2(s) — [max (0, K — SS}
where
C : The call premium
S_: Price of stock
K : Strike price
Max {0, K — S) = Out of the money amount
As per this formula, required margin is either (a) the market value of the call options plus 10
Percent of the market values of the stock, or (b) the market value of the call plus 20 percent of the
market of the stock minus any out-of-the money amount, the required amount is the greater of (a) and
(b) Similarly, the initial margin requirements for writing the naked puts of equity share is
Max{P + 0.1(s) P + 0.20 — [max(0, S - K)]} 496 Financial Derivatives (Theory, Concepts and Problems)
where P = Put premium, S = Stock price, K = Exercise price and Max {O, S ~ K) represents the put
out-of-the-money. .
In practice, although there are guidelines set for brokers as to the amount of margin they shou
take, it is actually down to the brokers, themselves to decide. Because of this, the funds require
to write contract may vary from one broker to another, and also the clients’ trading size. It is also
possible that the broker may not ask for margin if the client has actually owned the undertying
stock in call option and in case of put option, he has taken short position on the relevant underlying
security.
Further, there are some other possibilities where you can trade without depositing the Margin,
For example, writing options by using debit spreads. It means when you create debit, you woujg
usually be purchasing in the money options, and then writing cheaper out-of-the-money options to
recover some of the costs of doing so. For example, one could buy call options of stock X with a
strike price of %100, another write a call option on this stock X with a higher strike price, assuming
the same amount of contracts as of written option. In such situation, the losses will be limited, ang
thus, no need of margin money.
The margins are levied on the contract value and the amount (in percentage terms) as dictated
by the concerned exchange. It is largely dependent on the volatility in the price of the option. Higher
the volatility, greater is the amount of margin. This amount is typically ranges from 15 percent to
as high as 60 percent in times of extreme volatility. So, the seller of the call option of Reliance
share at a strike price of €970, who receives a premium of €10 would have to deposit a margin of
%1,16,400 assuming a margin of 20 percent of the total value €970 x 600), even though the value
of his outstanding position is €5,82,000. Margin requirements differ from exchange to exchange and
on the volatility of the underlying stocks. Investors should consult their brokers to learn the rules for
margin requirements.
Some brokers classify options trading at different levels. When an investor opens an account
with the broker, then he is to request to the broker for option trading authorization. Then the broker
will decide his level within different levels ranging usually from | to 4. For example, to buy options,
one needs the basic level or Level (1) clearance. If he plans on selling naked puts, then he needs
Level (2) clearance. Further, if the investor has the necessary experience, then he can try to obtain
Level (3) clearance or higher approval.
16.15 ROLE OF MARKET MAKERS IN OPTION MARKETS
The market makers play a significant role in the stock option market. If one wants to buy or sell
an option in the market, then he/she has to wait for another party to contact you about taking the
opposite position. Sometimes, it is difficult to find the opposite party. Generally, the stock exchanges
have one more market makers who are ready to create a market for option trading by quoting a bid
and ask price. It means the market makers will take opposite position. For example, if one party wish
to sell, the market maker will buy the option at the quoted bid price, and vice versa. Normally, the
specialist is given the franchise of market making at various exchanges through other competition
exists for specialists.
‘The market makers quote bid and ask prices. The bid is the option price at which the market
maker is ready to buy the option and ask the price at which he is ready to sell the option. The ask
price always exceeds the bid price. The difference between bid and ask spread varies stock to stock. If
the option is thinly traded, i.e. low volume, the bid-ask spread may be wider. However, it is expected
that the market makers will maintain fair and orderly markets, Normally, the stock exchanges specify
_the maximum range of the spreads on the options of the different stocks.
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