Chapter 2: Structure of Options Markets

There weren't many traders at the sharp end over thirty.

Eyes flitting between flickering lines of information on four
different screens, one ear on the phone, the other on the
cries of the colleagues, twelve hours of split-second
calculations, judging yourself and being judged on the score
at the end of every day. These men and women lived and
breathed the market.

Linda Davies
Into the Fire, 1999, p. 34

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 Important Concepts in Chapter 2
 Definitions and examples of call and put options
 Institutional characteristics of options markets
 Options available for trading
 Placing an options order
 The clearinghouse
 Accessing option price quotations
 Transaction costs
 Regulation of options markets
 Margins and taxes in option transactions

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 2

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 Option terminology
 price/premium
 call vs. put
 exercise price/strike price/striking price
 expiration date

Everyday examples of options

 rain check
 discount coupon
 airline ticket with cancellation right
 right to drop a course

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 3

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 Development of Options Markets
 Early origins – 1800s, on stocks
 Put and Call Brokers and Dealers Association – early 1900s
 No liquidity to sell the option to someone else before expiration
 Option writer’s performance guaranteed only by the broker/dealer
firm
 High transaction costs
 Chicago Board Options Exchange, 1973
 Central marketplace
 Standardized terms and conditions – liquidity
 A clearinghouse guaranteeing performance

 Resurgence of over-the-counter market – 1990s

 Institutional trading – large minimum transaction size, credit risk

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 4

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 Call Options
 E.g. February 8, 2013:
 PMigros stock = TL22

A call option on Migros:

 Exercise price = TL25

 Option premium = TL1.50

 Option expiration = March 28, 2013

 Objective of a call buyer

 Bullish expectations
 If the stock price increases, the value of the call option

increases
 Moneyness concepts
 In-the-money : stock price > exercise price
 Does not necessarily mean the option is going to be exercised

 Out-of-the-money : stock price < exercise price

 At-the-money : stock price = exercise price

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 5

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 Put Options
 E.g. February 8, 2013:
 PMigros stock = TL22

A put option on Migros:

 Exercise price = TL25

 Option premium = TL1.50

 Option expiration = March 28, 2013

 Objective of a put buyer

 Bearish expectations
 If the stock price decreases, the value of the put option

increases
 Moneyness concepts
 In-the-money : stock price < exercise price
 Does not necessarily mean the option is going to be exercised

 Out-of-the-money : stock price > exercise price

 At-the-money : stock price = exercise price

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 6

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 Options Trading Activity

 By the end of 2020, exchange-traded option volume approximately

$626 billion notional principal (Bank of International Settlements)
614 billion interest rate options
12 billion currency options
 By June 2020, over-the-counter option volume approximately $53.6
trillion notional principal (Bank of International Settlements)
38.3 trillion interest rate options
11.8 trillion currency options
3.5 trillion stock options
 OTC options notional amount outstanding fell dramatically during the
Financial Crisis of 2008 (see Figure 2.1)
 OTC options market value outstanding rose sharply during initial phase of
Financial Crisis of 2008 (see Figure 2.2)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 7

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 Over-the-Counter Options Market
 Worldwide
 Credit risk
 With no “exchange” guaranteeing performance, OTC transactions always
carry credit risk
 Institutions with good reputation are the major players in the OTC market
 Customized terms
 Underlying
 Expiration date
 Size of the transaction
 Private transactions
 Information signaled by large-size transactions is shielded from public
 Unregulated
 New contracts can be created without government approval
 Flexible enough to satisfy the changing needs of investors
 Options on stocks and stock indices, bonds, interest rates, commodities,
swaps and currencies
 Options on most organized exchanges are available on certain stocks and
stock indexes

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 8

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 Organized Options Trading
 A legal corporate entity organized for the trading of securities, options, or futures:
 Provides a physical place
 Establishes rules and regulations for conducting the trade transactions
 “Standardization” of the options contracts is the key role played by an

options exchange
• Standardization makes options contracts more liquid and marketable
 Listing Requirements – determination of eligible stocks on which options can be
traded (https://www.borsaistanbul.com/en/sayfa/3056/underlying-assets)
 Contract Size – how many stocks are represented by each option contract (each
call option contract represents options to buy 100 shares)
 Exercise Prices – an exercise price determined to attract trading volume (https://
www.borsaistanbul.com/en/sayfa/3068/strike-prices)
 Expiration Dates – only standardized expiration dates are available
 Position and Exercise Limits – maximum number of options an investor can hold
on one side of the market

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 9

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 Options Traders
 The Market Maker (Liquidity Providers)
 Stands ready to buy or sell
 Quotes

• bid price (max price that the market maker will pay to buy the option)
• ask price (min price that the market maker will accept to sell the option)
– bid-ask spread (ask price > bid price)
 Scalpers – hold positions for a few minutes; buy at bid and sell at ask before
price moves down or after price moves up
 Position Traders – hold positions for longer periods
 Spreaders – buy one option and sell another to make a profit with minimum
risk
 The Floor Broker
 Executes trades for members of the public
 Earns a flat salary or commission on each order executed

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 10

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 Options Traders (continued)
 Other Option Trading Systems
 Specialists
 Registered options traders
 Electronic trading systems
 Off-Floor Option Traders
 Option brokers
 Proprietary options traders

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 11

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 Mechanics of Trading
 Placing an Opening Order
 Types of orders:
 Market order (best price available)

 Limit order (max price to pay OR min price to sell at)

• Good-till-canceled
• Day order
 Stop order (sell the option if underlying price falls/rises)
(https://www.borsaistanbul.com/en/sayfa/2973/orders)
 Role of the Clearinghouse
(Takasbank https://www.takasbank.com.tr/en/Pages/Hakkimizda.aspx )
 Options Clearing Corporation (OCC)
 Clearing firms
 See Figure 2.3
 Margin (see Appendix 2.A)
 Open interest
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 12
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 Mechanics of Trading (continued)

 Placing an Offsetting Order

 In the exchange-listed options market
 In the over-the-counter options market
 Exercising an Option
 European vs. American style
 Assignment
 Cash settlement

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 13

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 Option Price Quotations

 See Web sites of newspapers and options exchanges

 Problems
 Delayed information
 Non-synchronized prices

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 14

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 Types of Options
 Stock Options
 Index Options
 Currency Options
 Other Types of Options
 interest rate options
 currency options
 options attached to bonds
 exotic options
 warrants, callable bonds, convertible bonds
 non-traded executive options
 Real Options

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 15

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 Transaction Costs in Option Trading

 Floor Trading and Clearing Fees

 Commissions
 Bid-Ask Spread
 Other Transaction Costs

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 16

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 The Regulation of Options Markets

 CMB (Capital Markets Board) regulation

• http://www.spk.gov.tr/apps/Mevzuat/?submenuheader=-1
 Industry (Borsa Istanbul) regulation
• https://borsaistanbul.com/en/sayfa/2967/market-
functioning
• Over-the-counter market regulation

Summary
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 17
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 Appendix 2.A: Margin Requirements
 Definitions
 Margin
 Initial margin
 Maintenance margin
 Margin Requirements on Stock Transactions
 Margin Requirements on Option Purchases
 Margin Requirements on the Uncovered Sale of Options
 Margin Requirements on Covered Calls

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 18

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 Appendix 2.B: Taxation of Option
Transactions
 Taxation of Long Call Transactions
 Taxation of Short Call Transactions
 Taxation of Long Put Transactions
 Taxation of Short Put Transactions
 Taxation of Non-Equity Options
 Wash and Constructive Sales

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 2: 19

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