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 Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. Important Concepts 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, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. 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, 7th ed.

Development of Options Markets Early origins Put and Call Brokers and Dealers Association Chicago Board Options Exchange, 1973 Resurgence of over-the-counter market Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. Call Options Current example Objective of a call buyer – profit from appreciation Moneyness concepts In-the-money Out-of-the-money At-the-money Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. Put Options Current example Objective of a put buyer – lock in stock price Moneyness concepts In-the-money Out-of-the-money At-the-money Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

Over-the-Counter Options Market Worldwide Credit risk Customized terms Private transactions Unregulated Options on stocks and stock indices, bonds, interest rates, commodities, swaps & currencies Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

Organized Options Trading The concept of an options exchange Listing Requirements Contract Size Exercise Prices Expiration Dates Position and Exercise Limits Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

Options Exchanges and Trading Activity See Table 2.1, p. 30 for options exchanges Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. Option Traders Market Maker Bid, ask, and bid-ask spread Scalpers, position traders, spreaders Floor Broker Designated primary market makers Dual trading Order Book Official Limit orders Electronic order processing Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

Options Traders (continued) Other Option Trading Systems Specialists Registered options traders Electronic trading systems Off-Floor Option Traders Cost and Profitability of Exchange Membership See Figure 2.1, p. 33 for CBOE seat prices Leasing a seat High risk, stressful work Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. Mechanics of Trading Placing an Opening Order Types of orders Role of the Clearinghouse Options Clearing Corporation (OCC) Clearing firms See Figure 2.2, p. 35 Margin (see Appendix 2.A) Open interest Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

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, 7th ed.

Option Price Quotations See web sites of newspapers and options exchanges Problems Delayed information Nonsynchronized prices Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. Types of Options Stock Options Index Options Currency Options Other Types of Traded Options interest rate options currency options options attached to bonds exotic options warrants, callable bonds, convertible bonds executive options Real Options Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

Executive Stock Options Executive stock options are a form of remuneration issued by a company to its executives They are usually at the money when issued When options are exercised the company issues more stock and sells it to the option holder for the strike price Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

Executive Stock Options They become vested after a period of time (usually 1 to 4 years) They cannot be sold They often last for as long as 10 or 15 years Accounting standards now require the expensing of executive stock options Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

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, 7th ed.

The Regulation of Options Markets Federal regulation Industry regulation Over-the-counter market regulation The issue of which agency has regulatory responsibility has occasionally arisen. Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

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, 7th ed.

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, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. (Return to text slide) Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. (Return to text slide) Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.

An Introduction to Derivatives and Risk Management, 7th ed. (Return to text slide) Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed.