All Rights Reserved Dr David P Echevarria 1 OPTIONS MARKETS (More on Derivative Securities) CHAPTER 14

Options A.Two Types of Options 1.Calls 2.Puts B.Buyer Expectations 1.Calls: stock prices will rise 2.Puts: stock prices will fall C.Seller Expectations (Writer) 1.Calls: prices will fall or stay level 2.Puts: prices will rise or stay level All Rights Reserved Dr David P Echevarria 2

All Rights Reserved Dr David P Echevarria 3 Option Writers A.Option Writers may be attempting to generate additional income in sideways market. 1.Call Writer Positions a.Covered writer; owns stock to deliver if option is exercised. b.Naked writer; does not own stock (very risky position) Highest margin requirement. Highest margin requirement. 2.Put Option Writers a.Must deposit margin equal to 50% of current value.

All Rights Reserved Dr David P Echevarria 4 GENERAL TERMINOLOGY A.Premium: the price paid per option; one option per share, contract = 100 options. B.Exercise Price (XP): the fixed [share] price for future transaction. C.Expiration date: the date the option expires.

All Rights Reserved Dr David P Echevarria 5 GENERAL TERMINOLOGY D.Profit (Loss) Definitions: In- At- or Out-of-the-Money 1.In-the-Money Call: The stock price is greater than the exercise price 2.At-the-Money Call: The stock price is equal to the exercise price 3.Out-of the Money Call: The stock price is less than the exercise price 4.In-the-Money Put: The stock price is less than the exercise price 5.At-the-Money Put: The stock price is equal to the exercise price 6.Out-of-the-Money Put: The stock price is greater than the exercise price

All Rights Reserved Dr David P Echevarria 6 GENERAL TERMINOLOGY E.Contract Specifics (CBOE) 1.Contract Size is for 100 shares. For indexes, a multiple of the index 2.Expiration Dates: current month, next month, next two months in the cycle. a.Several stocks have weekly options 3.Position Limits: max # of options held by one player on same side 4.Exercise Limits: max # of options exercised in a 5-day period.

All Rights Reserved Dr David P Echevarria 7 GENERAL TERMINOLOGY F.Players in the Options Market 1.Market Makers: Provide liquidity, Imposes spread as charge for liquidity services 2.Scalpers: near simultaneous buy at bid, sell at ask to lock in the spread. 3.Floor Broker: executes trades for public traders. 4.Order Book Official: Exchange official who oversees execution of limit orders entered into the computer. 5.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 8 TYPES OF OPTIONS A.Stock Options; 2009 > 1500 different issues (CBOE) 1. 1.Exercise (settlement involves stock delivery) Exercise also involves paying a commission on the purchase of stock. B.Index Options: settlement in CASH 1."OEX" S&P 100: Value is index value times Options available on all major market indexes 3.Advantages of Index Option Trading a.Cash settlement permits trading w/o necessity to make/take delivery. b.Options cover the market as a whole.

All Rights Reserved Dr David P Echevarria 9 OPTIONS CLEARING CORPORATION (OCC) A.Guarantees writer performance and as such is an important intermediary B.Handles the assignment on exercises C.All firms trading or brokering in options have accounts with OCC D.Sets capital requirements for members of the OCC E.Hold funds deposited for margin requirements

All Rights Reserved Dr David P Echevarria 10 MARGIN REQUIREMENTS A.Stocks 1.50% initial for long and short positions. 2.25% maintenance B.Options 1.100% of the price of the contract (already leveraged). C.Naked Calls % of current stock price plus/minus maintenance if option is in/out of the money. D.Index options have lower margin requirements (15% due to lower volatility). E.Covered Calls: Stock is usually in street name (held in margin account )

All Rights Reserved Dr David P Echevarria 11 REGULATION OF OPTIONS MARKETS A.SEC is primary regulator for options on stocks, foreign currencies, and indexes. a.CFTC is primary regulator for futures options. B.Exchanges also have rules, particularly in regards to capital requirements. C.OCC also has certain rules for member firms to follow.

All Rights Reserved Dr David P Echevarria 12 HOMEWORK QUESTIONS A.What is a derivative security and how is it valued? B.What functions do derivative securities play? C.What is a call option? a put option? D.What bet is a call buyer making? A put buyer? E.What is a naked writer? F. Understand what is meant by the following terms: 1.Option premium 2.Strike (or Exercise) price 3.Option Contract 4.Naked call writing 5.Covered call writing 6.In- and out-of-the-money for calls, puts G.What are index options? H.How index options settled?