Mechanics of Options Market

After completing this reading, you should be able to:

  • Describe the types, positions variations, and typical underlying assets of options.
  • Explain the specification of exchange-traded stock option contracts, including that of non-standard products.
  • Describe how trading, commissions, margin requirements, and exercise typically work for exchange-traded options.

Types, positions variations, and typical underlying assets of options

The buyer of an option has the right but not the obligation to exercise the option. The maximum loss to the buyer is equal to the premium paid for the option. On the other hand, the potential gains are theoretically infinite.

To the seller (writer), however, the maximum gain is limited to the premium received after writing the option. The potential loss is unlimited.

Some of the symbols used to represent relevant factors when dealing in options include:

\(X\) = strike price

\({ S }_{ t }\) = Price of the underlying asset at time \(t\)

\({ C }_{ t }\) = the market value of a call at time \(t\)

\({ P }_{ t }\) = the market value of put option at time \(t\)

\(t\) = the time to maturity/expiration of the option

A call option gives the owner/holder/buyer the right but not the obligation to buy the underlying stock at a given price on expiry. The buyer is said to hold a long position in the contract, while the seller is said to hold the short position.

When the stock price is less than or equal to the stock price at maturity, the buyer cannot exercise the option because the payoff would be zero. If the stock price is higher than the exercise price at maturity, the long will most likely exercise the option. The payoff of the call will be equal to the difference between the market price and the strike price \(\left( { S }_{ t }-X \right) \).

frm-call-optionsA put option gives the holder/buyer the right but not the obligation to sell the underlying stock at a specified price. At expiration, the buyer will only benefit if the prevailing market price is less than the exercise/strike price. The payoff is equal to \(\left( { X-S }_{ t } \right) \). If the stock stays at \(X\) or above, the payoff will be zero.

frm-put-optionsUnderlying Assets

Options can be initiated upon several underlying assets. In this regard, we can have four main types of options:

Stock options

These are usually exchange-traded, American style options. A single option contract is usually made up of 100 stocks. This implies that if a call option is trading at $5, the contract would cost $500.

Currency options

The holder of a currency option has the right to buy or sell an amount of foreign currency based on a domestic currency amount. The unit size for currency options is larger than stock options.

Index options

Index options have stock indices as the underlying. They are found in both over-the-counter markets and exchange-traded markets. The payoff of an index call is positive when the prevailing price of the stock index is higher than the index level specified in the option.

Futures options

An option on futures gives the holder the right, but not the obligation, to buy or sell a futures contract at a predetermined price, on or before its expiration.

Specification of Exchange-traded Stock Option Contracts

Expiration

Exchange-traded stock options can either be American or European style. While European options can only be exercised at expiry, American options can be exercised at any point during the life of the option. Expiration dates can control how options are named. For example, a January put option on Facebook stock means that the option expires in January. The actual date of expiry is also likely to be specified.

Strike Prices

The value of the stock directly controls the strike price. At the expiration date, the difference between the stock’s market price and the option’s strike price determine the option’s payoff.

Moneyness, Time Value, and Intrinsic Value

If an option stands to make money if it were to expire today, the option is said to be in-the-money (ITM). If the option wouldn’t make money if it were to expire today, it’s said to be out-of-the-money (OTM). If the current market price is equal to the strike price, the option is said to be at-the-money (ATM). Whether an option is ITM, OTM, or ATM depends on the investor’s position in the contract, i.e., short or long, and the strike price.

The intrinsic value of an option is the difference between the prevailing market price of the underlying and the strike price.

Intrinsic value of a call option = \(max\left( 0,{ S }_{ t }-X \right) \)

Intrinsic value of a put option = \(max\left( 0,{ X-S }_{ t } \right) \)

The time value of an option is the difference between the option premium and the intrinsic value.

We could also summarize it as:

$$ Option \quad premium = Time \quad value + Intrinsic \quad value $$

Non-standard Products

They include

  1. Flexible exchange (FLEX) OPTION: These are exchange-traded options on stock indices, but there’s a lot more flexibility. The strike price and expiration dates can be altered if the trading parties so wish.
  2. ETF options: These are American-style options that are settled by delivering the underlying shares rather than cash.
  3. Weekly options: These are short-term options with a maturity period of roughly 7 days. They are created on a Thursday, with the expiration date being the Friday of the next week.
  4. Binary options: Binary options have a fixed payoff in case the option is ITM at expiration.
  5. Credit event binary options (CEBOS): The CEBOs payoff is triggered when the reference entity suffers a credit event before the option’s expiration date.
  6. Deep out-of-the-money (DOOM) options: They are designed to only be ITM in the event of a large down price movement in the underlying asset.

The Effect of Dividends and Stock Splits

Stock dividends

Instead of paying cash, a stock dividend involves issuing extra shares to shareholders. For example, if a firm announces a 2% stock dividend, then for every 100 shares held, shareholders will receive 2 more shares.

Exchange-traded options are not usually adjusted for cash dividends. In other words, when a cash dividend occurs, there are no adjustments to the terms of the option contract.

Stock splits

A stock split involves increasing the total number of shares outstanding by issuing more shares to shareholders at a specified ratio. For example, a 2-for-1 stock split this means a shareholder will be awarded one more share for every two shares held.

If a stock has a b-for-a stock split, the share price will be reduced by a factor of (a/b). However, this is a theoretical assumption. In reality, the post-split share price can be different. The number of shares will increase by a multiple of (b/a).

The terms of exchange-traded options contracts are adjusted to reflect expected changes in a stock price arising from a stock split.

Market makers, Trading Commissions, and Margin Requirements

Most options exchanges use market makers to facilitate trading. The market maker will quote bids and offer prices.

A commission refers to the fee charged by a broker as a reward for their efforts in facilitating a transaction. Commission costs depend on the size of the trade as well as on the type of broker involved. They reduce the investor’s returns.

In options trading, the term “margin” refers to the collateral deposited by the option writer as a form of guarantee that they will honor their contractual obligations. Margin requirements differ from one broker to another and also depend on the nature of the underlying asset.

Question

What is the intrinsic value of a call option if the strike price is $63 and the prevailing market price of the underlying is $78?

  1. $15
  2. -$15
  3. $7.5
  4. $0

The correct answer is D.

Intrinsic value of a put option = \(max\left( 0,{ X-S }_{ t } \right) \)

$$ =max(0,63-78) =max(0,-15)  = 0 $$


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