Unit II: Structure of Option Markets

Option Contracts and Types

Option Contracts
Literal meaning of option: Freedom to choose.
Meaning in Financial Literature: Financial Contract
Can be used for trading various underlying assets.
General Practice of use of Option in stock trading= 1 contract for 100 shares.
Types of Option Contracts
Call Option
Put Option
Styles of Options
American Style
European Style
Asian Style
Bermudan Style
Option Terminologies
 Option Price or Value
Exercise or Strike Price
 Expiration Date
Underlying Asset
Exercising the Option

Mr Pandit bought a call option at Rs. 100 to buy 100 shares of common stock of
Sunrise Bank Limited at Rs. 800 each 3 months from the purchased date from
MR. Joshi. As the price of stock is continuously rising up and reaches to Rs. 1200
today, Mr. Pandit executes his option.
Option Terminologies
In the Money Option
Out of the Money Option
 At the Money Option
 The possible stock price of SRBL, for the contract purchased by Mr.
Pandit, on the due date were Rs. 750, Rs. 800, Rs, 850 and Rs. 1200.
WasMr. Pandit in the money, out of the money and at the money?
Option Position
Long Position
Short Position
Option Terminologies
Naked Option
Naked Call Option
Naked Put Option
Covered Option
Covered Call Option.
Option Quotation
• The option trading prices published in Newspaper is known as Option
Quotation.
Calls Last Sale Bid Ask Net Vol Open Int
19 Dec 60 10 12 13 2 150 15400

• Col 1: It is a call option and it will expire on 2019 December end.

• Col 1: 60 refers to the exercise price. Thus exercise price of this option is $60
• Col2: It was the last day’s of quotation day’s option price. The option price is $
10.
• Col3: The price of option at which dealer wants to purchase. It is $ 12
• Col4: The price of option at which dealer wants to sell . It is $ 13
• Col 5: The Net change in price of option is $2. It has gone up by$ 2 on the
quotation day.
Option Quotation
• Col 2 and Col 5: The Price of option on day before yesterday was $
8
• Col 6: On the published day, 150 units of call options were traded
• Col 7: The total options in transaction or traded were 15400.
These options have not yet been exercised
• Bid-Ask Price Spread: $1. it is a profit of a market maker.
Option Exchanges
• Tangible physical entities to trade the options.
• Organized Trading of Option: 1973.
• First Organized Option Exchange: Chicago Board of Option Exchange
[CBOE], started operation from 1973 April 26. Initially 16 call options
were traded.
• Characteristics of Option Exchanges
• Offers standardized contracts.
• Facilitates the transferability about option contracts between investors.
• Employs the market maker, which makes transacting in options more easy.
• Reduces the default Risk
• Offers the way to manage the risk.
The Mechanics of Trading
Placing an Order
 Market Order
Limit Order
Good-till- Cancelled
Day Order
Stop Loss Order
Margin Requirement
No margin purchase for options with less than 9 months maturity period.
25% of the cost of option can be borrowed for the option with maturity period more
than 9 months.
The writer of option requires to maintain sufficient fund in margin account.
 The margin deposited by the writer of the option serves as good-faith security deposit
which ensures the broker and exchange that the writer will not default if the option is
exercised by the writer.
The Mechanics of Trading
• Margin Requirement in Writing Naked Call Options
• Whichever is greater of the following is the margin requirement.
100 % of the sale proceeds +20% of the underlying share price
less amount if any by which option is out of the money or
100% of the sale proceeds +10% of the underlying share price
Example: An investor writes one naked call option contracts
on a stock. The option price is Rs. 15, the exercise price is Rs.
100 and the stock price is Rs. 95. Calculate the initial margin
requirement for option writer.
The mechanics of Trading
• Margin Requirement for Naked put option
• The margin requirement is greater off the following two:
• 100% of the sale proceeds +20% of the stock price less Amount if
any by which option is out of the money
• 100% of the sale proceeds +10% of the exercise price.
Example: Calculate Margin requirement for the previous example
considering that it is a naked put option.

In which case additional margin is called by the broker?

The mechanics of Trading
• Margin Requirement Writing Covered Options
Margin on a covered call is zero as there is no risk to the system in a covered call.
EXAMPLE
An investor decides to buy 200 shares of XYZ stock on margin and to write two call option
contracts on the stock. The stock price is Rs. 63, the strike price is Rs. 60 and the price of option
is Rs 7.
Required:
1. Calculate the total costs for the trading
2. How much the trader should borrow in normal case to purchase 200 shares of XYZ?
3. How much the trader should borrow if exercise price of stock is less than the market price ?
4. How much the trader can use to finance the purchase of 200 shares from the sale proceeds
of option?
5. Calculate the down-payment amount to cover the call for this trading.
The mechanics of Trading
• Role of Clearing House
• Option Clearing Corporation(OCC).
• Oversees how market is conducted and helps in orderly market.
• Makes buyer and seller of options obligated to the OCC.
The Mechanics of Trading
Placing an Offsetting Order
An order that offsets the previously opened position is called offsetting
order.
Investor can offset the order at any time by placing an opposite position
order in the same option.
 Over the Counter Market Trading
No facility for investor to offset the existing position .
Investor needs to hold the option till the expiration.
The mechanics of Trading
• Exercising the option

Option Option
Buyer writer

Option
writer
Broker OCC

Option
writer
 Regulation of option markets
• Exchange and Option Clearing Corporation
• Federal and State Regulatory Authorities

• The Security Exchange Commission is responsible for regulating options markets in

stock, stock indices, currencies and bonds.
• The Commodity Future Trading Commission is responsible for regulating markets for
futures.
Dividends and Stock Splits
• Dividend Protected Options: If there is effect on options due to
dividend declaration by a company, it is called Dividend Protected
Options. Over the counter options are Dividend adjusted options.

• Dividend unprotected options: The options which are not adjusted

for cash dividend are called Unprotected Options. Exchange Traded
Options are Dividend unadjusted options.
Dividends and Stock Split
• Exchange Traded Options are adjusted for stock split.
• Stock Split does not affect the assets or earning ability of the
company. That is it doesn’t have any effect on the wealth of the
shareholders.
• All else being equal, stock split reduces the stock price, and in
option contract, it reduces the exercise price and increases the
number of shares covered by one contract. It in this way keep the
position of traders unchanged.
Dividend and Stock Split
• Example: Consider a call option to buy 100 shares of common stocks for $ 30 per
share. Suppose the company makes 2 for 1 stock split. What are the effects on
option contract?

• Stock Dividend and Options

• Stock Options are adjusted for stock dividends.
• No effect on company’s earning power as well as on assets.
• Expected to reduce the price of stock. Therefore terms of contracts
should be adjusted so that positions will remain the same.
Adjustment for Right Issue
• Stock options are adjusted with right issues.
• Calculate theoretical price of rights and then reduce the strike price
by the same amount.