Options Market

1. Options Market Rashedul Hasan

2. Option • In finance, an option is a contract between a buyer and a seller that gives the buyer the right—but not the obligation—to buy or to sell a particular asset (the underlying asset) at a later day at an agreed price. In return for granting the option, the seller collects a payment (the premium) from the buyer.

3. Types of Option Options are classified as call or put. A call option gives the buyer the right to buy the specified financial instrument for a specific price called the strike price or exercise price within a specified period of time. A put option gives the buyer of the option the right to sell the specified financial instrument for a specific price within a specified period of time. • If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, or shares of stock or some other security.

4. Contract specifications • whether the option holder has the right to buy (a call option) or the right to sell (a put option) • the quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock) • the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise • the expiration date, or expiry, which is the last date the option can be exercised • the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount • the terms by which the option is quoted in the market to convert the quoted price into the actual premium–the total amount paid by the holder to the writer of the option.

5. Types of options based on Transaction Exchange traded options (also called "listed options") are a class of exchange traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange traded options include: • stock options, • commodity options, • bond options and other interest rate options • stock market index options or, simply, index options and • options on futures contracts

6. Types of options based on Transaction Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: • Interest rate options • Currency cross rate options

7. Markets used to trade Options The Chicago Board of Option Exchange (CBOE) which was created 1973, is the most important exchange for option trading. It serves as market for options on more than 1500 different stocks. Today 51% of all options trading in U.S. is conducted on the CBOE and the remaining trade divided among various stock exchange.

8. Markets used to trade Options • The International Securities Exchange is the first over the counter option exchange. It uses computer network instead of visible trading floor for transaction. • Initially an option contract for a particular firm would be sold on only one exchange. Today any particular option contract may be traded on various exchanges and the competitions among the exchanges may result in more favourable price for customers.

9. Role of Option Clearing Corporation (OCC) Like a stock transacton, the trading of options involve a buyer and seller. The sale of option impose specific obligations on the seller under specific condition. The exchange is simply a market where the options are bought and sold. Option Clearing Corporation servers as a gurantor on option contract trading in U.S. which means that the buyer of an option contract does not have to be concerned that the seller will back out of the obligation.

10. How option trades are executed • Floor Brokers • Market Makers

11. Floor Brokers Floor brokers executed transactions desired by the investors. An investor may tells the broker to place an purchase order of a specific option on a particular stock. The brokerage firm firm idenntifies the exchange where the stock option is listed. The floor broker execute the desired purchase of the stock option in the trading pit. The trade reflects an agreement between the floor broker and another floor broker in the pit, who is also responsible for selling the same type of option for different customer.

12. Market Makers Market Makers can execute stock option transactions for customers but they also trade stock options for their own account.

13. Types of order Customer can place both market order or Limit order. With a market order, the trade will automatically be executed at the prevailing price of theoption. On the other hand, with a limit order, the trade will be executed only if the price is within the limit specifies by the customer.

14. The basic trades of traded stock options (American style) • These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging.

15. Long call A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium (price) paid, he will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a much larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares

16. Long put A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid, he will profit. If the stock price at expiration is above the exercise price, he will let the put contract expire worthless and only lose the premium paid.

17. Short call A trader who believes that a stock price will decrease, can sell the stock short or instead sell, or "write," a call. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.

18. Short put A trader who believes that a stock price will increase can buy the stock or instead sell a put. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price at expiration is above the exercise price, the short put position will make a profit in the amount of the premium. If the stock price at expiration is below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock. A benchmark index for the performance of a cash-secured short put option position is the CBOE S&P 500 PutWrite Index (ticker PUT).