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

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 Important Concepts in Chapter 2
 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, 9th ed. Ch. 2: 2

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 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, 9th ed. Ch. 2: 3

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 Development of Options Markets

 Early origins
 Put and Call Brokers and Dealers Association
 Chicago Board Options Exchange, 1973
 Resurgence of over-the-counter market

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 Call Options

 Current example
 Objective of a call buyer
 Moneyness concepts
 In-the-money
 Out-of-the-money
 At-the-money

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 Put Options

 Current example
 Objective of a put buyer
 Moneyness concepts
 In-the-money
 Out-of-the-money
 At-the-money

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  In 2010, exchange-traded option volume (number of
contracts) approximately 11.1 billion contracts (Futures
Industry magazine)
 In 2010, over-the-counter option volume approximately
$64 trillion notional principal and $2.2 trillion market
value (Bank of International Settlements)
 OTC options notional amount outstanding fell dramatically
during the Financial Crisis of 2008 (see Figure 2.1)
 OTC options market value outstanding rose sharply during
initial phase of Financial Crisis of 2008 (see Figure 2.2)

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 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

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 Organized Options Trading
The concept of an options exchange
 Listing Requirements
 Contract Size
 Exercise Prices
 Expiration Dates
 Position and Exercise Limits

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 Option Traders
 Liquidity Providers
 Provide bid and ask prices to facilitate trading
 Scalpers, position traders, spreaders
 Lead market makers, designated primary market
makers
 Floor Broker – acts as agent for customers
 Order Book Official
 Limit orders
 Electronic order processing

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 Options Traders (continued)
 Other Option Trading Systems
 Specialists
 Registered options traders
 Electronic trading systems
 Off-Floor Option Traders
 Option brokers
 Proprietary options traders

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 Mechanics of Trading

 Placing an Opening Order

 Types of orders
 Role of the Clearinghouse
 Options Clearing Corporation (OCC)
 Clearing firms
 See Figure 2.3
 Margin (see Appendix 2.A)
 Open interest

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 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

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 Option Price Quotations

 See Web sites of newspapers and options exchanges

 Problems
 Delayed information
 Non-synchronized prices

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 Types of Options
 Stock Options
 Index Options
 Currency Options
 Other Types of Options
 interest rate options
 currency options
 options attached to bonds
 exotic options
 warrants, callable bonds, convertible bonds
 non-traded executive options
 Real Options

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 Transaction Costs in Option Trading

 Floor Trading and Clearing Fees

 Commissions
 Bid-Ask Spread
 Other Transaction Costs

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 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.

Summary

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 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

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 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

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