Exchange-Traded Option Markets - Essay Example

Running Head: INTERNATIONAL RISK MANAGEMENT Exchange Traded Option Markets Exchange Traded Option Markets Introduction Call and put options on the shares of individual companies can be bought over-the-counter (OTC) from dealers, or traded on major exchanges such as Eurex, LIFFE and the Chicago Board Options Exchange (CBOE). Exchange-traded contracts that are actively traded can be bought and sold in reasonable quantity without greatly affecting the market price. The performance of contracts is guaranteed by the clearing house associated with the exchange which eliminates any possibility of default. In recent years some exchanges have introduced so-called FLEX option contracts which allow investors to tailor certain terms of a contract. (Christopher, 2001; 45-57) However, most exchange-traded options are standardized. There are a set number of strikes and expiry dates available, and it is not generally possible to trade options on the shares of smaller companies. By contrast, in the OTC market dealers will sell and buy options on a wide range of shares, as long as they can find a way to manage the risks associated with such deals. Also, dealers offer a huge variety of non-standard contracts known collectively as exotic options. (John, 2002: 110-118) On some exchanges and with some contracts the buyer of an option is not required to pay the full premium at the outset. Instead, the purchaser deposits initial margin that is a proportion of the premium due on the contract. In the case of the individual stock options traded on LIFFE, the full premium is payable upfront. (Zuhayr, 2001, 63-70) However, the writers of options are subject to margin procedures. They must deposit initial margin at the outset, and will be required to make additional variation margin payments via their brokers to the clearing house if the position moves into loss. (Gordon, 2001: 121-129) The initial margin depends on the degree of risk involved, calculated according to factors such as the price and volatility of the underlying and the time to expiry of the contract. In practice, in order to cover margin calls, brokers often ask for more than the minimum initial margin figure stipulated by the clearing house. The derivatives exchanges also offer listed option contracts on major equity indices such as the S&P 500, the FT-SE 100 and the DAX. Contracts are of two main kinds. Some are options on equity index futures, and exercise results in a long or short futures position. Other contracts are settled in cash against the spot price of the underlying index. If a call is exercised the payout is based on the spot index level less the strike. If a put is exercised the payout is based on the strike less the spot index level. Options on indices and other baskets of shares can also be purchased directly from dealers in the OTC market. (Dimitris, 2000: 90-102) Some dealing houses issue securities called covered warrants which are longer-dated options on shares other than those of the issuer. Warrants are usually listed and trade on a stock market such as the London Stock Exchange. The term 'covered' means that the issuer is writing an option and hedges or covers the risks involved, often by trading in the underlying shares. (Austin, 2000: 73-81) Warrants are purchased by both institutional and retail investors (historically the retail market has been more active in Germany than in the UK). (Christopher, 2001; 45-57) Warrants can be calls or puts and written on an individual share or a basket of shares. They are sometimes settled in cash, and sometimes through the physical delivery of shares. UK Stock Options on LIFFE Table 1 shows some recent prices for stock options on Royal Bank of Scotland Group plc (RBOS) traded on LIFFE. These are the offer or sale prices for contracts posted by dealers placed on the exchange's electronic dealing system, LIFFE Connect. At the time the quotations were taken the options had just over two weeks remaining until expiry and the underlying RBOS share price was 1781 pence or 17.81. The stock option contracts on LIFFE are American-style and can be exercised on any business day up to and including expiry. Table 1 only shows a small sample of the strikes available in RBOS options at the time. Most market participants tend to deal in options that are around the at-the-money level. As the share price fluctuates in the cash market, the exchange creates additional strikes so that there are sufficient contracts available that are likely to appeal to buyers and sellers. The quotations are in pence per share, but each contract is based on a lot size of 1000 RBOS shares. These contracts are physically settled. If the holder of one long (bought) RBOS call contract exercises the option then he or she will receive 1000 shares. In return, the 'long' will have to pay the strike price times 1000. A market participant who is short the contract will be 'assigned' at random by the clearing house and required to deliver the shares in return for cash. The delivery of shares and the payment of cash is always made via the clearing house, to eliminate any possibility of default. The open interest figures in the table show how many long and short contracts were still outstanding at the time. Some traders keep track of the open interest in call and put options as a means of gauging market sentiment. An excess of put options being traded may indicate that investors and speculators are bearish about the share, and are actively buying put options from dealers in anticipation of a sharp decline in the price of the underlying. An excess of calls may indicate the reverse. (Austin, 2000: 73-81) To explore the values in a little more detail, we will take a number of examples from the data in the table. 1600 Strike Calls The buyer of a contract has the right but not the obligation to buy 1000 shares at a cost of 16 per share. The option is being offered at a premium of 1.865 per share or 1865 on a contract. The option is in-the-money (it is the right to buy a share for 16 that is worth 17.81). The intrinsic value per share is 1.81. Therefore the time value is 1.865 - 1.81 = 0.055 per share. This is quite low, partly because there are only a few weeks to expiry, and partly because there is not much uncertainty about what is going to happen to the option - it is very likely to expire in-the-money. 1800 Strike Calls These are out-of-the money. The intrinsic value is zero and the time value is 0.275 per share. There is a reasonable chance that the share price will trade above 18 at or before expiry, and the purchaser of the contract has to pay for that possibility. On the same day 1800 strike calls on RBOS with an extra month to expiry were being offered at 0.50 a share. The chances of the share price moving above the strike is that much greater with a longer expiration date. 2000 Strike Calls These are struck well out-of-the money, since they convey the right to buy shares for 20 each. The intrinsic value is zero and the entire premium cost of 0.02 per share is time value. The time value is low and the option is cheap because there is only a remote chance that the share price (currently 17.81) will be trading above 20 by expiry in a few weeks' time. 1700 Strike Puts These contracts are slightly out of the money, since they represent the right to sell RBOS shares below the current cash price of 17.81. The intrinsic value is zero and the premium cost of 0.145 per share is all time value. Figure 1: Expiry payoff profile for long RBOS long call strike 18 At 18.275 the intrinsic value is 0.275, which just recovers the initial premium; therefore the net profit and loss is zero. A buyer of the call would have to be fairly confident that the share price will trade above 18.275; otherwise the deal will make no money. In reality the share would have to trade a little higher to recover additional costs such as brokerage and the cost of borrowing money to buy the option (or the interest forgone from not putting the money used to buy the option on deposit with a bank). CME Options on S&P 500 Index Futures In addition to options on individual shares it is also possible to trade options on stock market indices on the exchanges. Table 2 shows the specification for one of the most actively traded contracts, the options on S&P futures available on Chicago Mercantile Exchange (CME). The underlying here is a futures contract on the S&P 500 index - an index of 500 leading US shares calculated by Standard and Poor's. (Alan, 2001: 33-40) If the owner of a call exercises the contract then he or she will acquire a long position in an S&P 500 index futures contract with a specific expiry month. If the owner of a put exercises, he or she will acquire a short position in futures. The contract months for the underlying futures are March, June, September and December. (Gordon, 2001: 121-129) On the options, as on the futures, each full index point is worth $250. A one tick movement in the price of an option is 0.1 index point and is worth 250 x 0.1 = $25. Contracts are traded on floor of CME and then after hours on the exchange's electronic trading system, GLOBEX. FT-SE 100 Index Options Index options traded on exchanges can also be settled directly in cash rather than through the acquisition of a position in a futures contract. Table 3 lists details of the FT-SE 100 index options contract traded on LIFFE through its electronic trading system LIFFE Connect. This is the European-style contract. The exchange also lists an American option on the FT-SE 100, which can be exercised on any business day up to and including expiration (it is far less actively traded). In either case, if a contract is exercised in-the-money the owner is paid cash in sterling based on the difference between the spot price of the underlying FT-SE 100 index at that point and the strike of the option. (Sidney, 1979, 1-22) No shares ever change hands. On the FT-SE 100 index option each full index point is worth 10 and the tick size (the minimum movement in the price quotation) is 0.5 point, so each one-tick move in the price of an option results in a profit or loss per contract of 5. The exchange creates new strikes as the underlying index level changes. The full option premium is payable on the day after an option is purchased. Exercising FT-SE 100 Index Options What happens to FT-SE 100 index options on the last trading day The answer is that they are cash settled against the underlying index on that day, and then they simply expire. The level used is known as the Exchange Delivery Settlement Price (EDSP). It is an average of the cash market index taken between 10:10 and 10:30 a.m. on the last trading day. The averaging process reduces the scope for market manipulation. Many traders chose not to retain their positions up to the expiration date. Speculators who are long calls will hope that the market rises and they can sell the contracts back into the exchange at a higher premium before expiry.( Sidney, 1979, 1-22) Equally, those who are long puts are hoping for a fall in the index to enable them to sell the contracts back at a higher premium. The American-style FT-SE 100 index option contracts traded on LIFFE provide the additional advantage that they can be exercised early. However, if a trader wishes to realize the gains from a purchase of an exchange-traded option it is usually preferable to sell the contract back into the exchange. (John, 2002: 110-118) An equity option conveys the right but not the obligation to buy or to sell an underlying share or basket of shares at a predetermined strike price. Exercising an exchange-traded option on an individual share (a stock option) results in the delivery of the underlying share. In the over-the-counter market contracts can be set up to enable them to be settled in cash.(Pruitt, 1989: 4) The terms of exchange-traded stock options are not adjusted for ordinary dividends, although they are adjusted for certain exceptional events such as stock splits and rights issues. American-style contracts can be exercised before expiry, although this kills off any remaining time value and, in many cases, it is better to retain the option or sell it back into the market.(Levi, 2005: 163-78) Exceptions include some deeply in-the-money puts and some call options just before an ex-dividend date. Conclusion Exchange-traded options on stock market indices are either settled against the level of the cash index or result in a long or short position in a futures contract on the underlying index. Equity index options offer a diversified exposure to a large number of shares and can provide leverage opportunities - the return on investment can be much higher than that achieved by investing in the actual shares that comprise the index. On the other hand, there is no opportunity to re-invest dividends and the options have a defined life. If at expiry the contracts are not in-the-money the premium has been lost and cannot be recovered. One alternative to exchange-traded equity options is the covered warrant. This is a longer-dated option that is issued by a dealer and trades in the form of a security on a stock market. It can be a call or a put based on a single share or a basket or an index. References Christopher L. Culp (2001) "The Risk Management Process: Business Strategy and Tactics" Publisher: Wiley, 45-57 Austin Murphy (2000) "Scientific Investment Analysis" Quorum Books: 73-81 John Board; (2002) "Transparency and Fragmentation: Financial Market Regulation in a Dynamic Environment" Publisher: Palgrave Macmillan: 110-118 Gordon De Brouwer; (2001) "Hedge Funds in Emerging Markets" Cambridge University Press: 121-129 Zuhayr Mikdashi; (2001) "Financial Intermediation in the 21st Century" Palgrave Macmillan, 63-70 Dimitris N. Chorafas; (2000) "New Regulation of the Financial Industry" Macmillan: 90-102 Alan M. Rugman, Thomas L. Brewer; (2001) "The Oxford Handbook of International Business" Oxford University Press: 33-40 Pruitt S. W. and R. E. White, (1989), "Exchange-traded options and CRISMA trading", Journal of Portfolio Management, 15:4 Sidney M. Robbins, Robert B. Stobaugh, Francis L. Sterling, Thomas H. Howe. (1979). "The Impact of Exchange-Traded Options on the Market for New Issues of Common Stock of Small Companies". Financial Review 14:1, 1-22. Levi, Maurice D., (2005) International finance: the markets and financial management of multinational business; 4th ed. London; New York: Routledge: 163-78 Appendix Strike Call premium (pence) Calls open interest Put premium (pence) Put open interest 1600 186.5 37 3.5 102 1700 92 255 14.5 171 1800 27.5 224 58.5 62 1900 4 62 134 0 2000 2 0 - 0 Table 1: Call and put option premiums and open interest on RBOS share options Contract size: One S&P 500 futures contract Regular tick size: 0.1 index point Tick value: $25 per contract Contract months: All 12 calendar months Table 2: CME options on S&P 500 futures Index point value: 10 per point Delivery months: March, June, September and December, plus additional months so that the next four calendar months are available Quotation: In FT-SE 100 index points Tick size: 0.5 point Tick value: 5 Last trade: Third Friday in the expiry month Exercise day: Exercise on the last trading day only Table 3: FT-SE 100 index option (European-style exercise) Read More