1.3 Options and Organized Exchanges

Options are traded on various exchanges, where their prices are set by traders who submit bids and asks for these contracts. In the United States, options are traded on the following exchanges:

Chicago Board of Exchange (CBOE)

Philadelphia Stock Exchange (PHLX)

New York Stock Exchange (NYSE)

American Stock Exchange (AMEX)

Pacific Stock Exchange (PSE)

The exchanges provide a physical trading location and specify a set of rules and regulations that govern trade (and that therefore affect the prices of options).  Some of the rules are similar to those of other types of exchanges, such as limits on price changes, limits on the size of the bid-ask spread, capitalization requirements on traders, and limits on individual trader positions.

However, there are important differences between an options exchange and other exchanges.  When you buy a stock, you become a part owner of a company, and are entitled to receive your share of dividends.  The role of the stock exchange in this case is mainly to facilitate the trade.  When you buy a call option, you have the right to demand delivery of the underlying asset for a fixed price from the person who sold you the option.  An important role of an options exchange is that it guarantees the other side of the trade.  This means that even if the option writer defaults, the exchange will provide you with the underlying asset.  Thus, in addition to facilitating trade and other "regular" services of an exchange, an options exchange minimizes default risk.  In fact, the two parties in an options contract typically do not even trade with each other; instead, each takes an opposite position with the exchange.

A second important role of an options exchange is to standardize the terms of option contracts.  To understand the importance of this, you may want to think about how many different strike prices and expiration dates can be set for a stock option.  To complicate things further, consider an option on wheat or corn.  If such an option is exercised, what type and what quality of wheat must be delivered, and within what time frame?  To maintain an orderly and liquid market, exchanges specify the strikes to be traded, the maturities, the settlement dates, the precise nature of the underlying asset, and the physical process of settlement. 

The terms of a standardized option contract influence the price of an option.  Understanding some of these standard contractual terms will help you interpret reported information from options markets.

Strike Prices

The largest options trading exchange is the CBOE.  On this exchange, the standard option contract (lot size) is for 100 individual options.  For example, an IBM stock option is for 100 shares in IBM.

The menu of strike prices made available is based on the rule shown in Table 1.1.

Table 1.1

Strike Prices 

 This means that if a stock price is 20, the strike prices will differ by $2.50.  If the stock price is around 50, the strike prices will differ by $5.  A typical menu of options would have set strike prices equal to $40, $45, $50, $55, and $60.

Options on other types of underlying assets follow other rules.  For the S&P 100 index, the interval is 5 points of the index, while strike prices for gold options have $10 intervals when the price is below $500 and $20 intervals above $500.

The financial press and the exchanges themselves provide this information for each specific contract.

Settlements

There are different types of option settlements: 

Options on Physicals

Settlement of options on physicals leads to an exchange of the underlying asset.  For example, stock options are settled by an exchange of a stock certificate.  Currency options can be settled by delivery of foreign currency to an approved depository in the country of the origin at the pre-specified exchange rate.  (For a currency option, setting the strike price is  equivalent to fixing the exchange rate.)

Options on Futures

Upon exercise of options on futures, the buyer obtains a position in futures that can be defined on physicals, interest rates, and indices.  As a result, if the option is exercised, the owners  right to buy or sell some underlying asset becomes transformed into an obligation to buy or sell some underlying asset.

Options with Cash Settlement

Some options are settled for cash.  For example, index options are settled for cash at the closing index value.  The most popular such options are those on the CBOE S&P100 index.  To see how this works, suppose that at the time of settlement of a call 425 option, the underlying index value is 433.  If you are the owner of this call, you will choose to exercise your right to buy at 425 because your option is in-the-money.  Once you exercise, the option writer will have to pay you 100(433 - 415)=$1,800.

Another example is gold.  The underlying asset for gold options traded on the AMEX is 100 troy ounces of gold, but the options are settled for the cash value of this gold, not the gold itself.

Expiration Dates  (Expiration Cycles)

The expiration date is the last day on which an option can be traded.  These dates are determined by putting every underlying asset into a "cycle."  A cycle is named after one of the first three months of the year.  Thus, there is a January cycle, a February cycle, and a March cycle.  The January cycle consists of  options expiring in January, April, July, and October.  The February cycle has expiration dates in February, May, August, and November, while the remaining months form the March cycle.  When stock options trading first began on the CBOE, there was only a January cycle.

Recently, the expiration dates have been increased to include the two nearby months as well.  In a cycle, only three out of the four possible expiration times are available at one time.  For example, a January cycle stock trading in early March will have options trading that mature in March, April, July, and October.  That is, they have the two nearby months plus the January cycle.

Interesting cycle variations first introduced by both the CBOE and the AMEX are the "Long-Term-Equity-Anticipation-Securities," or LEAPS, which have January expirations and last for up to two years.

The cycle determines the expiration month.  The actual expiration day in the month depends on the underlying asset.  The expiration day for stocks, stock indices, and many commodity options is the Saturday following the third Friday of the month.  For currencies the expiration date is the Friday before the third Wednesday of the month.

Investors must notify their brokers of their intent to exercise by 4:30 central time (for stocks) or 5:30 central time (for index options) on the day of expiration.  Note that this is after the market in stocks closes.

POSITION LIMITS

Exchanges limit the total number of option contracts an individual trader can acquire.  The limit depends on why the trader is buying the options.  If options are traded to hedge an existing position then traders are permitted to hold more options than if the options are traded for speculative reasons.

For example, on the CBOE, the limit for the S&P100 index options is 25,000 contracts, which rises to 75,000 if the purchase is for hedging an existing  position.

MARKET MAKING

An individual who purchases a seat on the CBOE can apply to be either a market maker or a floor broker.  The floor broker makes money by executing trades for the public for a commission.  The market maker profits by posting a bid/ask spread (i.e., prices at which the market maker is willing to buy options and sell options).  The selling price (the ask) is higher than the buying price (the bid).  At the CBOE, market makers are restricted by spread limits.  These limits are imposed to ensure a certain amount of liquidity in the market.  Spread limits depend on the prices, as shown in Table 1.2.

Table 1.2

Spread Limit Formulas 

 A quarter point is $US 0.25.

TRADING MECHANICS

Trading hours for options vary widely, and depend on the trading hours for the underlying security.  For example, stock and stock index options at CBOE trade (approximately) when the NYSE is open:  8:30 am to 3:10 pm (central time).  Other options trade at different times.  Currency options, for example, trade from 7:20 am to between 1:16 and 1:24 pm central time; the yen options market closes at 1:22 pm.

The floor broker executes orders on behalf of the public.  There are many different types of orders.  The main difference between the types of orders is that they specify either a price or a time limit.  Some of the more common orders are:

A market order is an order to buy or sell now at the best possible available price, and therefore should be executed immediately upon receipt.  This is the fastest way to trade, although in a very volatile market, you have little control over the price that you will pay/receive.  As a result, there are many variations on the "plain vanilla" market order.

A limit order places a price threshold either above (if a limit sell) or below (if a limit buy) the current market price.  If this threshold is reached, the order is immediately executed at the limit (or better) price.

A hybrid of the two is a stop order.  This type of order becomes a market order once the limit is reached.  That is, for a buy stop order, nothing happens until the limit is reached.  At this time it is executed at the best possible price, which can be higher or lower than the limit.  A sell stop order is similar.  This type of order is often put in place by traders to limit losses if and when some unfavorable event occurs.

Another variation is the stop limit order.  This order does not convert into a market order but places a bound on the price.  The order is interpreted as: buy (sell) at the current market price unless the price exceeds (falls below) the limit.

Other variations place time limits on an order.  One example is a good ‘til canceled order, which stays valid until withdrawn by the investor.  Another popular variation is the day order which only lasts for the day.  A fill or kill order has to be executed immediately or it becomes invalid.

After a trade takes place, a clearing house such as the Options Clearing Corporation (OCC) enters into the transaction as an intermediary.  Its function is to minimize the possibility of default risk.  The OCC actually enters into two contracts, one with the buyer and one with the seller.  The OCC guarantees the contracts in case one party to the contract defaults.

Therefore, if a buyer exercises a large position in American options at some point in time, then this buyer actually exercises against the OCC.  The OCC in turn closes out the required position of some randomly selected options writers (sellers).  The writers settle with their brokerage firms, which in turn settle with the OCC.

The options clearing house thus assumes all the default risk.  As protection against this potential liability, clearing houses such as the OCC require brokerage firms (the floor brokers) to deposit a "margin."  The margin is a deposit of either cash or marketable securities, and the amount required depends on the total number of outstanding contracts (open interest) with the clearing house.  In turn the brokerage firm requires a margin account to be set up by the individual investor (approximately 5% of the security value plus a premium). 

This institutional background should allow you to interpret option prices listed in the financial press.  You can learn about this next in Options:  An Online Application

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