Chapter 2: Structure of option markets

Concept of option:
Option is a contract that gives its buyer the right but not the obligation to buy or sell an
asset at a fixed price on or before a given date. The seller of the option grants the buyer
of option the right to purchase from or to sell to the option seller something. There is
no obligation to the buyer of the option to do this. The writer grants this right to the
buyer in exchange for a certain sum of money which is called option price/ option
premium.
The option holder will exercise the option in future if he is in benefit otherwise, he will
ignore it, that is, nobody can force him to exercise so it so just the option for the holder,
not the obligation. In terms of timing of exercise, the option may be American or
European. European option can be exercised only at the end of the given period but
American option can be exercised anytime within the period.
Features of option:
1. Option price/ Option premium: The fee/ subscription price which is paid by the
buyer to the seller for buying the option is called option premium or option price. It is
nonrefundable and not a down payment. Option price refers to the current market price
of the option. The option premium and option price are the same at the time of option
contract. However, the option price can be changed over the time with prevailing
market condition.
2. Exercise price / Strike price: The fixed price specified in the option contract at
which the holder can buy or sell the underlying assets is called exercise price.
3. Option buyer (Holder): An option buyer is the purchaser of an option contract.
Option buyer has the right to buy/sell the underlying assets at pre-determined price.
4. Option seller (writer): Option seller is the person from whom the option buyer
purchases the option contract. Option seller takes the short position in the option. They
are obligated to honor the terms of option contract if the buyer decides to exercise the
option.
5. Expiration date: The expiration date of the option contract is the date on which the
option expires.
6. Underlying assets: The underlying asset is the asset to be exchanged on or before
expiration date in the option contract.
7. Exercising the option: Exercising the option is the act of actually buying or selling
the underlying assets as per option contract.
8. Option position: Since option is a contract, it involves two parties taking two
different positions. The buyer of the option takes long position and the seller of the
option takes short position. The seller of the option receives cash up front but has
potential liabilities later.
9. Moneyness: During its life span, an option is classified as either in the money, at the
money or out of money. In the money- Option is said to be in the money if it is worth
exercising. If the price of underlying assets is higher than the exercise price, call option
is in the money. If the price of the underlying assets is lower than the exercise price,
put option is in the money. If there is substantial difference in price of the underlying
assets and exercise price, it is said to be deep in the money.
10. Out of the money : Option is said to be out of the money, if it is not worth
exercising. If the price of an underlying asset is lower than the exercise price, call option
is out of money. If the price of an underlying asset is higher than the exercise price, put
option is out of money.
11. At the money: Option is at the money when the market price of underlying assets
is equal to the exercise price. The option holder may exercise the option or may ignore
it which depends upon his perception. At and after expiry, the option becomes
worthless. When it is in the money, the difference between the exercise price and market
price of the stock gives the intrinsic value. In other cases, there is no intrinsic value.
The intrinsic value is always less than the selling price of option. The positive difference
is called time value. The time value is also referred to the premium over intrinsic value.
12. Naked option and covered option: If the seller of the option writes the option on
the stock which is not belong with him or if the seller writes the option without any
share, that is called naked option. If the seller writes the option upon the stock which
he has already purchased or if the seller writes the option with shares is called covered
option.

Types of options
There are two basic types of option; Call option and put option
1. Call option: A call option is a contract that gives its holder the right but not the
obligation to buy the specified assets at specified price on or before specified date. Call
option holder (owner) on the stock has right to buy at fixed price at on or before given
date no matter what happens in the market price of the stock. As a call option buyer, if
the stock price is lower than exercise price the holder would buy the stock from market
price instead of exercising the option. On the other hand, if the stock price is higher
than the exercise price, the holder would exercise the right and get the profit by reselling
it back to the market- provided the difference is greater than cost of option. When an
investor buys a call, he is anticipating a price upward movement in the stock before the
expiry date, this is the bullish attitude. The call option contract specifies the following:
- Name of the company whose shares can be purchased.
- Number of shares can be purchased.
- Price at which shares can be purchased.
- Time length for the expiration.
The value of call option at expiration is as follows;

Value of call option (VC) = Max [(ST – E) or 0]

Where, ST = Price of stock at expiration
E = Exercise price/ strike price
Expected value of Call option = Max [(ST – E) or 0] × P
P = Probability of occurrence
Profit/loss to the call option buyer
Investors that expect the price rise of a particular security in the future buy a call option
and take a long position. If the stock price decreases the buyer loses only premium.
There is no upper limit on the profits if the stock price continuous to increase. The
maximum loss is the initial premium for the call option buyer.
Profit/loss for call option buyer = Value of call option - Call premium
= VC – CP
Where, CP = premium on call option
Breakeven price for call option buyer
It is the price of an option at which call option buyer neither makes a profit nor loss.
Call option buyer will be at the breakeven price if the security's price increases to the
exercise price plus premium paid.
Breakeven price for call option buyer = Exercise price + Call premium
= E + CP
Profit/loss to the call option seller (writer)
Call option seller sells options in an expectation that the price will fall in the future.
Therefore s/he holds a short position in the option. The profit and loss for the call option
writer is the proceeds or the premium received from writing the option. If the stock
price increases, call seller’s profit decreases.
Profit/ loss for call option seller = Call premium - Value of call premium
= CP – VC
Breakeven price for call option seller
It is the price of an option at which call option seller neither makes a profit nor loss.
Call option seller will be at the breakeven price if the security's price increases to the
exercise price plus premium paid by the call option buyer.
Breakeven price for call option seller = Exercise price + Call premium
= E + CP
2. Put option: A put option is a contract that gives its holder the right but not the
obligation to sell the specified assets at specified price on or before specified date. Put
option holder (owner) on the stock has right to sell at fixed price at on or before given
date no matter what happens in the market price of the stock. For a put option holder,
it is experienced when the stock price is lower. When an investor buys a put, he is
anticipating a price downward movement in the stock before the expiry date, this is the
bearish attitude. The put option contract specifies the following:
- Name of the company whose shares can be sold.
- Number of shares can be sold.
- Price at which shares can be sold.
- Time length for the expiration.
The value of put option at expiration is as follows;
Value of put option (VP) = Max [(E - ST) or 0]
Where, ST = Price of stock at expiration
E = Exercise price/ strike price
Expected value of Put option = Max [(E - ST) or 0] × P
P = Probability of occurrence
Profit/loss to the put option buyer
Investors who expect the price decreases of a particular security in the future buy a put
option and take a short position. If the stock price decreases, the buyer gains and seller
losses. The loss to the put option buyer will be limited to the amount of premium if the
price of the stock rises.
Profit/loss for put option buyer = Value of put option - Put premium
= VP - PP
Where, PP = Premium on put option
Breakeven price for put option buyer
Break-even price of an option at which put option buyer neither makes a profit nor loss.
Put option buyer will be at the breakeven price if the security's price decreases up to the
exercise price minus premium paid.
Breakeven price for put option buyer = Exercise price - Put premium
= E- PP

Profit/loss to the put option seller (writer)

A put option writer sells options in an expectation that the price will rise in the future.
Therefore s/he holds a long position in the option. If the stock price increases in the
future, put writer’s profit increases.
Profit/ loss for put option seller = Put Premium – Value of put option
 = PP - VP
Breakeven price for put option seller
Put option seller will be in at the break-even price when the securities price decreases
to the price equal to the exercise price minus the premium received.
Breakeven price for put option seller = Exercise price - Put premium
= E - PP
Over-the-counter options market:
Over the counter (OTC) contracts are those transactions that are created by both buyers
and sellers anywhere else. In other words, over-the -counter market is the market where
transaction occurs between two parties, without the supervision of an exchange. OTC
markets do not have any norms, rules, and regulations. There is an absence of a formal
exchange or an exchange regulator who can supervise its functioning. OTC market
may not have a physical location at all, and may just operate online through brokers,
dealers, and their networks.
Exchange-listed option trading:
An exchange is a legal corporate entity organized for the trading of securities, options,
or futures. It provides a physical facility and stipulates rules and regulations governing
the transactions in the instruments trading thereon. In the options markets, organized
exchange evolved in response to the lack of standardization and liquidity of over-the-
counter options. The terms and conditions of the contracts, such as the exercise price
and expiration date, were tailored for the parties involved. Organized exchanges filled
the need for standardized option contracts wherein the exchange would specify the
contracts' terms and conditions. Thus, providing a trading facility, specifying rules and
regulations, and standardizing contracts, options became as marketable as stocks.
Mechanics of option trading:
Placing an order: An investor who wants to trade option must first open an account
with a brokerage firm. The individual then instructs the broker to buy or sell a particular
option. The broker sends the order to the firm’s floor broker on the exchange on which
the option trades. An investor can place several orders such as market order, limit order
or top order etc.
Margin requirement: In stock market, investors have two options available to
purchase the shares of stocks. An investor can either pay full cash or pay some portion
in cash and borrows rests to purchase the shares of stock. Second option is called buying
on margin.
In the option market, purchaser of call and put option must pay the price in full.
Investors are not allowed to purchase option on margin. i.e., margin requirement is 100
percent. But option with maturities of greater than nine months, can however, are
margined. An investor who writes the option is required to maintain funds in margin
account. The margin deposit from the writer of the option serves as a good faith security
deposit. This deposit ensures the broker and the exchange that the investor will not
default if the option is exercised.
Role of clearing house: After trade is completed, the clearing house enters the process.
The clearing house, formally known as the option clearing corporation (OCC) is an
independent corporation that guaranteed the writers performance. The OCC is the
intermediary in each transaction. It keeps the records of all long position and short
position. Thus, a buyer of the option should not look to the writer but to the OCC. The
writer of the option therefore, makes payment for or delivers underlying stocks to the
clearing house (OCC). The OCC has number of members known as a clearing firm. All
option trades must be cleared through a member. Thus, the market makers and
brokerage firms should clear option trade through a member. Although in some cases
a brokerage firm is also a clearing firm. Member of OCC should open an account with
a certain minimum amount of funds. This fund is used to offset the loss if any member
defaults on an option obligation.
Exercising options: An American option can be exercised before or on the expiration
date. European option on the other hand can be exercised only on expiration date. When
the buyer of an option wishes to exercise the option should notify to his broker. The
broker then notifies the OCC. The OCC then selects particular investor on random basis
who has written the same option. The OCC member using a procedure established and
made known to its customer in advance. If call option is going to be exercised writer is
required to sell the stock at given exercise price. If it is put option, writer of the put
option is required to buy the stock at a given exercise price.
Placing an offsetting order: Suppose an investor holds a call option. The stock price
recently has been increasing and the call’s price is now much higher than the original
purchase price. Investor can get profit by selling the option in the market. This is called
an offsetting order. Investor could open a position by buying a call and later close that
position by selling the call option. Similarly, one could open a position by selling a put
and close the position by buying the put option. So, investor can offset the position by
taking the opposite position for the existing position in the same option.
Option price quotation:
Option quotation provides the necessary information, terms and condition and rules
and regulations about the way of trading. Option contracts is option exchange. So,
every investor of option contract should be familiar about option quotation and the
meaning of various terminologies, which are used in option quotation. The quotation
of option is published in daily newspaper or they can be seen in website or related
exchange. Option price quotations always are of the last day transaction along with the
current Bid and Ask price. The option quotation which was published on 7th Nov 2019.
Calls Last Ask Bid Net Vol Open
sale change interest
Dec 5 6 5  050 900
09, .5
60

 The first column shows that the call option will expire on Dec 2009 and exercise
price is Rs. 60 is also called triggering price, striking price. (The maturity period
and exercise price of the option)
 The second column "Last sale" shows the price of call, at which option were
traded on last day or yesterday. (Last sale is the price of option that was traded at
last of the quotation day)
 The third column "Ask" shows the purchased price of option for the buyer or
selling price of option for seller on the day of quotation. ( Ask price is the dealer's
selling price)
 The fourth column "Bid" shows the selling price of option for the holder of
purchase price of option for the dealer or broker. (Bid price is dealer's purchase
price)
 Ask-Bid indicates the spread for the dealer's Spread = Profit.
 The fifth column "Net change" shows the change in option price the day before
yesterday. (Net change is the change in yesterday's last price)
 Previous day price = Last sales - Net change
 Sixth column "Vol" shows the number of options that has been traded on
the day of quotation. (Volume is the number call options traded on quotation day)
  Last column "open interest" shows the total number of options that are issued
but has not been exercised up to now. (Open interest is the number of open contracts
during the life of this call contract)
The same model or format is used for the quotation for put option and meaning and
terminologies are same as above.
Underlying assets in the option contracts:
Options can be traded on a wide range of commodities and financial assets. The
commodities include wool, corn, wheat, sugar, tin, petroleum product, gold etc. and
financial assets include stocks, currencies, treasury bonds. Exchange traded options are
actively traded on stocks, stock indices (index option), foreign currencies and future
contract.
Stock option – Stock option is a contract that gives the holder right to buy or sell shares
at specified
exercise price. Shares are normally traded in a lot of 100 shares in USA. Thus, an option
contract
consists of 100 shares.
Foreign exchange options – Foreign exchange option is a contract that gives the right
to buy or
sell stated amount of foreign currencies at a specified domestic rate in a given time.
Currency options are primarily traded in over the counter market.
Index option – Index option is an option contract on a stock index. It gives right to buy
or sell the index with the given multiplier at the specified exercise price.
Future options – An option on a future contract or a future option is an option that
takes a future contract as its underlying assets.
Transaction costs in option trading:
Trading option in the option exchange is no free of cost. It entails two types of cost.
Market impact transaction cost: Bid ask spread is market impact transaction cost.
Placing buying order will be executed at ask price (dealer’s selling price) whereas
placing selling order will be done at the bid price (dealer’s purchase price). For traders
buying price is always greater than selling price. This spread (Ask price minus bid
price) represents the cost of immediacy (price paid for immediate trade).
Broker commission: There is range of commission for trading options. Trade occurs
electronically over the internet usually involves lower commissions than trade that
involve a broker. Full-service brokers usually charge more than discount brokers.
Traders are also ready to pay more because they receive personalize service on trading
options.
Regulation of option markets:
The primary aim of a regulated financial market is to protect the rights and interest of
the common investor by enforcing the required set of protocols. Options regulators
establish, register, standardize, amend, or revise (as necessary) the rules for options
trading, involving:

 Option chains for given strike price and expiry dates

 Trading units
 Lot size
 Position holding limits
 Exemptions in limits for hedged positions
 Exercise mechanisms
 Rules for order reporting and exception handling
 Rules for off exchange options transactions
 Setting leverage and margin limits
 Short selling rules.