Structure of Options Market

Lesson 02
Development of Options Markets

• Early origins: Options market traces its

origins to the nineteenth century, when
puts and calls were offered on shares of
stock
• 1800s: little is known about the options
world other than it was fraught with
corruption
Development of Options Markets
• 1900s: A group of firms calling itself the Put and Call
Brokers and Dealers Association created an options
market.
• If someone wanted to buy an option, a member of the
association would find a seller willing to write it.
• If the member firm could not find a writer, it would
write the option itself.
• Thus, a member firm could be either a broker – one
who matches buyer and seller – or a dealer – one who
actually takes a position in the transaction.
Development of Options Markets
Although this over-the-counter market was
viable, it suffered from several deficiencies:
• First: It did not provide the option holder the
opportunity to sell the option to someone else
before it expired. Options were designed to be
held all the way to expiration, whereupon they
were either exercised or allowed to expire.
Thus, an option contract had little or no
liquidity.
Development of Options Markets

Although this over-the-counter market was

viable, it suffered from several deficiencies:
• Second: The writer’s performance was
guaranteed only by the broker-dealer firm.
If the writer or the Put and Call Brokers
and Dealers Association member firm
went bankrupt, the option holder suffered
a credit loss.
Development of Options Markets

Although this over-the-counter market

was viable, it suffered from several
deficiencies:
• Third: The cost of transacting was
relatively high, due partly to the first two
problems.
Development of Options Markets
• In 1973: A revolutionary change occurred in the
Options World
• The Chicago Board of Trade, the world’s oldest and
largest exchange for the trading of commodity futures
contracts, organized an exchange exclusively for
trading options on stocks.
• The exchange was named: Chicago Board Options
Exchange (CBOE). It opened its doors for call option
trading on April 26, 1973, and the first puts were
added in June 1977.
Development of Options Markets
• CBOE created a central marketplace for Options. The terms
and conditions are standardized, that added to the options
liquidity.
• Moreover, CBOE added a clearinghouse that guaranteed to
the buyer that the writer would fulfill his or her end of the
contract.
• Thus, unlike in the OTC market, option buyers no longer
had to worry about the credit risk of the writer. This made
options more attractive to the general public.
• Since this time, several stock exchanges and almost all
futures exchanges have begun trading options.
Development of Options Markets

• The industry grew until the great stock

market crash of 1987 and just recovered
in 1997.
Options
• A contract between two parties – a buyer
and a seller, or writer - in which the
buyer purchases from the writer the right
to buy or sell an asset at a fixed price
Options
• As in any contract, each party grants
something to the other. The buyer pays
the seller a fee called the PREMIUM,
which is the options price.
Options
• The premium is the price a buyer pays the
seller for an option.
• Price of the option is how much investor
pays for the right to buy or sell (a.k.a.
premium)
Options
• The premium is paid up front at purchase
and is not refundable - even if the option
is not exercised. Premiums are quoted on
a per-share basis. 
Options
Example:
• A premium of $0.21 represents a premium
payment of $21.00 per option contract
($0.21 x 100 shares).
Options
• The writer grants the buyer the right to
buy or sell the asset at a fixed price.
• Options can be either ”American” or
”European”
– American-style options can be
exercised on any day
– European-style options can be
executed only on the expiration date
Options
• An option to buy an asset is a CALL
OPTION.
• An option to sell an asset is a PUT
OPTION.
• The fixed price at which the option buyer
can either buy or sell the asset is called the
EXERCISE PRICE or STRIKE PRICE or
sometimes the STRIKING PRICE.
Options
• The option has a definite life.
• The right to buy or sell the asset at a
fixed price exists up to a specified
expiration date : the last day you can
exercise an option
Call Options

• A call option is an option to buy an asset

at a fixed price – the exercise price.
• A Call option is a contract that gives the
buyer the right to buy 100
shares of an underlying equity at a
predetermined price (the strike price) for
a preset period of time. 
Call Options
• Seller of option MUST sell shares at Strike
Price if exercised
• Calls are in-the-money if the strike price is
below the stock price
• Calls are out-of-the-money if the strike
price is greater than the stock price
• Calls are at-the-money if the strike price is
equal to the stock price
Call Options
Example:
• On August 1, 2005, several exchanges offered options on
the stock of Microsoft. One particular call option had an
exercise price of $27.5 and an expiration date of September
16. Microsoft stock had a price of $25.92. The buyer of this
option received the right to buy the stock at any time up
through September 16 at $27.5 per share. The writer of that
option therefore was obligated to sell the stock at $27.5 per
share through September 16 whenever the buyer wanted it.
For this privilege, the buyer paid the writer the premium, or
price, of $0.125
Put Options
• A put option is an option to sell an asset, such
as stock.
• A Put option is a contract that gives the buyer
the right to sell 100 shares of an underlying
stock at a predetermined price for a preset time
period. The seller of a Put option is obligated to
buy the underlying security if the Put buyer
exercises his or her option to sell on or before
the option expiration date.
Put Options
• A put option is an option to sell an asset, such
as stock.
• A Put option is a contract that gives the buyer
the right to sell 100 shares of an underlying
stock at a predetermined price for a preset time
period. The seller of a Put option is obligated to
buy the underlying security if the Put buyer
exercises his or her option to sell on or before
the option expiration date.
Put Options
• The holder of option can sell shares at Strike Price
• Thus, the seller of option MUST buy shares at
strike price if exercised
• Puts are in-the-money if the strike price is greater
than the stock price
• Puts are out-of-the-money if the strike price is less
than the stock price
• Puts are at-the-money if the strike price is equal to
the stock price
Put Options
Example:
• On August 1, 2005, with an exercise price of $27.5 per
share and an expiration date of September 16. It allowed the
put holder to sell the stock at $27.5 per share any time up
through September 16. The stock was currently selling for
$25.92.Therefore, the put holder could have elected to
exercise the option, selling the stock to the writer for $27.5
per share. The put holder may, however, have preferred to
wait and see if the stock price fell further below the exercise
price. The put buyer expected the stock price to fall, while
the writer expected it to remain the same or rise.
Over-the-Counter (OTC) Options Market

• An option traded off-exchange, as

opposed to a listed stock option. The
OTC option has a direct link between
buyer and seller, has no secondary
market, and has no standardization of
striking prices and expiration dates.
Organized Exchange

• 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.
Listing Requirements

• The options exchange specifies the

assets on which the option trading is
allowed.
Contract Size

• A standard exchange-traded stock

option contract provides exposure to 100
individual stocks. Thus, if an investor
purchases one contract, it actually
represents options to buy 100 shares of
stock.
Exercise Prices
• On options exchanges the exercise price are
standardized. Exchanges prescribe the exercise
prices at which options can be written.
• Investors must be willing to trade options with
the specified exercise prices.
• Of course, over-the-counter transactions can
have any exercise price the two participants
agree on.
Expiration Dates

• Expiration dates of over-the-counter

options are tailored to the buyer’s and
writer’s needs.
• On options exchanges, each stock is
classified into a particular expiration
cycle.
Expiration Dates
There are three cycles for most exchange-traded stock options:
• Cycle 1: January Cycle. Expirations in January, April, July,
October (the first month of each quarter)

• Cycle 2: February Cycle. Expirations in February, May,

August, November (the second month of each quarter)

• Cycle 3: March Cycle. Expirations in March, June,

September, December (the third month of each quarter)
Position Limits

• A position limit is a preset level of

ownership, or control, of derivative
contracts – like options or futures – that
a trader, or affiliated group of traders,
may not exceed.
Exercise Limits

• An exercise limit is a restriction on the

amount of option contracts of a single
class that any one person or company
can exercise within a fixed time period
(usually a period of five business days).
Thank you…..