the right to enter into a transaction with the seller to either buy or sell an
underlying at a specified price on or before a specified date. If the right is
to purchase the underlying, the option is a call option. If the right is to
sell the underlying, the option is a put option. The specified price is
called the strike price or exercise price and the specified date is called the
expiration date. The option seller grants this right in exchange for a certain
amount of money called the option premium or option price. The
underlying for an equity option can be an individual stock or a stock
index. The option seller is also known as the option writer, while the
option buyer is the option holder.
An option can also be categorized according to when it may be exercised
by the option holder. This is referred to as the exercise style. A
European option can only be exercised at the expiration date of the contract.
An American option, in contrast, can be exercised any time on or
before the expiration date.
The terms of exchange are represented by the contract unit, which is
typically 100 shares for an individual stock and a multiple times an index
value for a stock index. The terms of exchange are standard for most contracts.
Exhibit 3.4 summarizes the obligations and rights of the parties to
American calls and puts.
The most actively traded equity options are listed option (i.e., options
listed on an exchange). Organized exchanges reduce counterparty risk by
requiring margin, marking to the market daily, imposing size and price
limits, and providing an intermediary that takes both sides of a trade.
For listed options, there are no margin requirements for the buyer of an
option, once the option price has been paid in full. Because the option price
is the maximum amount that the option buyer can lose, no matter how
adverse the price movement of the underlying, margin is not necessary. The
option writer has agreed to transfer the risk inherent in a position in the
underlying from the option buyer to itself. The writer, on the other, has
certain margin requirements, including the option premium and a percentage
of the value of the underlying less the out-of-the-money
amount.
Stock Options and Index Options
Stock options refer to listed options on individual stocks or American
Depository Receipts (ADRs). The underlying is 100 shares of the designated
stock. All listed stock options in the United States may be exercised
any time before the expiration date; that is, they are American
style options.
Index options are options where the underlying is a stock index
(broad based or narrow based) rather than an individual stock. An
index call option gives the option buyer the right to buy the underlying
stock index, while a put option gives the option buyer the right to sell
the underlying stock index. Unlike stock options where a stock can be
delivered if the option is exercised by the option holder, it would be
extremely complicated to settle an index option by delivering all the
stocks that comprise the index. Instead, index options are cash settlement
contracts. This means that if the option is exercised by the option
holder, the option writer pays cash to the option buyer. There is no
delivery of any stocks.
Index options include industry options, sector options, and style
options. The most liquid index options are those on the S&P 100 index
(OEX) and the S&P 500 index (SPX). Both trade on the Chicago Board
Options Exchange. Index options can be American or European style.
The S&P 500 index option contract is European, while the OEX is
American. Both index option contracts have specific standardized features
and contract terms. Moreover, both have short expiration cycles
The dollar value of the stock index underlying an index option is
equal to the current cash index value multiplied by the contract’s multiple.
That is,
Dollar value of the underlying index = Cash index value × Multiple
For example, suppose the cash index value for the S&P 500 is 1,100.00.
Since the contract multiple is $100, the dollar value of the SPX is
$110,000 (= 1,100.00 × $100).
For a stock option, the price at which the buyer of the option can
buy or sell the stock is the strike price. For an index option, the strike
index is the index value at which the buyer of the option can buy or sell
the underlying stock index. The strike index is converted into a dollar
value by multiplying the strike index by the multiple for the contract.
For example, if the strike index is 1,000.00, the dollar value is
$100,000 (= 1,000.00 × $100). If an investor purchases a call option on
the SPX with a strike index of 1,000.00, and exercises the option when
the index value is 1,100, then the investor has the right to purchase the
index for $100,000 when the market value of the index is $110,000.
The buyer of the call option would then receive $10,000 from the
option writer.
LEAPS and FLEX options essentially modify an existing feature of
either a stock option, an index option, or both. For example, stock
option and index option contracts have short expiration cycles. Long-
Term Equity Anticipation Securities (LEAPS) are designed to offer
options with longer maturities. These contracts are available on individual
stocks and some indexes. Stock option LEAPS are comparable to
standard stock options except the maturities can range up to 39 months
from the origination date. Index options LEAPS differ in size compared
with standard index options having a multiplier of 10 rather than 100.
FLEX options allow users to specify the terms of the option contract
for either a stock option or an index option. The value of FLEX options
is the ability to customize the terms of the contract along four dimensions:
underlying, strike price, expiration date, and settlement style.
Moreover, the exchange provides a secondary market to offset or alter
positions and an independent daily marking of prices.
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