3.3.2 Option Markets

2. Option Markets

2.1 Exchange-Traded Options on Stocks

2.1.1 Basics of Trading Rules on CBOE

The options on individual stocks are American-style, and include 100 shares.

CBOE also offers index options which is cash settled.

CBOE also provides exchange-trade products (ETPs) options such as options on ETFs.

2.1.2 Dividends and Stock Splits

Cash dividends do not affect the terms of stock options unless they are unusually high.

Stock splits and stock dividends do result in strike price adjustments.

• If a company announces a 3-to-1 stock split which means each share is replaced by 3 new shares, the strike price will be reduced to one third of the original price and the number of options is multiplied by three.
• Note that a 5% stock dividend means shareholders receive 1 new share for each 20 shares owned, this is identical to an 21-to stock split.

2.2 Trading&Margin Requirements

2.2.1 Trading Mechanics

Market Makers quote both bid and offer price on the option to ensure buy and sell orders be executed without any delays and add liquidity to the market.

• Bid price is the price market maker prepares to buy.
• Offer or ask price is the price market maker prepares to sell.

Like futures, exchange-traded options can be closed out by taking an offsetting position.

CBOE imposes position and exercise limits on traded options to prevent the market from being controlled by one investor.

2.2.2 Margin Requirements

The buyer fully paid for an option would be no margin requirements. However, the option seller does have potential future liabilities.

Options with maturities less than nine months must be paid in full price upfront.

Options with maturities greater than nine months can be bought on margin, but no more than 25% can be borrowed.

2.2.3 Option Clearing Corporation(OCC)

OCC performs the same function for options markets as the clearing house does for futures markets.

It guarantees that options writers willeir a record of all long and short positions.

When an investor instructs a broker to exercise an option, the broker notifies the OCC member that clears its trades. This member then places an exercise order with the OCC.

2.3 Other Types of Options

2.3.1 Over-the-Counter Market

Option characteristics in the OTC market can differ from those available on the exchanges.

E.g. strike prices, maturity dates, and the times when options can be exercised.

OTC market is large and the options often last longer than those trader on exchanges.

OTC options can also be exotic.

2.3.2 Warrants

Warrants are options issued by a corporation, and are usually call options on the corporation’s own stock.

Warrants can be used by firms to make debt issuances more attractive to investors.

Difference between warrant and option: exercising an option will not affect the number of the outstanding shares while if warrants are exercised, more shares will be issued.

The stock price after exercise:
$$\frac{NS+WK}{N+W}$$

The value of the warrant
$$\frac{NS+WK}{N+W}-K=\frac{N}{N+W}(S+W)=\frac{N}{N+W}\ast \text{Call Value}$$

• $S$ is the stock price, $K$ is the strike price of warrant.
• $N$ is the number of stocks outstanding, $W$ is the number of new warrant issued.
• The total value of the equity and the warrants:$NS+NW$

The company’s stock price will decline by (dilution cost):
$$S-\frac{NS+WK}{N+W}=\frac{W}{N+W}(S-K)=\frac{W}{N+K}\ast CallValue$$

2.3.3 Convertible Bonds

Gives bondholder the right to exchange the bond for a specified number of common shares in issuing company.

Hybrid security with both debt and equity features.

Convertible bond = straight bond + call option on equity.

Convertible bond is similar to a warrant. When an investor chooses to convert, the company issues more stock to be exchanged for the bonds.

Warrants and convertibles are often traded on exchanges.

2.3.4 Employee Stock Options

Employee stock options are call options granted to its employees by a company.

There is usually a vesting period during which options cannot be exercised.

Employees may forfeit their options if they leave their jobs during the vesting period.

Employees are not permitted to sell their stock options to a third party.