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Mechanics of the Options Market

8 important questions on Mechanics of the Options Market

What option positions exist?

Payoffs:
- Long Call: max(S-K,0)
- Long Put: max(K-S,0)
- Short Call: min(K-S,0), writer of a call
- Short Put: min(S-K,0), writer of a put

What are potential underlying assets for options?

- Stock options, most straightforward, sold in package of 100 (just like stocks themselves)
- Foreign currency options, OTC, usually 10.000 units of a currency (Yen: 1 mln)
- Index options, both OTC and exchange, S&P500, most European (except S&P100), settlement is in CASH (more convenient than selling the complete underlying)
- Futures options, on most futures contracts an option exist. Usually the maturity is a short period of time before expiration of the future. For a call that is exercised the gain is the excess of the futures price over the strike price.

What about the expiration date?

Expiration dates: Saturday after the THIRD Friday of the expiration month. That last Friday is the last trading date, exercise should be notified before 4:30 PM. The broker has until 10:59 PM next day to complete. Months following cycles: January, February or March and then 3 months moving. How (in January):
- Before expiration date: January, February, April, July
- After expiration date: February, March, April, July
Meaning that if trading for one month expires a new month comes in.
LEAP (Long-term Equity AnticiPation Securities), trade up to 39 month is the future.

What about the strike price?

Exchanges chooses the strike prices at which the options can be written so that they are spaced either 2.5, 5 or 10 apart, depending on the stock price:
- Between 5 and 25 dollar it is 2.5
- Between 25 and 200 dollar it is 5
- More than 200 dollar it is 10
When a new expiration date is introduced the two or three closest strike prices are selected by the exchange. If it moves outside the range, a new strike option is usually introduced.

What about FLEX and nonstandard?

Flexible options (on equity and equity indices) have nonstandard terms, usually European. Attempt by the exchange to regain market share in options. Minimum size of 100.

Nonstandard products, options on/like:
- ETF
- Weeklys (write on Thursday and expire Friday in a week)
- Binary options (pay-off $100 if price above strike, in case of a call)
- CEBO (credit event binary option), suffer credit event by maturity it will payoff
- DOOM options, deep out-of-the-money put options that are CDS like. Only payoff when the stock really plunges.

What about dividends and stock splits?

(exchange traded) Options are usually not adjusted for CASH dividends unless exception is made in case of a large cash dividend. They are however adjusted for stock splits and stock dividends as this has virtually no effect on the equity or cash of the company. A 3-for-1 split is exchanging 1 to get 3. Following an n-to-m split, the new strike should go down to m-to-n of old strike. This leaves positions of both sides unchanged. Stock dividend is the same, just treat them as 6-for-5 in case of 20% stock dividend.

What about limits (position and exercise)?

To prevent the market from being influenced by and individual or group of investors CBOE often specifies a maximum position limit on one side. A side is defined as long call and short put, while the other is short call and long put. Whether really necessary is a controversial issue.

An exercise limit is usually equal to the position limit. Maximum number of contracts that can be exercised in any period of 5 consecutive business days. Ranging from 250k to 25k, depending on capitalization and amount of shares.

What about regulation and taxation?

SEC for options on stocks, CFTC for commodities, etc. ISDA, Internation Swaps and Derivatives Association.

Taxation is tricky due to:
- Difference between capital gain and income
- If exercised rolled over into stock (put premium that is pay counts!)
- Wash Sale Rule: unrealized loss into realized and repurchase, not for 30 days
- Constructive sales, if "constructively sold" it is taxed.
- Note: buying in-the-money put option is not triggering!! It should eliminate gain and loss, both sides!

The question on the page originate from the summary of the following study material:

Part 3: Financial Market and Products

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Mechanics of the Options Market

8 important questions on Mechanics of the Options Market

What option positions exist?

What are potential underlying assets for options?

What about the expiration date?

What about the strike price?

What about FLEX and nonstandard?

What about dividends and stock splits?

What about limits (position and exercise)?

What about regulation and taxation?

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