Chapter 10: Mechanics of Options Markets

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Types of Options

Feature	Call	Put
Right	To buy	To sell
Exercise	When $S > K$ (in-the-money)	When $S < K$ (in-the-money)

American vs. European: American options can be exercised at any time up to expiration; European options only at expiration. Most exchange-traded stock options are American.

Option Positions

There are four basic positions:

Position	View on Price	Max Profit	Max Loss
Long call	Bullish	Unlimited	Premium
Short call	Bearish/neutral	Premium	Unlimited
Long put	Bearish	$K -$ premium	Premium
Short put	Bullish/neutral	Premium	$K -$ premium

Payoff formulas (at expiration, $S_T$ = stock price, $K$ = strike):

Long call: $max(S_T - K, 0) - c$
Short call: $c - \max(S_T - K, 0)$
Long put: $max(K - S_T, 0) - p$
Short put: $p - \max(K - S_T, 0)$

where $c$ and $p$ are the call and put premiums.

Underlying Assets

Asset Type	Examples
Stocks	Individual company shares
Stock indices	S&P 500, DJIA, NASDAQ 100, FTSE 100, Nikkei 225
Currencies	Options on forex rates
Futures	Options on commodity/financial futures
Bonds	US Treasury bond options

Specification of Stock Options

An exchange-traded stock option contract typically covers 100 shares of the underlying stock.

Parameter	Description
Expiration date	Saturday following the third Friday of the expiration month
Strike price	Prices at standardized intervals ( $2.50,$ 5, $10 depending on stock price)
Option class	All calls or all puts on the same stock
Option series	Same class, same strike, same maturity

Adjustments

Stock splits: Strike prices and number of shares are adjusted. A 2-for-1 split doubles the number of shares and halves the strike.
Stock dividends: Exchange options are generally not adjusted for cash dividends.

Trading

Exchange-traded options are facilitated by market makers who provide continuous bid and ask quotes. The bid-ask spread compensates market makers for the cost of providing liquidity.

Margin Requirements

For US options markets:

Buying options: Must be paid in full (no margin). Options can't be purchased on margin since they already provide leverage.
Writing naked calls: Initial margin is the greater of:
- 100% of option proceeds + 20% of underlying stock value — out-of-the-money amount
- 100% of option proceeds + 10% of underlying stock value
Writing covered calls: No margin requirement (the underlying stock serves as collateral)

Warrants, Employee Stock Options, and Convertibles

Instrument	Description
Warrants	Call options issued by the company on its own stock. Exercise dilutes existing shareholders.
Employee stock options (ESOs)	Call options granted to employees as part of compensation. Typically long-dated with vesting periods.
Convertible bonds	Corporate bonds that can be converted into a specified number of shares of the issuing company.

Over-the-Counter Options Markets

OTC options offer flexibility not available on exchanges:

Customized strike prices, maturities, and contract sizes
Exotic payoff structures
Can be tailored to specific hedging needs

The downside is counterparty risk, which is typically managed through collateral agreements (Credit Support Annexes — CSAs).