Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 10. Exchange-Traded Equity Options

INTRODUCTION

Call and put options on the shares of individual companies can be bought over-the-counter (OTC) from dealers, or traded on major exchanges such as Eurex, LIFFE and the Chicago Board Options Exchange (CBOE). Exchange-traded contracts that are actively traded can be bought and sold in reasonable quantity without greatly affecting the market price. The performance of contracts is guaranteed by the clearing house associated with the exchange which eliminates any possibility of default.

In recent years some exchanges have introduced so-called FLEX option contracts which allow investors to tailor certain terms of a contract. However, most exchange-traded options are standardized. There are a set number of strikes and expiry dates available, and it is not generally possible to trade options on the shares of smaller companies. By contrast, in the OTC market dealers will sell and buy options on a wide range of shares, as long as they can find away to manage the risks associated with such deals. Also, dealers offer a huge variety of non-standard contracts known collectively as exotic options.

On some exchanges and with some contracts the buyer of an option is not required to pay the full premium at the outset. Instead, the purchaser deposits initial margin that is a proportion of the premium due on the contract. In the case of the individual stock options traded on LIFFE, the full premium is payable upfront. However, the writers of options ...