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

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Exchange-Traded Equity Options

INTRODUCTION

Call and put options on the shares of individual companies can be traded over-the-counter (OTC) with dealers or on major derivatives exchanges such as Eurex, NYSE Liffe, and the Chicago Board Options Exchange (CBOE). On the exchanges the more actively traded contracts can be bought and sold without greatly affecting the market price. In addition, the settlement of contracts is guaranteed by the clearing house associated with the exchange, which effectively eliminates counterparty default risk (see also Chapter 20 which covers clearing).

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 underlying shares, as long as they can find a way to manage the risks involved. Also, OTC dealers offer a huge variety of nonstandard contracts known collectively as exotic options. Appendix B describes some of the main types of exotic options.

BASIC CONCEPTS

With some exchange-traded options the buyer is not required to pay the full premium at the outset. Instead, the buyer deposits a proportion of the premium as initial margin. However if the option is exercised the full premium has to ...