Option

From MarketsWiki

An option is a financial instrument that conveys the right, but not the obligation, to buy or sell another financial instrument or asset at a specific price within a specific period of time. Options are traded either in the over-the-counter market or in the exchange-traded market. These instruments were first introduced to the exchange community in April 1973, when Chicago Board Options Exchange introduced options on just a handful of companies (only calls and no puts until four years later in 1977). Today options on more than 50 exchanges worldwide cover stocks, stock indexes, currencies, interest rates, commodities, metals, energy products and other categories.

1 Overview
2 History of Options
3 Growth Projections
4 Options Exchanges
5 Option Valuation Models
6 Option Trading Strategies
7 References

Overview

An option provides an explicit structure for the potential transaction, detailing the exact type and quantity of financial instrument to be bought or sold, the price for the transaction, and the length of time that the transaction right will be granted.

As a hypothetical example, a stock option could be an option to purchase (a "call" option) or sell (a "put" option) 100 shares of XYZ Corporation at $50 per share, with an expiration date of June 30, 2007.

An option has its own value that is determined by a number of factors, including the amount of time left to expiration, the current value of the security it represents, and the amount of volatility in the security's market. The option buyer pays the cost of the option (the "premium"), which is transferred to the seller minus the seller's transaction costs.

Until the end of the expiration day, the buyer of this option would have the right to exercise his option and either buy or sell the stock (depending on whether he bought a put or call option). In the above example, no matter at what price XYZ stock is trading, exercising a call option (an option to purchase) will result in the option owner buying 100 shares of XYZ at $50 per share. Once exercised, the option is removed from the owner's portfolio.

If the buyer of the option exercises it, the seller is given the opposing side of the exercise transaction. In the above simple example, if the option buyer exercises his call option and purchases 100 shares of XYZ at $50, the option seller will be made to sell 100 shares of XYZ at $50.

If the owner of the option does not exercise it, then at the end of the expiration day, the option is removed from the owner's portfolio and no action is taken. The seller of that option will no longer have the risk of being assigned the opposite side of that option's transaction.

Options may be bought and sold purely for the profit and loss of those transactions, where the buyers and sellers have no intention of exercising the options and entering into transactions in the underlying instrument. Options may also be bought and sold in specific combinations, either with each other or with the underlying security, to create different risk/reward profiles.

History of Options

It is not known when when the first option contract traded; however, similar contracts can be traced back as far as the Romans and the Phoenicians, who used them in shipping, and ancient Greece, where a mathematician and philosopher named Thales used them to secure a low price for olive presses in advance of the harvest. They were also used in the tulip trading craze in Holland in the 1600s.

Options appeared in America roughly the same time as stocks. At first they were not traded on an exchange; trades were done privately between buyers and sellers. After the Depression, options came under scrutiny. They were legitimized by the Investment Act of 1934, which also put them under the SEC's jurisdiction.

Growth in options trading remained slow for the next few decades, mostly because trading by phone without being able to determine the real market for a contract made them illiquid and cumbersome to trade.

In the late 1960s, with commodities volumes low, the Chicago Board of Trade was examining other market opportunities and decided to go into options trading. Joseph W. Sullivan, who was then vice president of planning for the CBOT, proposed standardizing the contract terms. He also recommended the creation of an intermediary to issue contracts and guarantee settlement and performance. This intermediary eventually became the Options Clearing Corporation, established in 1975.^[1]

The Chicago Board Options Exchange(CBOE) began trading listed call options on 16 stocks on April 26, 1973. Average daily volume leapt from 911 contracts the first trading day to more than 20,000 the following year. After regulators enabled banks and insurance companies to include options in their portfolios, exchange membership doubled, and by the end of 1974, average daily volume was more than 200,000 contracts.

With the advent of CBOE, traders had access to published quoted options prices for the first time, and a market maker system to make sure that there was a secondary or resell market for options.^[2]

Other exchanges began trading listed options, beginning in 1974, including the American Stock Exchange (AMEX), the Pacific Stock Exchange (PSE), and what is now known as the Philadelphia Stock Exchange (PHE). The most recent entrants to the game are the International Securities Exchange (ISE), Boston Options Exchange (BOX), NYSE Arca, and NASDAQ OMX'S NASDAQ Options Market.^[3]

The launch of the International Securities Exchange (ISE) on December 31, 1999, ushered in a new electronic era in the options world. Up until that year, the open-outcry options exchanges had unofficially, by a "gentleman's agreement," made it a practice not to trade one another's products. The SEC ended this practice in 1999, and the exchanges were free to compete against each other. The ISE came online on May 26, 2000. Its growing success spurred the other exchanges to move forward into the electronic age.^[4]

The increased competition among options exchanges and the advent of electronic trading platforms have led to huge growth in options volume. It has also led to narrower spreads, lower fees, and an influx of institutional participation.

Growth Projections

The amount of buy-side equity options traded electronically is expected to more than double by 2010 as new technologies enable investors to trade more efficiently, according to a study published by financial market research firm TABB Group, released in mid-February 2008.^[5]

According to the study, 30 percent of buy-side equity options were currently traded electronically, with the proportion set to rise to 62 percent in the next two years.

Two of TABB Group's analysts involved with the study, Andy Nybo and Kevin McPartland, said that the option markets are exploding, not just in terms of trading volume but also with respect to new participants that are suddenly discovering the potential benefits associated with option. U.S. equity options turnover jumped 41 percent to 2.8 billion contracts in 2007 from a year earlier, according to Options Clearing Corp.

Catalysts for growth include increased electronic trading, improved customer educational awareness, more stock market volatility, as well as regulatory changes that allowed for the quoting of options in penny increments, and new flexible margin rules.

With this new institutional growth will come increased quote volumes through the Options Price Reporting Authority, which merges quotes into one feed and pushes them out to the market. During periods of heavy market activity, OPRA sends out as many as 300,000 messages per second,^[6] far above what was seen just a few years ago, and this is expected to increase exponentially.

Options Exchanges

In the United States alone, seven securities options exchanges exist: Amex, Boston Options Exchange, Chicago Board Options Exchange, International Securities Exchange, NASDAQ Options Market, NYSE Arca and Philadelphia Stock Exchange.

The U.S. options markets are the most competitive financial markets in the world. Unlike the stock and futures markets where a particular product may trade on only one exchange, the competition amongst options exchanges is fierce because identical options contracts may trade on multiple exchanges. This multiple listing of products gives investors the ability to freely choose among seven exchanges to execute their orders. For each exchange, speed becomes a critical factor in determining who “wins” an order.