Exchange Traded Option Markets Essay Example | Topics and Well Written Essays - 2000 words

Exchange Traded Option Markets - Essay Example (Christopher, 2001; 45-57) 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 a way to manage the risks associated with such deals. Also, dealers offer a huge variety of non-standard contracts known collectively as exotic options. (John, 2002: 110-118) 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. (Zuhayr, 2001, 63-70) However, the writers of options are subject to margin procedures. They must deposit initial margin at the outset, and will be required to make additional variation margin payments via their brokers to the clearing house if the position moves into loss. (Gordon, 2001: 121-129) The initial margin depends on the degree of risk involved, calculated according to factors such as the price and volatility of the underlying and the time to expiry of the contract. In practice, in order to cover margin calls, brokers often ask for more than the minimum initial margin figure stipulated by the clearing house. The derivatives exchanges also offer listed option contracts on major equity indices such as the S&P 500, the FT-SE 100 and the DAX. Contracts are of two main kinds. Some are options on equity index futures, and exercise results in a long or short futures position. Other contracts are settled in cash against the spot price of the underlying index. If a call is exercised the payout is based on the spot index level less the strike. If a put is exercised the payout is based on the strike less the spot index level. Options on indices and other baskets of shares can also be purchased directly from dealers in the OTC market. (Dimitris, 2000: 90-102) Some dealing houses issue securities called covered warrants which are longer-dated options on shares other than those of the issuer. Warrants are usually listed and trade on a stock market such as the London Stock Exchange. The term 'covered' means that the issuer is writing an option and hedges or covers the risks involved, often by trading in the underlying shares. (Austin, 2000: 73-81) Warrants are purchased by both institutional and retail investors (historically the retail market has been more active in Germany than in the UK). (Christopher, 2001; 45-57) Warrants can be calls or puts and written on an individual share or a basket of shares. They are sometimes settled in cash, and sometimes through the physical delivery of shares. UK Stock Options on LIFFE Table 1 shows some recent prices for stock options on Royal Bank of Scotland Group plc (RBOS) traded on LIFFE. These are the offer or sale prices for contracts posted by dealers placed on the exchange's electronic dealing system, LIFFE Connect. At the time the quotations were taken the options had just over two weeks remaining until expiry and the underlying RBOS share price was 1781