Option Market Concepts
Types of Options
In this section we’ll give you some more context to the way that options markets work and who are the main participants involved.
There are two main types of options: Over the Counter (OTC) options and Exchange Traded Options (ETO). OTCs are privately traded between the buyer and seller and include company issued options. This course focuses on ETOs, so when you see the word options in this course, we are referring to Exchange Traded Options.
Exchange Traded Options
Exchange Traded Options are a derivative product issued over an existing stock or index. Each contract consists of the following standardised components: strike price, expiry date, underlying instrument and contract size. These components are found in all options traded on the exchange and are governed by clearly defined rules. The only variable that remains is the premium—the amount of money the option can be purchased or sold for (i.e. the market price of the option).
Equity Options
Equity or stock options are options traded over listed stocks. In U.S. markets, the standard number of shares covered by one stock option contract is 100.
Index Options
Index options allow investors to trade in a specific industry group or market without having to buy all the stocks individually. Each index has a specific mathematical calculation to determine the price change up or down. An index option is an option that is tied directly to the change in the value of an index. You will not typically receive a percentage of each stock; rather the index option will have a cash value as represented by the index itself. Broad-based indexes cover a wide range of industries and companies (for example, the S&P 500).
A few indexes were specifically designed for trading futures and options. This contributed to the proliferation and explosive growth of index trading. The philosophy of an index is that a group of stocks—a portfolio—will diversify the risk of owning just one stock. In addition, an index of stocks will better replicate what is happening in an industry or the market as a whole. This allows an investor or trader to participate in the movement of a specific market, to either the upside or the downside.
Throughout the rest of this course, we will examine the basic terminology and use of options. As you start to work with these terms, try to become so familiar with them that they become second nature. A sound understanding of option basics will enable you to build a strong trading foundation.
Margins
Margin is a vital key to successful trading as it is the amount of money necessary to cover an option writer’s potential obligations to the market. When an option buyer pays a premium for an option, the premium paid (or the debit), is the maximum amount of money the option buyer can lose. The option buyer has no financial obligations to the market after the premium is paid and therefore there are no margins required. On the other hand, when an option seller writes an option contract, they are creating a financial obligation to the market. To protect the integrity of the market the clearing house, through your broker, will reserve a certain amount of cash or put a hold on the required number of underlying shares from the option writer’s account to act as collateral and cover those obligations.
Some combination option strategies which include written options may also require margin payments. Strategies that include multiple options or a combination of bought and written options typically have the margin calculated on the total risk, meaning one leg of the strategy may offset part or all or the other leg and may serve to reduce the total margin payable. For example, a bull call spread strategy involves the combination of a long call option at one strike price and a short call option at a higher strike price. In this instance, the long option covers the short position, which means no margins are required for the strategy. Remember to check with your broker before placing a combination order to see what margin requirements, if any, are required for the option strategy you are considering.
Margin Payments
Margins are calculated on a daily basis to ensure an adequate level of margin cover is maintained. This means that you may have to increase your level of margin cover if the market moves against you, or your margins may be reduced if the market moves in your favour. If the market moves against you, your broker may call you (margin call) to top up your margin cover. Margin calls are usually required to be settled within 24 hours of being advised of the margin call by your broker. If you do not meet your margin call in time, your can take action to close out your position without further reference to you.
Cash is not the only collateral that is acceptable as cover. Your broker/clearing house also accepts certain stocks and bank guarantees. For example, with a covered call position, the broker/clearing house accepts the underlying shares as cover and therefore no cash margin will be required for the written call option. The broker/clearing house will typically apply a discount or haircut to the current market value of some collateral to protect against a sudden fall in the value of collateral held. It is important to always check these requirements with your broker.
Market Makers
Market makers play an important role in the options market by acting as intermediaries between your broker and the market. They are required by the exchange to make a two- sided market by providing both a bid and offer quotes in certain option series. Market makers compete against one another while trading on their own account at their own risk, and derive the bulk of their profits from the bid/ask spread.
- The bid is the highest price a prospective buyer is prepared to pay for a specified security.
- The ask is the lowest price acceptable to a prospective seller of the same security.
- These two prices constitute a quote.
The difference between the bid and ask is called the spread, and that’s where market makers make a good portion of their livings.
Each market maker is assigned two or more stocks in which they must maintain a market in. This involves quoting buy and sell prices for a certain number of option series and/or responding to requests from brokers for prices.
Each security over which exchange traded options are traded has a category designated by the exchange. This determines the maximum spread (the difference between the bid and ask prices) that the designated market maker(s) may quote when making a market and the minimum number of contracts for which the market maker must quote a price for.
Ultimately the market maker’s primary goal is to make money while providing a two-sided market. Market makers exist to ensure liquidity in the market, so that traders are more easily able to trade in and out of their positions.
Brokers
Brokers act as agents between buyers and sellers of securities and the market. They have direct access to the market via computer systems for the purpose of trading approved instruments (i.e., stocks, options, futures etc.) on your behalf, for which a fee maybe charged. A broker may also offer a range of other products and services including advice on which stocks to buy or sell, or which options strategies to employ. Brokers also raise capital for companies through Initial Public Offerings (IPOs) or stock placements.
Traders and Investors
The words trader and investor are used to describe two distinct styles of investment. An investor is someone like famed US investor Warren Buffett, a classic “buy and hold” kind of guy. He keeps an investment through thick and thin, understanding that wealth can be created over time, provided the company has solid management and is in an industry that’s likely to prosper.
The trader, on the other hand, is seen as a person that buys and sells often, looking for price swings and situations he or she can trade profitably. These are the people that constantly monitor every move the market makes, looking for trends, reversals, breakouts and all manner of price movements.
The two styles are not separate of one another. In fact, it’s common for traders to operate different portfolios incorporating both styles. For example, an individual may operate one portfolio for their short-term trading and another for their longer term investments, such as a self-managed super fund.
Professionals Traders & Investors
Professional traders and investors typically trade stocks on behalf of other people. They are usually employed by institutions, fund managers, stockbrokers and the like or they work under a special arrangement with them. In theory, professionals have the academic and professional backgrounds necessary to make superior stock selections. In reality, many professionals fail to deliver superior results. Nevertheless, professionals trade in large quantities of securities and are an important part of today’s market environment. (Note: Individual traders who derive the bulk of their income from full time trading often refer to themselves as professional traders.)
Institutional Investors
An institutional investor is a professional money manager whose job it is to put money into stocks and other assets on behalf of private investors. Institutional investors mainly focus on pooled investments such as managed funds and investment trusts. They enjoy greater contact with stockbroking analysts as well as the management staff of the companies in which they invest. It is common for individual investors to follow sizable stock trades initiated by institutional investors since they can have a significant effect on a stock’s performance, not to mention market sentiment.
Individuals Traders & Investors
Individuals who trade and invest in the markets through their own accounts are commonly referred to as retail investors and represent the bulk of the investing public. Traders and investors fall into two categories: long-term and short-term.
Long-term Investors
Long-term investors enjoy a lower risk and reduced stress approach. Investments are made with the intention of accumulating profits and dividends over the long run. Long-term investors need to do their homework carefully in order to find companies that can potentially double and triple in the decades ahead. Focusing on long-term returns makes long-term investors relatively impervious to day-to-day price fluctuations, which is a much less stressful way to live.
Short-term Traders
Short-term traders are generally speculators looking to profit from advantageous trends and momentum changes in volatile stocks. Many short-term traders integrate the use of options into their master trading plan to hedge risk and utilise leverage. Time is a big factor for short-term traders. Not just time spent in a trade, but the time required monitoring the market in search of golden opportunities.
Short-term trading can be an extremely active process. It requires specific tools to do the job right including real-time quote services and trading analysis software. If you want to compete in this arena, you have to be prepared. It’s more than a matter of tools. You need to have the right kind of psychological stamina to withstand the tests that will come your way.
