Over the Counter Options

Many derivative instruments such as forwards, swaps and most exotic derivatives are traded OTC.

� OTC Options are essentially unregulated

� Act like the forward market described earlier
� Dealers offer to take either a long or short position in option and then hedge that risk with transactions in
other options derivatives.
� Buyer faces credit risk because there is no clearing house and no guarantee that the seller will perform
� Buyers need to assess sellers' credit risk and may need collateral to reduce that risk.
� Price, exercise price, time to expiration, identification of the underlying, settlement or delivery terms, size of
contract, etc. are customized
� The two counterparties determine terms.

Exchange-Traded Options
An option traded on a regulated exchange where the terms of each option are standardized by the exchange. The
contract is standardized so that underlying asset, quantity, expiration date and strike price are known in advance.
Over-the-counter options are not traded on exchanges and allow for the customization of the terms of the option
contract.

� All terms are standardized except price.

� The exchange establishes expiration date and expiration prices as well as minimum price quotation unit.
� The exchange also establishes whether the option is American or European, its contract size and whether
settlement is in cash or in the underlying security.
� Usually trade in lots in which 100 shares of stock = 1 option
� The most active options are the ones that trade at the money, while deep-in-the-money and deep-out-of-the
money options don't trade very often.
� Usually have short-term expirations (one to six months out in duration) with the exception of LEAPS, which
expire years in the future
� Can be bought and sold with ease and holder decides whether or not to exercise. When options are in the
money or at the money they are typically exercised.
� Most have to deliver the underlying security.
� Regulated at the federal level

Types of Exchange Traded Options

1. Financial Options: Financial options have financial assets, such as an interest rate or a currency, as their
underlying assets. There are several types of financial options:

� Stock Option - Also known as equity options, these are a privileges sold by one party to another. Stock
options give the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon
price during a certain period of time or on a specific date.

� Index Option - A call or put option on a financial index, such as the Nasdaq or S&P 500. Investors trading
index options are essentially betting on the overall movement of the stock market as represented by a
basket of stocks.

� Bond Option - An option contract in which the underlying asset is a bond. Other than the different
characteristics of the underlying assets, there is no significant difference between stock and bond
options. Just as with other options, a bond option allows investors to hedge the risk of their bond portfolios
or speculate on the direction of bond prices with limited risk.
 A buyer of a bond call option is expecting a decline in interest rates and an increase in bond prices. The
buyer of a put bond option is expecting an increase in interest rates and a decrease in bond prices.

� Interest Rate Option - Option in which the underlying asset is related to the change in an interest rate.
Interest rate options are European-style, cash-settled options on the yield of U.S. Treasury securities.
Interest rate options are options on the spot yield of U.S. Treasury securities. They include options on 13-
week Treasury bills, options on the five-year Treasury note and options on the 10-year Treasury note. In
general, the call buyer of an interest rate option expects interest rates will go up (as will the value of the call
position), while the put buyer hopes rates will go down (increasing the value of the put position.) Interest rate
options and other interest rate derivatives make up the largest portion of the worldwide derivatives market.
It's estimated that $60 trillion dollars of interest rate derivatives contracts had been exchanged by May
2004. And, according to the International Swaps and Derivatives Association, 80% of the world's top 500
companies (as of April 2003) used interest rate derivatives to control their cash flow. This compares with
75% for foreign exchange options, 25% for commodity options and 10% for stock options.

� Currency Option - A contract that grants the holder the right, but not the obligation, to buy or sell currency
at a specified price during a specified period of time. Investors can hedge against foreign currency risk by
purchasing a currency option put or call.

2. Options on Futures: Like other options, an option on a futures contract is the right but not the obligation, to buy or
sell a particular futures contract at a specific price on or before a certain expiration date. These grant the right to enter
into a futures contract at a fixed price. A call option gives the holder (buyer) the right to buy (go long) a futures
contract at a specific price on or before an expiration date. The holder of a put option has the right to sell (go short) a
futures contract at a specific price on or before the expiration date.

Learn more about the product specifications of options on futures in our article Becoming Fluent In Options On
Futures

3. Commodity Options: These are options in which the underlying asset is a commodity such as wheat, gold, oil and
soybeans. The CFA Institute focuses on financial options on the CFA exam. All you need to know regarding
commodity options is that they exist.

4. Other Options: As with most things, as time goes on procedures and products undergo drastic changes. The
same goes for options. New options have underlying assets such as the weather. Weather derivatives are used by
companies to hedge against the risk of weather-related losses. The investor who sells a weather derivative agrees
to bear this risk for a premium. If nothing happens, the investor makes a profit. However, if the weather turns bad, the
company owns the derivative claims the agreed amount.

Exchange traded options are contracts that give the right, but not the obligation, to purchase or sell financial products.
These types of options are also called “ETOs” or “listed options.” Most ETO contracts include a set price for the product,
which is commonly referred to as the strike price. Exchange traded option contracts also typically specify the underlying
asset, quantity and expiration date. While the right to buy or sell the product can generally be exercised on or before the
expiration date, the option becomes void after the expiration date.

The booming exchange-traded currency derivatives segment will soon see the introduction of options
trading. The National Stock Exchange (NSE) and the United Stock Exchange (USE) have received the
regulator’s approval for launching options trading on the rupee-dollar spot rate.
According to market participants, the move will boost the turnover of exchange-traded currency
derivatives, where only futures trading is allowed at present. Options will provide an additional tool to
hedge against currency volatility.

Apart from NSE and USE, the MCX Stock Exchange (MCX-SX) offers currency futures.

The popularity of currency derivatives can be gauged from the fact that the daily combined turnover of
the three exchanges — NSE, USE and MCX-SX — is well above Rs 40,000 crore. This is much higher
than the cash segment turnover at NSE and the Bombay Stock Exchange (BSE).

USE said it "would begin operations in currency options very soon". NSE is expected to launch
currency options within a fortnight. Exchanges have been doing mock trading in options for quite
some time now.

According to BSE Managing Director and Chief Exceutive Officer Madhu Kannan, options trading will
provide "a powerful mechanism for corporate entities and SMEs (small and medium enterprises) to
hedge their currency risk and at the same time bring all the benefits of exchange-traded products like
transparency and efficient price discovery". BSE holds 15 per cent in USE. All its members are
connected to the USE platform.

It is well over two months since the Securities and Exchange Board of India (Sebi) released a circular
allowing options contracts on the rupee-dollar spot rate. Sebi said, "It has now been decided to permit
options on the USD-INR spot rate on currency derivatives segments of stock exchanges. Eligible stock
exchanges may do so after obtaining prior approval from Sebi."

The regulator has allowed exchanges to introduce premium styled European call and put options. A
European option can be squared off only on the day of expiry (maturity). The American option can be
squared off before the expiry day. Stock options offered by Indian stock exchanges are American
options.

The regulator has fixed the contract size at $1,000, with three serial monthly contracts followed by
three quarterly contracts. The maturity of the contracts cannot exceed 12 months. While the premium
will be quoted in rupee, the outstanding positions will be in dollar terms. The gross open position of
each trading member across all contracts (both futures and options contracts) has been capped at 15
per cent of the total open interest, or $50 million, whichever is higher.

For banks, this has been capped at 15 per cent of the total open interest, or $100 million, whichever is
higher.

OTC:

Exotic options traded on the over-the-counter market, where participants can choose the characteristics
of the options traded.

� Over-the-counter options (OTC options, also called "dealer options") are traded between two
private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted
and may be individually tailored to meet any business need. In general, at least one of the
 counterparties to an OTC option is a well­capitalized institution. Option types commonly traded
over the counter include:

1. interest rate options

2. currency cross rate options, and
3. options on swaps or swaptions.

Over-the-Counter Option
An option traded off-exchange, as opposed to a listed stock option. The OTC option has a direct
link between buyer and seller, has no secondary market, and has no standardization of striking
prices and expiration dates.

Features of call options:

Call option premiums are always quoted per stock, but sold in lots of 100 shares minimum. Call options are always an
agreement about being able to purchase the stock at the agreed upon price. Call options come in both European style and
American style.

European style call options are sold on European exchanges, while American style call options are sold in North American
exchanges. The difference is quite simple. European options can only be exercised on the expiry day, while American
style options can be exercised at any time during the life of the call option.

Call options are frequently described by the relationship of the strike price to the stock price. A call option for which the
strike price is equal to the stock price is said to be an "at the money" call option. If the strike price is above the stock price,
the call option is said to be an "out of the money" call option. Finally, if the strike price is less than the stock price, the call
option is said to be "in the money".

There are two investment styles when investing in call options. Conservative investors sell an "out of the money" call
option on a stock that is part of their portfolio to increase the overall return on their portfolio. The intention is that the
stock price will not increase at such a rate that it becomes equal to or greater than the strike price. In this case, the investor
gets to keep the premium and the stock, and the call option expires worthless. The process will then be repeated.

The speculative call option investor will purchase "at the money" call options without owning the underlying stock. The
expectation is that the price of the call option will increase as the price of the stock increases. Typically, if the stock price
increases by one US dollar (USD), the price of the call option will also increase by one USD. However, since the call
option may cost as little as one tenth of the stock, the rate of return on the investment is much higher with the call option
than it would be if the stock were purchased.

When to use this futures option strategy: A person would buy a call option in the commodities or
futures markets if he or she expected the underlying futures price to move higher.

Buying a call option entitles the buyer of the option the right to purchase the underlying futures
contract at the strike price anytime before the contract expires. This rarely happens and there is not
much benefit to doing this, so don’t get caught up in the formal definition of buying a call option.
Most traders buy call options because they believe a commodity market is going to move higher and
they want to profit from that move. You can also exit the option before it expires – during market
hours, of course.

All options have a limited life. They are defined by a specific expiration date by the futures exchange
where it trades. You can visit each futures exchange’s website for specific expiration dates of each
commodities market.

� Limited Risk
� Less Volatility

American Options vs. European Options

by Siam Luu
When choosing forex options, make sure you also look to see if they are American-style
options or European style options. American-style options give the trader the ability to
exercise his or her option at any point in time up to the expiration date. The European
option allows the trader to only exercise his or her option exactly on the date the option
expires. The difference between the two is small, but important enough to make a
difference on an investor's timing abilities.

American and European options

The key difference between American and European options relates to when the options can be
exercised:

� A European option may be exercised only at the expiry date of the option, i.e. at a single pre­
defined point in time.
� An American option on the other hand may be exercised at any time before the expiry date.

For both, the pay-off - when it occurs - is via:

Max [ (S – K), 0 ], for a call option

Max [ (K – S), 0 ], for a put option:

(Where K is the Strike price and S is the spot price of the underlying asset)

Option contracts traded on futures exchanges are mainly American-style, whereas those traded
over-the-counter are mainly European.

Nearly all stock and equity options are American options, while indexes are generally
represented by European options. A list of European and American options can be found on the
Options Industry Council website.
Expiration date

American options expire the third Saturday of every month. They are closed for trading the
Friday prior.

European options expire the Friday prior to the third Saturday of every month. Therefore they are
closed for trading the Thursday prior to the third Saturday of every month.
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