limit equals the position limit. It defines the maximum number of contracts that can beexercised by any individual (or group of individuals acting together) in any period of fiveconsecutive business days. Options on the largest and most frequently traded stocks have positionslimits of 75,000 contracts. Smaller capitalization stocks have position limits of 60,000, 31,500,99 SAN) or 12. SAN contracts
22,0UU, OF 15,0UU CONracis.
Position limits and exercise limits are designed to prevent the market from being undulyinfluenced by the activities of an individual investor or group of investors. However, whetherthe limits are really necessary is a controversial issue.
7.3_— NEWSPAPER QUOTES
 
Many newspapers carry options quotations. In the Wall Street Journal, stock option quotationscan currently be found under the heading “Listed Options” in the Money and Investing section.Table 7.1 shows an extract from the quotations as they appeared in theWall Street Journal ofFriday March 16, 2001. The quotations refer to trading that took place on the previous day(Thursday March 15, 2001).
The company on whose stock the option is written together with the closing stock price is listedin the first column of Table 7.1. The strike price and maturity month appear in the second andthird columns. If a call option traded with a given strike price and maturity month, the next twocolumns show the volume of trading and the price at last trade for the call option. The final twocolumns show the same for a put option.
The quoted price is the price of an option to buy or sell one share. As mentioned earlier, onecontract is for the purchase or sale of 100 shares. A contract therefore costs 100 times the priceshown. Because most options are priced at less than $10 and some are priced at less than $1,investors do not have to be extremely wealthy to trade options.156
CHAPTER 7
Table 7.1 Stock option quotations from the Wall Street Journal on March 16, 2001
 
 
LISTED OPTIONS QUOTATIONS
 
-CALL- -PUT-OPTIONSTRIKE EXP = VOL. LAST VOL. LASTADC Tel 10 May 25 208 1035131
AmOniine 30 Mar 608 1070 .463750 Mar 50532020004089 4) Mar «3071 $05 820080408 40 Apr «2302 7731042 at50 Mar 12700)? 24045 Mar 758 (O05 1458480459 45 Apr 119517597 gid4-50 Ape 58304709040850 ul, 805 (2452891080ASM Int 4250 Jun 650383770185,ATT wris 20 Mar 15015 65370180 20 Apr 128712070 ate 0 a 620 40a0) 25 Mar 63580a235 2H Mar 119410552 O102335S Apr 2833-2 12889 4102395 (5 Mar «800 ONS 26520235-25 Apr 201 O80 38q 380235 «40 Apr «= O10 582.1670ATMI Inc 20, Sep, 1000413Abt L 4250 Mar 821 0Ce eeAbefFilch 35 May 534268i oe eemins «Mer 1 Mi30 Mar (987 537550Kivricm 25 Ay HHO.AMD 20 Mar 181 380 600 ts23s Das0 Mar 2855120 32 002356 2 Mar 4184 «0 BS o175| 2S Apr BBB 18188 3 |os Hl 1180,
CALL: -PUT-OPTIONSTRIKE EXP. VOL. LAST VOL. LAST | OPTION/STRIKE — EXP.2356 2S Oct «1004 «60, FH 65 MayAgilent = 35 Apr 700, 340, 22 8B | G38 70 Mar3465 40 Apr 2758150 ~ | Be 70 heeAlamesa = 1250 App 80083, = | 638 75 MarMbnyMic 35 Aug 6251028. | Analog 40 MarAibtsn = 2750 Mar 18080476048 And 45 AprAllegTel = 20 Apr 2580 368] 308'50 AprwidWaste 20) Mar ss 2128 sgt 69 qiAlste 40 in 1085 «130 142150 | angwthink §=5 =| Mar4007 4250 Mar 275000. 526 5 r40074280 Apr «7080128 30,260 | Apache = 65. MarNphand = 1750 in 1052168, | BIE 5 ArHera % Mar 77? 1 122 008 opie 152825 2750 Mar = 121645 [968 1750 AprAmazon 70 i 255 413 1040 O44 | 1969 20 Mar1 4 Mar a 1347 3378 | 1969 AprAmdocs 65 io 2 3 2124 970] 1969 25 AprAnbar 40 Mar 1186 (050 430 1968 Ju40 Apr «= 622,250 234 280 | 1969 0 Apr3960 4208 Apr 2181185 140 420 1 30 rAmGenl = 3750 Jul «= 625480 202 4613 ar3933 40 Mar = 49420205 | G18 40Am Hem 55 Mar 2698185080 | 46134250, Mar5656 55 ul «= 280386 5 480 7 4613 456 AAmintGp = =95 = May ve ome 1700 1710 4613 45 larAmsid 45 ul = on 1001 435Aon 55 r S10 1288 99 HBP | AGt8 4750 Mar3 60 Mar 7168 6728] 4BtS 5 Mar651365 Mar 455125634125. | 461350 Apr65370 Apr A783 2257 46385 Apr651375 Apr «524183 300 1080 | ANCE 20653 8D Apr 1208 HC 18, 236335 MarAnak «= 55 May . 500 160 | 2783 4750 Ane6436S Mar 788M) 1020 «220 | Ariba 1750 he6ys 6 Ap 1113 32 18190 lay
 
CAIVOL,505
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PUTLAST VOL. LAST40 4560» 2201 7016 2101 700% 975 11505642M 1325180
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Source: Reprinted by permission of Dow Jones, Inc., via copyright Clearance Center, Inc.© 2001 Dow Jones & Company, Inc. All Rights Reserved Worldwide.
The Wall Street Journal also shows the total call volume, put volume, call open interest, and putopen interest for each exchange. The numbers reported in the newspaper on March 16, 2001, areshown in Table 7.2. The volume is the total number of contracts traded on the day. The openinterest is the number of contracts outstanding.
From Table 7.1 it appears that there were arbitrage opportunities on March 15, 2001. Forexample, a March put on Amazon.com with a strike price of 45 is shown to have a price of 33.75.Because the stock price was 11, it appears that this put and the stock could have been purchased andthe put exercised immediately for a profit of 0.25. In fact, these types of arbitrage opportunities
Table 7.2 Volume and open interest reported in the Wall Street Journal on March 16, 2001
Exchange Call volumeChicago Board 777,845American 481,780Philadelphia 261,970Pacific 253,995Total 1,775,590
46,667,87217,343,48727,454,32341,893,009
133,358,691
Call open interest
Put volume
787,278371,031226,953200,690
1,555,949
Put open interest
26,436,6119,331,58614,051,37522,910,071
72,729,643Mechanics of Options Markets 157
almost certainly did not exist. For both options and stocks, Table 7.1 gives the prices at which thelast trade took place on March 15, 2001. The last trade for the March Amazon.com put with a strikeprice of 45 probably occurred much earlier in the day than’the last trade on the stock. If an optiontrade had been attempted at the time of the last trade on the stock, the put price would have beenhigher than 33.75.
7.4. TRADING
 
Traditionally, exchanges have had to provide a large open area for individuals to meet and tradeoptions. This is changing. Eurex, the large European derivatives exchange, is fully electronic, sothat traders do not have to physically meet. The Chicago Board Options Exchange launchedCBOEdirect in 2001. Initially it will be used to trade certain options outside regular trading hours,but it is likely that eventually it will be used for all trading.
Market Makers
Most options exchanges use market makers to facilitate trading. A market maker for a certainoption is an individual who, when asked to do so, will quote both a bid and an offer price on theoption. The bid is the price at which the market maker is prepared to buy, and the offer is the priceat which the market maker is prepared to sell. At the time the bid and the offer are quoted, themarket maker does not know whether the trader who asked for the quotes wants to buy or sell theoption. The offer is always higher than the bid, and the amount by which the offer exceeds the bidis referred to as the bid—offer spread. The exchange sets upper limits for the bid—offer spread. Forexample, ii wighi specify thai the spread be no more than $0.25 for options priced ai tess than$0.50, $0.50 for options priced between $0.50 and $10, $0.75 for options priced between $10 and$20, and $1 for options priced over $20.
The existence of the market maker ensures that buy and sell orders can always be executed atsome price without any delays. Market makers therefore add liquidity to the market. The marketmakers themselves make their profits from the bid-offer spread. They use some of the proceduresdiscussed later in this book to hedge their risks.
Offsetting Orders
An investor who has purchased an option can close out the position by issuing an offsetting orderto sell the same option. Similarly, an investor who has written an option can close out the positionby issuing an offsetting order to buy the same option. If, when an options contract is traded,neither investor is offsetting an existing position, the open interest increases by one contract. If oneinvestor is offsetting an existing position and the other is not, the open interest stays the same. Ifboth investors are offsetting existing positions, the open interest goes down by one contract.
7.5 COMMISSIONS
 
The types of orders that can be placed with a broker for options trading are similar to those forfutures trading (see Section 2.8). A market order is to be executed immediately; a limit orderspecifies the least favorable price at which the order can be executed; and so on.158 CHAPTER 7
Table 7.3 A typical commission schedule for a discount broker
 
Dollar amount of trade Commission*< $2, 500 $20 + 0.02 of dollar amount$2,500 to $10,000 $45 + 0.01 of dollar amount> $10, 000 $120 + 0.0025 of dollar amount
* Maximum commission is $30 per contract for the first five contracts plus $20 percontract for each additional contract. Minimum commission is $30 per contract forthe first contract plus $2 per contract for each additional contract.
For a retail investor, commissions vary significantly from broker to broker. Discount brokersgenerally charge lower commissions than full-service brokers. The actual amount charged is oftencalculated as a fixed cost plus a proportion of the dollar amount of the trade. Table 7.3 shows thesort of schedule that might be offered by a discount broker. Thus, the purchase of eight contractswhen the option price is $3 would cost $20 + (0.02 x $2,400) = $68 in commissions.
If an option position is closed out by entering into an offsetting trade, the commission must bepaid again. If the option is exercised, the commission is the same as it would be if the investor placedan order to buy or sell the underlying stock. Typically, this is 1% to 2% of the stock’s value.
Consider an investor who buys one call contract with a strike price of $50 when the stock price is$49. We suppose the option price is $4.50, so that the cost of the contract is $450. Under theschedule in Table 7.3, the purchase or sale of one contract always costs $30 (both the maximumand minimum commission is $30 for the first contract). Suppose that the stock price rises and theoption is exercised when the stock reaches $60. Assuming that the investor pays 1.5% commissionon stock trades, the commission payable when the option is exercised is
0.015 x $60 x 100 = $90The total commission paid is therefore $120, and the net profit to the investor is$1,000 — $450 — $120 = $430
Note that selling the option for $10 instead of exercising it would save the investor $60 incommissions. (The commission payable when an option is sold is only $30 in our example.) Ingeneral, the commission system tends to push retail investors in the direction of selling optionsrather than exercising them.
A hidden cost in option trading (and in stock trading) is the market maker’s bid—offer spread.Suppose that, in the example just considered, the bid price was $4.00 and the offer price was $4.50at the time the option was purchased. We can reasonably assume that a “fair” price for the optionis halfway between the bid and the offer price, or $4.25. The cost to the buyer and to the seller ofthe market maker system is the difference between the fair price and the price paid. This is $0.25per option, or $25 per contract.
7.6 MARGINS
 
 
In the United States, when shares are purchased, an investor can either pay cash or borrow using amargin account. (This is known as buying on margin.) The initial margin is usually 50% of theMechanics of Options Markets 159
value of the shares, and the maintenance margin is usually 25% of the value of the shares. Themargin account operates similarly to that for a futures contract (see Chapter 2).
When call and put options are purchased, the option price must be paid in full. Investors are notallowed to buy options on margin, because options already contain substantial leverage. Buying onmargin would raise this leverage to an unacceptable level. An investor who writes options is
reauired to maintai na margin account. Both the investor’s broker and the exchange wantrequires [O Maman runes in a Margin account, Sotn ine invesiors oroser and ine cxcnange Want
to be satisfied that the investor will not default if the option is exercised. The size of the marginrequired depends on the circumstances.
 
Writing Naked Options
A naked option is an option that is not combined with an offsetting position in the underlying stock.The initial margin for a written naked call option is the greater of the following two calculations:
1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less theamount if any by which the option is out of the money2. A total of 100% of the option proceeds plus 10% of the underlying share price
For a written naked put option it is the greater of:
1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less theamount if any by which the option is out of the money
2. A total of 100% of the option proceeds plus 10% of the exercise price
The 20% in the preceding calculations is replaced by 15% for options on a broadly based stockindex, because a stock index is usually less volatile than the price of an individual stock.
Example 7.3 An investor writes four naked call option contracts on a stock. The option price is $5,the strike price is $40, and the stock price is $38. Because the option is $2 out of the money, the firstcalculation gives400(5 + 0.2 x 38 — 2) = $4,240The second caicuiation gives400(5 + 0.1 x 38) = $3,520
The initial margin requirement is therefore $4,240. Note that if the option had been a put, it would be$2 in the money and the margin requirement would be
400(5 + 0.2 x 38) = $5,040
In both cases the proceeds of the sale, $2,000, can be used to form part of the margin account.
A calculation similar to the initial margin calculation (but with the current market price replacingthe proceeds of sale) is repeated every day. Funds can be withdrawn from the margin account whenthe calculation indicates that the margin required is less than the current balance in the marginaccount. When the calculation indicates that a significantly greater margin is required, a margincall will be made.
Writing Covered Calls
Writing covered calls involves writing call options when the shares that might have to be deliveredare already owned. Covered calls are far less risky than naked calls, because the worst that can160 CHAPTER 7
 
happen is that the investor is required to sell shares already owned at below their market value.If covered call options are out of the money, no margin is required. The shares owned can bepurchased using a margin account, as described previously, and the price received for the optioncan be used to partially fulfill this margin requirement. If the options are in the money, no marginis required for the options. However, for the purposes of calculating the investor’s equity position,the share price is reduced by the extent, if any, to which the option is in the money. This may limitthe amount that the investor can withdraw from the margin account if the share price increases.
Example 7.4 An investor in the United States decides to buy 200 shares of a certain stock onmargin and to write two call option contracts on the stock. The stock price is $63, the strike price is$60, and the price of the option is $7. The margin account allows the investor to borrow 50% of theprice of the stock, or $6,300. The investor is also able to use the price received for the option,$7 x 200 = $1,400, to finance the purchase of the shares. The shares cost $63 x 200 = $12,600. Theminimum cash initially required from the investor for the trades is therefore
$12,600 — $6,300 — $1,400 = $4,900
In Chapter 9, we will examine more complicated option trading strategies such as spreads,combinations, straddles, and strangles. There are special rules for determining the margin require-ments when these trading strategies are used.
7.7 THE OPTIONS CLEARING CORPORATION
 
The Options Clearing Corporation (OCC) performs much the same function for options marketsas the clearinghouse does for futures markets (see Chapter 2). It guarantees that options writerswill fulfill their obligations under the terms of options contracts and keeps a record of all long andshort positions. The OCC has a number of members, and all options trades must be clearedthrough a member. If a brokerage house is not itself a member of an exchange’s OCC, it mustits trades with a member. Members are required to have a certain mamount of capital and to contribute to a special fund that can be used if any member defaults 0 onan option obligation.
When purchasing an option, the buyer must pay for it in full by the morning of the next businessday. The funds are deposited with the OCC. The writer of the option maintains a margin accountwith a broker, as described earlier. The broker maintains a margin account with the OCC memberthat clears its trades. The OCC member in turn maintains a margin account with the OCC. Themargin requirements described in the previous section are the margin requirements imposed by theOCC on its members, A brokerage house may require higher margins from its clients. However, itcannot require lower margins.
     
Exercising an Option
When an investor notifies a broker to exercise an option, the broker in turn notifies the OCCmember that clears its trades. This member then places an exercise order with the OCC. The OCCrandomly selects a member with an outstanding short position in the same option. The member,using a procedure established in advance, selects a particular investor who has written the option.If the option is a call, this investor is required to sell stock at the strike price. If it is a put, theMechanics of Options Markets 161
investor is required to buy stock at the strike price. The investor is said to be assigned. When anoption is exercised, the open interest goes down by one.
At the expiration of the option, all in-the-money options should be exercised unless thetransactions costs are so high as to wipe out the payoff from the option. Some brokerage firmswill automatically exercise options for their clients at expiration when it is in their clients’ interestto do so. Many exchanges also have rules for exercising options that are in the money at expiration.
7.8 REGULATION
 
Options markets are regulated in a number of different ways. Both the exchange and its OptionsClearing Corporation have rules governing the behavior of traders. In addition, there are bothfederal and state regulatory authorities. In general, options markets have demonstrated a willing-ness to regulate themselves. There have been no major scandals or defaults by OCC members.Investors can have a high level of confidence in the way the market is run.
The Securities and Exchange Commission is responsible for regulating options markets instocks, stock indices, currencies, and bonds at the federal level. The Commodity Futures Trading,Commission is responsible for regulating markets for options on futures. The major optionsmarkets are in the states of Illinois and New York. These states actively enforce their own lawson unacceptable trading practices.
7.9 TAXATION
 
 
Determining the tax implications of options strategies can be tricky, and an investor who is in doubtabout this should consult a tax specialist. In the United States, the general rule is that (unless thetaxpayer is a professional trader) gains and losses from the trading of stock options are taxed ascapital gains or losses. We discussed the way capital gains and losses are taxed in the United States inSection 2.10. For both the holder and the writer of a stock option, a gain or loss is recognized when(a) the option expires unexercised or (b) the option position is closed out. If the option is exercised,the gain or loss from the option is rolled into the position taken in the stock and recognized when thestock position is closed out. For example, when a call option is exercised, the party with a longposition is deemed to have purchased the stock at the strike price plus the call price. This is then usedas a basis for calculating this party’s gain or loss when the stock is eventually sold. Similarly, theparty with the short position is deemed to have sold at the call price plus the strike price. When a putoption is exercised, the writer is deemed to have bought stock for the strike price less the original putprice and the purchaser is deemed to have sold the stock for this price.
Wash Sale Rule
One tax consideration in option trading in the United States is the wash sale rule. To understand thisrule, imagine an investor who buys a stock when the price is $60 and plans to keep it for the longterm. If the stock price drops to $40, the investor might be tempted to sell the stock and thenimmediately repurchase it so that the $20 loss is realized for tax purposes. To prevent this sort ofthing, the tax authorities have ruled that, when the repurchase is within 30 days of the sale(.e., between 30 days before the sale and 30 days after the sale), any loss on the sale is not deductible.162 CHAPTER 7
The disallowance also applies where, within the 61-day period, the taxpayer enters into an option orsimilar contract to acquire the stock. Thus, selling a stock at a loss and buying a call option within a30-day period will lead to the loss being disallowed. The wash sale rule does not apply if the taxpayeris a dealer in stocks or securities and the loss is sustained in the ordinary course of business.
Constructive Sales
Prior to 1997, if a United States taxpayer shorted a security while holding a long position in asubstantially identical security, no gain or loss was recognized until the short position was closedout. This means that short positions could be used to defer recognition of a gain for tax purposes.The situation was changed by the Tax Relief Act of 1997. An appreciated property is now treatedas “constructively sold’ when the owner does one of the following:
1. Enters into a short sale of the same or substantially identical property
2. Enters into a futures or forward contract to deliver the same or substantially identicalproperty
3. Enters into one or more positions that eliminate substantially all of the loss and opportunityfor gain
It should be noted that transactions reducing only the risk of loss or only the opportunity for gainshould not result in constructive sales. Therefore, an investor holding a long position in a stock canbuy in-the-money put options on the stock without triggering a constructive sale.
Tax Planning Using Options
Tax practitioners sometimes use options to minimize tax costs or maximize tax benefits. Forexampie, it is sometimes advantageous to receive the income from a security in Country A and thecapital gain/loss in country B. This could be the case if Country A has a tax regime that providesfor a low effective tax rate on interest and dividends and a relatively high tax rate on capital gains.One can accomplish this by arranging for a company in Country A to have legal ownership of thesecurity and for a related company in Country B to buy a call option on the security from thecompany in country A with the strike price of the option equal to the current value of the security.As another example, consider the position of a company with a large holding in a particular stockwhose price has risen fast during the holding period. Suppose the company wants to sell the stock.If it does so in the usual way, it will be subject to capital gains tax. An alternative strategy is toborrow funds for 20 years under an agreement where the company has the option at the end of the20 years to repay the loan with the stock. This delays the recognition of the capital gain.
Tax authorities in many jurisdictions have proposed legislation designed to combat the use ofderivatives for tax purposes. Before entering into any tax-motivated transaction, a treasurer shouldexplore in detail how the structure could be unwound in the event of legislative change and howcostly this process could be.
7.10 WARRANTS, EXECUTIVE STOCK OPTIONS,AND CONVERTIBLES
 
 
Usually, when a call option on a stock is exercised, the party with the short position acquiresshares that have already been issued and sells them to the party with the long position for the strikeMechanics of Options Markets 163
 
price. The company whose stock underlies the option is not involved in any way. Warrants andexecutive stock options are call options that work slightly differently. They are written by acompany on its own stock. When they are exercised, the company issues more of its own stockand sells them to the option holder for the strike price. The exercise of a warrant or executive stockoption therefore leads to an increase in the number of shares of the company’s stock that areoutstanding.
Warrants are call options that often come into existence as a result of a bond issue. They areadded to the bond issue to make it more attractive to investors. Typically, warrants last for anumber of years. Once they have been created, they sometimes trade separately from the bonds towhich they were originally attached.
Executive stock options are call options issued to executives to motivate them to act in the bestinterests of the company’s shareholders. They are usually at the money when they are first issued.After a period of time they become vested and can be exercised. Executive stock options cannot betraded. They often last as long as 10 or 15 years.
A convertible bond is a bond issued by a company that can be converted into equity at certaintimes using a predetermined exchange ratio. It is therefore a bond with an embedded call option onthe company’s stock. Convertible bonds are like warrants and executive stock options in that theirexercise leads to more shares being issued by the company. We discuss convertible bonds in moredetail in Chapter 27.
7.11 OVER-THE-COUNTER MARKETS
 
 
Most of this chapter has focused on exchange-traded options markets. The over-the-countermarket for options has become increasingly important since the early 1980s and is now largerthan the exchange-traded market. As explained in Chapter 1, in the over-the-counter market,financial institutions, corporate treasurers, and fund managers trade