NONSTANDARD OPTIONS
The basic structure of an option contract can be applied to a host of different products. Like standard options, these products involve placing a put or call on a quantity of an underlying product, have expiration dates, and have exercise (strike) prices. However, as the terms of these contracts are negotiated, there isn’t a fixed protocol that has to be followed. Included in this group of nonstandardized options are options that are not listed for trading on exchanges and are commonly known as over-the-counter (OTC) options.
As alluded to before, over-the-counter options are custom made. The transactions are accomplished between options dealers and clients, or clients being represented by broker-dealers. The terms are negotiated and confirmations are sent between the broker-dealer and the client, and between the broker-dealer and the options dealer. Neither Options Clearing Corporation nor any other clearing corporation is involved with these transactions. Therefore, the transactions are not guaranteed, and there are no corporate action notifications or other services that clearing corporations offer. In case of default of one of the two parties, the remaining party must seek legal action to recover the loss. On exercise, it is one on one, between the original participants or the designees, which enter the required information into the underlying issue’s regular processing stream. For example, exercise of an over-the-counter equity option would be sent to National Securities Clearing Corporation (NSCC), and exercise of an option on U.S. Treasury bonds would be sent to Fixed Income Clearing Corporation (FICC).
Options that are not listed to trade on an exchange are referred to as over-the-counter options. While there are still puts and calls, the underlying issue, underlying quantity in some underlying products may not be the standard unit, and the expiration day and/or strike price will not be standardized as they are in listed options and the currency used to settle an exercise is also negotiated. These are customized options or one offs without any secondary market such as the Chicago Board Options Exchange (CBOE) or the New York Stock Exchange (NYSE); therefore the secondary trading that occurs in “listed” options is a nonoccurrence with this product. Options in this market are negotiated between the initiator, who is attempting to achieve some strategy, and a put and call dealer. It is usual in this market for the dealer who was used to get the principal into the position to be the same dealer used to close out the position. In addition, the dealer who was used to get into the position is the contra side to any option exercise. As there isn’t a clearing corporation involved in the processing stream with this type of option, the contract remains between the originator and the dealer. The dealer may refer an option exercise to be against another financial institution but the dealer remains responsible as the contra party. If the dealer defaults or ceases as a business entity, the contract ceases to exist.
In case of exercise, the one triggering the action notifies the counterparty of the intention and then submits the underlying transaction into its processing stream. For example, if it is an FX (foreign exchange option), the terms of the option contract would be sent to the clearing banks of both parties and the currency exchanged.
The capped option is generally an out-of-the-money long option position with an embedded feature that states that if the market price of the underlying issue should reach or pass the option’s strike price, thereby changing the option status from out of the money to at the money or in the money, it is to be automatically exercised. In the case of a call option, the underlying security would have to close at or above the strike price of the option. In the case of a put, the underlying security price would have to close at or below the option’s capped price.
One use of a capped option is to protect a short security position. Let’s suppose a client went short 10,000 shares of WIP $66 per share. The stock is now $49 per share. The client is concerned as to whether this is the “bottom” or the stock will lose even more value. If it is the bottom, the stock may start to rise in value, dissolving same of the paper profit. The client can see if the near-term option is inexpensive enough for the client to buy 100 near-term calls with a strike price of $50. For that cost, the client is attempting to lock in a 16-point profit (less expenses). If the stock continues to fall in value, the short-term call options will expire worthless. If the stock begins to rise and closes at $50 per share or above, the options will be exercised and the short position will be closed out.
LEAPS stands for Long-term Equity AnticiPation Securities, which are options with longer terms for expiration than the standard option. A LEAPS option, which trades as a put or a call, can exist for up to three years with an expiration in January. Whereas a standard option is not marginable, LEAPS generally are. As the LEAPS’s life dissipates when it matches the standard option, it ceases to exist as a LEAPS and takes on the role and settlement cycle of the standard nine-month option. LEAPS are primarily used by long-term investors and can be used as a surrogate for the underlying stock itself. As with all options that are owned, you can never lose more than the price you paid for it. In the case of LEAPS, you don’t have to buy the stock if you think whatever event is going to happen will happen within the next two years. If you buy the stock you are tying up a considerable amount of money. If you buy a LEAPS on the same security, you’re tying up less money and your downside risk is only the cost of the option.
The next option we will look at is a flex option. The standard equity and index option has a fixed expiration date; it expires the Saturday after the third Friday of the appointed expiration month. With flex options, the terms of the contract are negotiated, and that includes the strike price and the expiration date. Because of the uniqueness of each option, they do not trade in a continuous market. They are, however, cleared through a central clearing corporation, Options Clearing Corporation. Therefore the structure of a flex option is very similar to that of the standard over-the-counter option as all terms are negotiated. The major difference, a very important one, is that the flex option clears through a clearing corporation, which guarantees performance.
Options Clearing Corporation (OCC) is the issuer and guarantor of all listed option products, and it also provides price transparency. Regular over-the-counter options, those not traded on an exchange, are between the buyer and the seller of the option. They are also generally illiquid. If something should happen to the buyer or seller in an over-the-counter option transaction, the counterparty must work any problems out by themselves. This includes absorbing any losses and reinstating their clients to their true positions. On listed options, standard options, LEAPS options, or flex options, should a counterparty default, the clearing corporation stands up for the terms of that contract and makes the transaction valid, along with the exercises and other terms.
The products Options Clearing Corporation offers options on are equity, interest rate, debt, index, dollar-based currency, ETFs, ELX futures, futures on the VIX index, and others that are pending. Unlike standard equity products, options go on for a second life. Therefore, OCC not only settles trades, but maintains the record of outstanding or open positions. This is known as the options’ open or products’ open interest. Because of the second life, clearing firms must tell OCC what effect the option trade has on the overall position. By federal law, clearing firms must separate client trades from their own, known as proprietary trades. Orders going to the options exchanges must carry the designation C for customer or F for firm. OCC doesn’t care or want to know what effect the trade will have on a particular customer’s account—that is the broker-dealer’s responsibility—but they do want to know what effect it has on the overall customers’ position. The instruction as to what effect the trade will have on the position are B o for “Buy to open,” as in opening a long or owner’s position; S o for “Sell to open,” as in establishing a writer or short position; B c for “Buy to close,” which closes out a previous S o position; and S c for “Sell to close,” which closes the previous B o position.
Most listed options, including all equity options, expire the Saturday after the third Friday of the expiration month. Therefore, the third Friday of the month is the last day of trading. Equity options that are in the money by $0.75 or more will automatically be exercised. To prevent an unwanted exercise, clients should use “Ex by EX,” a process that stops the exercise. Investors should be mindful that an option close to being at the money and qualifying for exercise on “expiration Friday” may be, based on the expired option’s strike price, theoretically out of the money by Monday.
A binary option, which is traded over the counter and on the NYSE Amex, is considered high risk and illiquid as there is very little, if any, trading between the time it originates and the time it expires. Recently, binary option trading platforms have been developed to encourage trading of these products. The binary options that trade on the NYSE Amex exchange are known as fixed return options or FROs. They are offered in two versions: “cash or nothing” and “asset or nothing.” These options are binary in practice as there are only two outcomes. Either they pay a preestablished value or, if the option is not in the money at expiration, it is terminated.
Let’s say the option will be in the money at expiration. If it is, the option owner will receive $5,000. If the option is out of the money, the option owner receives nothing. This is an example of a cash-or-nothing binary option. If it was an asset-or-nothing binary option, the option owner would receive the value of an asset, perhaps the market value of the underlying stock, if the option finished in the money at expiration—and nothing if it is out of the money. There are cash-or-nothing puts, and cash-or-nothing calls, as well as asset-or-nothing calls and asset-or-nothing puts. Notice that in this product, the amount by which the option is in the money is unimportant, as a fixed amount or the current value of a chosen asset will be paid.
Quite often, there is a security position backing the option.
For example, a client buys 1,000 shares of Whipper Corporation currently trading at $50 a share. The client sells ten calls on Whipper Corp. with a strike price of $55 per share. This strategy is called “income writing.” The client wants the options to expire out of the money so that the premium received from the sale of the options becomes income to the client. If the stock rises from $50 per share to just below $55 per share, the client is still in a good position as the options have a $55 strike price and are still out of the money. If the stock should rise above $55, the client will risk losing the securities. In doing so, though, the client picks up the premium from the options that were sold and the 5 points gained from the rise in the underlying stock’s price increase. However, if the stock begins to fall in value instead of rise, the client has a problem.
If the client decides to liquidate the stock, and limit the loss, the client would have ten naked (uncovered) call options in the account, which, even though they are out of the money, must be margined. If the stock should turn upward and start to run up in value, the client could face a major loss, especially if the stock surprisingly opened for trading one day to a price way above $55 per share. However, the whole sequence changes if the position was originally structured as follows: The client buys 1,000 shares of stock at $50 per share and proceeds to sell ten three-month call options with a strike price of $55 per share. Also built into the option transaction is the premise that if the stock falls in value below a certain price, the options contract is canceled. This protects the client from the stock’s turning around after it went down in value and the client sold the shares to limit its loss. Therefore the aforementioned transactions could be: buy 1,000 shares at $50 per share, sell ten knock-out call three-month options with a strike price of $55 and a knock-out provision if and when the stock falls and reaches $45 per share. The $45 is the safe zone where the client can close out the stock position without concern about exposure to the uncovered option. All of this will be factored into the premium paid and negotiated between the buyer and seller of the options.
The “knock out, knock in” option is more complicated than it presents itself. It is part of a group called “barrier options.” There are actually four types of knock-out options: an up-and-out call option, a down-and-out call option, an up-and-out put option, and a down-and-out put option. An up-and-out call option would have a limited upside value.
For example, suppose the stock is trading at $30 per share and the knock-out option contract reads that if the stock rises to $40 per share, the option is canceled. That means that the writer of the option faces a 10-point loss, maximum. Whatever value the stock may have going forward, no matter how high in value it rises, once it reaches $40 per share the option is dead. The buyer of the option must think that the stock will not rise to $40 and therefore is not going to rise more than 10 points, so the buyer can buy this option at a much lower premium than if the upside potential were unlimited.
A down-and-out call option would be a very good protection should someone own a large block of stock and have sold calls against it, as reviewed in the previous paragraph. As the stock loses value, the owner of that position is losing money and the options are going further and further out of the money. However, liquidating the security position would leave the client with uncovered options. The down-and-out call option would automatically terminate the option obligation when the stock fell to a certain price. This type of thought process could also be used in put option strategies. Supposing a client believes that a stock is going to fall in value by about 6 or 7 points. The client can reduce the cost of that put by making it a down-and-out put option at 10 points. The writer of that option knows that the maximum risk is 10 points. The buyer of that put option is looking for less than a 10-point downswing; therefore, the put will cost much less as the writer’s risk is contained.
Let’s assume, for a knock-in option, that the current market price of an underlying security is at $30 per share and the strike price of an option with that underlying is $30. The option is selling at 5 points, which means that underlying security must rise 5 points before the purchase of the option becomes profitable. The buyer of that over-the-counter option will be paying 5 points time value for no reason other than to hope that the underlying stock rises above those 5 points to cover that cost. If the buyer of the option was of the opinion that the stock was worth more than $35 per share, the buyer would be better served if an “up and in” call option was negotiated, stating that the option does not become alive until the stock has reached the 5-point level. The writer of the $30 strike price option does not have any obligation during the time the stock moves from $30 to $35 and the option goes into the money. Therefore, the 5 points of the $30 strike price option’s premium is a throwaway. The option can be negotiated for a much lower cost to the buyer than it would be if it were just a straight over-the-counter option with a strike price of $30. A down-and-in would work in the same fashion for an over-the-counter put option.
The Worsco Company is in financial trouble and its common stock is falling in price. Its common stock is presently trading at $47 per share, down from $80 per share. Mr. Theodore Bear believes that the company will fail and file for bankruptcy. A six-month put with a strike price of $45 is trading for 7 points. That means that $38 is the breakeven point. Bear negotiates a down-and-in six-month option with a “kick-in” at $38. With the writer of the option getting the next 7 points down, obligation free, the premium Bear would be charged is significantly less.
Part of the negotiation that goes on with these barrier options is what constitutes a barrier event. For example, on an up-and-in call option, if the stock rises to that barrier price one time over the life of the option, does that trigger an event? Or does the price have to be sustained over a period of time? Must the event happen at a given time during the day? That’s all part of the negotiation that goes into the barrier option contract between the writer and the holder, the seller and the buyer.
The last form of options we will look at is options on options. Another name for these compound options is “mother and daughter options.” If the holder of one of this type of options exercises it, the former holder will either own or write another option. So what we have here is a three-tier situation. There is the underlying asset, over which is the first option, and over that option is the second option. There are four variations of this form of option: There is a call on a call, a call on a put, a put on a put, or a put on a call.
Pricing this form of option is naturally more complicated. As with the standard or regular option, the premium consists of time value, which was explained earlier, and the intrinsic value or in-the-money sum of the option, should it exist. Starting with the price of the underlying security, apply the strike price of the option that covers it and then the exercise price of the secondary option that covers the first option. What also must be taken into consideration in determining the premium are three factors: dividends, as dividends affect the price of the underlying securities (though not the value of the option directly); the risk-free interest rate, or the Treasury bill rate, which would be earned if the money was simply invested in U.S. Treasury bills; and the time remaining to the expiration of the first option and time remaining to the expiration of the second option. Naturally, the second option has to expire on or before the first option.
Here’s an example:
Let’s assume there is a very volatile stock that Steve Adore has a long American-style put option on. The option has a duration of two years, and the premium is very expensive. The owner of that position is willing to “sell” a slice of the time remaining for a fee. Izzy Smart is interested and negotiates a call contract with the put holder, Steve, for three months, which gives the call buyer, Izzy, the right to “call in” the put position for the next three months, starting today. If the underlying stock should drop in value to a point allowed in the negotiated agreement, the call holder can call in the put option and exercise it.
Previously, we looked at the rationale behind buying calls or buying puts or selling calls or selling puts. As stated in the opening, options are a tool, and therefore there are many different ways they can be applied.
The following exercises involve the use of an underlying product and a call option and a put option. Each of these has the ability to be long or short, owned or owed. The three products, therefore, offer a total of six possibilities for use. In a spread position, for example, the participant is long and short equal numbers of calls or puts on the same underlying product but different series. One of the two options is the main option; the other option is there to either reduce the premium cost of the main option, or act as an insurance policy, to curtail further losses. In a straddle position the participant can have long equal numbers of puts and calls, or short equal numbers of puts and calls on the same underlying product having the same series designation (straddle) or different series designation (combination). In the above cases, we used options but left the stock position out. Now let’s include it.
Elsewhere in the book we mentioned a buy/write—the buying of stock and writing of an out-of-the-money call against it as a way to enhance income. If the long stock position increases in value, that’s good. If the short call position increases in value that’s bad, because once the call is in the money the underlying stock will be called by an option’s owner, or if not, the short call increases in value as the underlying stock increases in value, making it more expensive to buy the short call back and close out the short option position. Therefore the long stock and the short call cancel each other out as the stock rises. For every dollar the long stock rises, which is a good thing for the owner of the stock, the in-the-money or intrinsic part of the short option premium increases too, which is bad for the short options writer. If the long stock loses value, that is bad for the stock owner but good for the short call position because it becomes less expensive to buy it in, and once the stock’s value falls below the option’s strike price, the option is out of the money. The problem is that the long stock can continue to lose value after the option is worthless. Therefore, what put option position has a negative impact on its owner the more the underlying security or index value decreases?
ANSWER: A short put position. This is an example of a synthetic short put position.
Here’s another example:
Let’s suppose Dynaflow (DYN) common stock index has a value of 50. If a client was long a call on the DYN index with a strike price of 50 and short a put option on the DYN with a strike price of 50, what index position would that replicate? Hint: What stock position develops a profit when the price increases and creates loss when the value falls?
ANSWER: A long stock position. A rise in price would benefit the long call owner, but a drop in value would be bad for the short put writer.
Staying with DYN common stock, what position is replicated if the position comprised a short DYN stock at 50 and a short put option with a strike price of 50?
ANSWER: A short DYN call position. An increase in value of DYN would have a negative impact on short DYN stock, which would be offset by the loss in value of the short put to a point. The position is bad for the short stock, but good for the short put. Once the short put is worthless, should the stock continue to rise, the short stock sale would be working against the position.
What if a client’s position was short DYN stock position long a DYN call? What put position would be replicated?
ANSWER: A long put. If the stock rose, the loss on the short stock position would be offset by gain on the long call, a zero-sum game. If the value of the stock fell, the short stock position would benefit and the long call would lose value and eventually become worthless. A long put position benefits from a drop in the underlying’s value.
If a client is long DYN stock and long a DYN put, this would replicate what position?
ANSWER: A long call. As the stock lost value, the long put would gain value, offsetting the loss in the long stock position. As the stock gained value, the long put would become worthless and the stock would benefit.
Finally, what does a long DYN put and a short DYN call equate to?
ANSWER: A short stock position. As the value of DYN rises, the short call gains value and the put loses value until it becomes worthless. This is bad for the position holder. As the value of the stock falls, the short call loses value until it becomes worthless and the long put gains value, which benefits the position owner as would a short stock position.
The options we have discussed thus far are focused on one product. For instance, a call on PIP common stock or a put on IND index option is only interested in the performance of that underlying. A rainbow option is focused on multiple events happening. It is as if the option were on a basket of independent, unrelated items. Using a sports example, you’re not just selecting a baseball team to win the World Series; rather, you are selecting a baseball team to win the World Series, a football team to win the Super Bowl, and a car and driver to win the Daytona 500 NASCAR race. All three selections must be successful or the selection option is worthless. A rainbow option is based on assets, and each asset has a color—hence the rainbow. In addition, there should be some correlation between the components.
An example of the use of this type of product could be the number of successful oil wells that will be dug and the quantity of oil that will be discovered. Alternatively, one might ask what the interest rate will be on a floating-rate note at its maturity, and which currency the client will choose to be paid in. The components can have different expiration dates and/or different exercise terms. The important factor is that there is a correlation of the components’ all moving the same way. In the first example, the number or percentage of successful wells must be reached and the estimate as to the amount of oil pumped must still be valid.
There are multiple payoff types depending on the assets making up the rainbow option. If there are two deliverable assets, the payoff may be one of the two assets or cash. If option payout is in cash, the currency that it is to be paid in is the choice.
To understand currency options, one must first understand foreign exchange. Let’s assume that ZOW common stock was trading at $25 per share. The stock increases in price to $40. We can say the dollar fell against the value of the ZOW stock, because formerly $25 was needed to buy one share of ZOW stock, and now $40 is needed. In this example, the common stock is the commodity and the dollar is the currency. Now let’s assume one British pound sterling costs $1.46. If the U.S. dollar rose and got stronger against the British pound sterling, the dollar figure would decrease because now you would need fewer dollars to buy one British pound.
If a British pound sterling option is denominated in dollars, the British pound is the commodity and the dollar is the currency. If the U.S. dollar rose against the British pound, the value of the call would decrease, and put options would increase in value. If the option has a strike price of USD $1.50 and the conversion rate was USD $1.50 per British pound, the option would be at the money. If the U.S. dollar rose against the British pound to where it was USD $1.40, a put would have 10 points intrinsic value. The owner of the USD $1.50 British pound put would purchase the British pound at $1.40 per pound and exercise the long put to receive $1.50 per British pound.
Currency options are European-style and dollar-denominated options. They are traded on the PHLX and the International Securities Exchange. The PHLX trades the Australian dollar, British pound, Canadian dollar, euro, Japanese yen, New Zealand dollar, and Swiss franc. The International Securities Exchange trades those plus the Brazilian real, Mexican peso, and Swedish krona. These too are dollar denominated.
The options are denominated in dollars. The British pound and the euro are always quoted in dollars; the others are converted into dollars for trading purposes. In other words, the natural quote for the New Zealand dollar is NZ $1.23 to the U.S. dollar. The exchange rate is USD $0.7991 per NZ dollar, which is the complementary side.
The formula for an uncovered written equity call option is 20 percent of the underlying market value plus the premium, less the out-of-the-money sum, or 10 percent of the underlying market value plus the premium, whichever is greater, with a minimum of $250 per option contract, also whichever is greater.
An uncovered put is almost the same, except it’s 20 percent of the underlying market value plus the premium, less the out-of-the-money sum, or 10 percent of the option exercise price plus the premium, whichever is greater, with a minimum of $250 per option contract, whichever is greater.
Ms. Mary Land sells one Call PUP Apr 50 @ 2. PUP is now trading at $47 per share. Therefore, PUP is out of the money by 3 points. The margin calculation for this uncovered call is:
|
20% of the underlying value − $4,700 × 20% = |
$ 940.00 |
|
Plus the premium + 200.00 |
$1,140.00 |
|
Less the out-of-the-money sum − 300.00 |
$ 840.00 |
|
10% of the underlying value − $4,700 × 10% = |
$470.00 |
|
Plus the premium + $200.00 |
$670.00 |
|
with a minimum of $250 per contract |
|
|
The margin requirement is |
$840 |
Ms. Della Ware sells one Put BOW Jul 60 @ 1 with BOW trading at $62 per share. The option is out of the money by 2 points. The margin calculations for this uncovered put are:
|
20% of the underlying value − $6,200 × 20% = |
$1,240.00 |
|
Plus the premium + $100.00 |
$1,340.00 |
|
Less the out-of-the-money sum − $200.00 |
$1,140.00 |
OR
|
10% of the exercise price − $6,000 × 10% = |
$ 600.00 |
|
Plus the premium + $100.00 |
$ 700.00 |
|
with a minimum of $250 per contract |
|
|
The margin requirement is |
$1,140 |
Spread option margins are more intricate. A spread is defined as having equal numbers of long and short options of the same type (put or call), but different series.
If the long option expires on or after the short option and is the more valuable one, no margin is required; the account’s principal pays the required difference between the two premiums.
If the option that was sold expires after the long option, opening the firm to risk for the period after the long option expired, the client pays the difference or receives the difference in the premium price between the two and must post margin on the short (sold) option as if the sold were an uncovered option.
Ms. Minnie Soto buys 1 Put DOG Nov 50 @ 2 and sells 1 Put DOG Nov 55 @ 4. DOG is trading at 53.
The short (sold) option position has the most value, but as the long (bought) options expire with or after the short option, spread margin is applied. Spread margin is the difference between strike prices of the two positions, or the margin required on the short option as if it were an uncovered position—whichever is less.
Difference between strike prices
55 − 50 × 100 shares = $500
Calculation for an uncovered option:
|
20% of the underlying value − $5,300 × 20% = |
$1,060.00 |
|
Plus the premium |
+ $400.00 |
|
$1,460.00 |
|
Less the out-of-the-money sum = 0 |
$1,460.00 |
The option with the strike price of $55 is in the money as the stock can be acquired by the put owner at $53 per share and put to the put seller at $55 per share. In other words, the $50 strike price put is out of the money but is reducing risk of the $55 written (sold) put to only 5 points. The current price of DOG has the $55 put at a 2 point disadvantage.
OR
|
10% of the exercise price − $5,500 × 10% = |
$550.00 |
|
Plus the premium |
+ $400.00 |
|
$950.00 |
Whichever is greater, with a minimum of $250 per contract.
In spread margin, either the lower difference between strike prices or the calculation for an uncovered margin is used, as it represents the minimum necessary margin to cover the risk to the firm. Therefore the margin required for this position is $500 because it represents the maximum the firm and customer have at risk.
Miss Zori buys 1 Call ZIP Aug 50 @ 5 and buys 1 Put ZIP Aug 50 @ 2 for a total cost of 7 points. As this straddle covers a long position call and a long position put, the client pays for both in full. Another client, Miss Azipi, sells 1 Call WIP Mar 60 @ 3 and sells 1 Put WIP Mar 60 @ 2. WIP common stock is trading at $62. As this straddle contains a short put and a short call, the margin requirement is the uncovered margin from the greater side plus the premium from the other side.
|
Call |
Put |
|
|
20% of underlying value = |
$1,240 |
$1,240 |
|
Plus the premium |
+ $300 |
+ $200 |
|
$1,540 |
$1,440 |
|
|
Less the out-of-the-money sum |
0 |
$200 |
|
$1,540 |
$1,240 |
OR
|
exercise price = |
$600 |
|
|
10% of underlying value = |
$620 |
|
|
Plus the premium |
+ $300 |
+ $200 |
|
$920 |
$800 |
With a $250 per option minimum
Take the requirement from the greater side ($1,540) plus the premium from the other side ($200) to arrive at the requirement ($1,740).