Introduction

In the world of financial derivatives, exchange-traded stock option contracts play a crucial role. These contracts provide investors with the opportunity to manage risk and capitalize on market movements. In this chapter, we will delve into the intricacies of exchange-traded stock option contracts, exploring their components, characteristics, and the key differences between exchange-traded and over-the-counter options.

Components of Option Contracts

An exchange-traded stock option contract consists of several essential components that define its terms and conditions. These include:

• Underlying Asset: The asset on which the option contract is based. This is typically a stock or an index.

• Type of Option: Options come in two main types: call options and put options. A call option gives the holder the right (but not the obligation) to buy the underlying asset, while a put option gives the holder the right (but not the obligation) to sell the underlying asset.

• Strike Price: Also known as the exercise price, this is the price at which the option can be exercised. It determines the price at which the underlying asset will be bought or sold if the option is exercised.

• Expiration Date: The date on which the option contract expires. After this date, the option becomes invalid.

• Contract Size: The quantity of the underlying asset covered by a single options contract. For stocks, it’s often 100 shares per contract.

• Premium: The price paid by the buyer of the option to the seller (writer) for the rights granted by the option.

Exchange-Traded vs. Over-the-Counter Options

Exchange-traded options differ from over-the-counter (OTC) options primarily in terms of standardization, liquidity, and counterparty risk. Exchange-traded options are standardized contracts that are traded on organized exchanges, such as the Chicago Board Options Exchange (CBOE). They have set terms and are subject to regulations. In contrast, OTC options are customized contracts negotiated directly between two parties, which can lead to more flexibility but also increased counterparty risk.

Nonstandard Option Products

While exchange-traded options are standardized, there are instances where nonstandard or exotic options are created to meet specific needs. Nonstandard options may have unique features like non-standard strike prices or expiration dates. Exotic options, such as barrier options or Asian options, come with complex conditions that make their payoffs contingent on certain events or averages.

Example: Consider a technology company, TechCo, whose stock is currently trading at $150. An investor believes that the stock will rise substantially within the next six months. They purchase a call option with a strike price of $160 and an expiration date six months from now. If TechCo’s stock price indeed rises above $160 within the specified time, the investor can exercise the option and buy the stock at the lower strike price, capitalizing on the price difference.