Options Market

What Is An Options Market?

An Options Market is a financial market where participants can buy and sell options contracts. Options are financial derivatives (derivative securities) that give the holder the right but not the obligation to buy or sell an underlying asset at an agreed-upon price on or before a set expiration date.

Options contracts can be traded in two primary ways: Over-the-Counter (OTC) or on an exchange as exchange-traded options. The choice between OTC and exchange-traded options depends on various factors, including the trader's or investor's specific requirements, the level of customization required, and the need for standardized contracts with liquidity and transparency.

• Options markets facilitate the buying and selling of options contracts, which grant the holder the right but not the obligation to buy or sell an underlying asset at a set price by a specified expiration date.
• These contracts can be traded in two ways: Over-the-Counter (OTC) or through an exchange. The choice depends on factors like investors’ customization, contract standardization, liquidity, and transparency preferences. Executing transactions in regulated markets is easier than open markets.
• Options markets offer more flexibility for hedging and speculation, allowing customization for risk profiles and market views or opinions. The futures market carries high risk but offers huge profit potential.

Options Market Explained

Options market is where traders engage in trading options. The market, in its current format can be considered recent, but options trading has some pertinent history. Thales of Miletus, a Greek philosopher, mathematician, and astronomer, who lived around 624-546 BC used a concept similar to options to profit. It is one of the earliest known examples of an options transaction.

The evolution of options markets in the United States is not only interesting but also insightful. It underwent a significant transformation in the 1970s. At this point, the foundation for modern options trading was laid. Before this change occurred, investors traded option contracts over-the-counter. However, the lack of standardization in these contracts led to unrest, disagreement, and inadequate liquidity in the market.

In 1973, the Chicago Board Options Exchange (CBOE) was established, which aimed to resolve the issues investors and traders faced while trading without defined rules. The CBOE introduced standardized options contracts with specific strike prices and expiration dates, addressing the issues of non-standardization. This change made options trading more accessible to investors; it also boosted transparency.

The Options Clearing Corporation (OCC) was established in 1975 to serve as the central clearinghouse for all options contracts traded on various exchanges. The OCC's role in guaranteeing contract performance reduced counterparty risk, further boosting confidence and liquidity in the options market.

The introduction of put options by the CBOE in 1977 expanded the range of trading strategies available to investors. Earlier, only call options were traded on the exchange. This development allowed investors to better manage risk and speculate on price movements.

As options trading gained momentum, it extended beyond US borders, with options exchanges opening worldwide. This global expansion broadened the availability of options products, contributing to the growth of the options market on a global scale.

In parallel, pricing models for options, such as the Black-Scholes-Merton Model, became increasingly sophisticated, helping investors estimate the fair value of options. Additionally, the risk management function evolved, with complex combinations of options and other financial instruments becoming part of it. This offered investors a diverse set of tools to meet specific investment needs.

Types

Options contracts can be traded in two primary ways: Over-the-Counter (OTC) or on an exchange (exchange-traded options).

• Over-the-Counter (OTC): In OTC markets, options are customized contracts negotiated directly between two parties, typically facilitated by brokers or dealers. These contracts can be tailored to meet the specific needs of the parties involved, including the choice of the underlying asset, strike price, expiration date, and contract terms. OTC options are often used for more complex or specialized strategies and are not as standardized as exchange-traded options. Due to their customization, OTC options may offer greater flexibility but can also involve counterparty risk.
• Exchange-Traded Options: Exchange-traded options are standardized contracts that are bought and sold on organized options exchanges, such as the Chicago Board Options Exchange (CBOE) in the United States. These contracts have set terms, including fixed strike prices, expiration dates, and contract sizes. Standardization ensures that all market participants have access to the same terms, making it easier to hedge positions and trade. Exchange-traded options also benefit from centralized clearinghouses that act as intermediaries, reducing counterparty risk.

Structure

The options market is a critical component of the financial markets, providing investors with a platform to trade options contracts. Options are financial derivatives representing rights to buy (call options) or sell (put options) an underlying asset at a specified price (strike price) on or before a set date (expiration date). The structure of an options market, governed by certain players and several key determinants, has been discussed below.

• Participants: The market includes buyers (option holders) and sellers (option writers or issuers). Buyers pay a premium to acquire options, while sellers receive premiums for creating them.
• Types of Options: Call options grant the holder the right to buy the underlying asset; put options, on the other hand, grant the holder the right to sell it. However, in both cases, deal execution is not obligatory or binding on parties.
• Underlying Assets: Options can be pegged or connected to a wide range of assets, including stocks, indexes, commodities, currencies, and interest rates.
• Options Contracts: Each contract typically covers a specific quantity of the underlying asset (contract size). Contracts specify the strike price at which the asset can be bought or sold, and the expiration date is also mentioned to facilitate trading. They may also specify the exercise style (e.g., American or European).
• Exchanges: Organized exchanges, such as the Chicago Board Options Exchange (CBOE), provide a centralized marketplace for options trading. These exchanges establish standardized contract terms and facilitate trade execution.
• Options Chains: Options chains display available options for a particular underlying asset, including the corresponding strike prices and expiration dates.
• Market Participants' Objectives: Buyers of call options may seek capital appreciation in the underlying asset, while buyers of put options often use them for hedging or downside protection. Sellers aim to earn income from premiums.
• Option Premium: The price of an option contract, known as the premium, is determined by factors like the underlying asset's price, volatility, time remaining until expiration, and interest rates.
• Clearing and Settlement: Option contracts are cleared and settled through clearing houses, ensuring the obligations of each contract are met to reduce counterparty risk.
• Option Strategies: Traders and investors use various option strategies, such as covered calls, protective puts, straddles, and spreads, to achieve specific financial goals.
• Regulation: Options markets are regulated by financial regulators to maintain fairness and transparency in trading and promote investor protection.
• Market Makers: Market makers, typically firms or individuals, facilitate options trading by providing liquidity. They quote bid and ask prices for options to maintain a liquid market.
• Market Data: Real-time market data, including option prices, volumes, and open interest, is available for analysis and decision-making.
• Risk Management: Participants in the options market employ risk management techniques to protect their portfolios from adverse price movements.

The diagram given below shows the structure clearly. The options market can be categorized as primary or secondary, depending on whether the contracts are exchange-traded or over-the-counter. At each level of the market, the main features that can be used to differentiate them are mentioned below, like the nature, type, market form, the main trading driver, etc. It is interesting to note that the trading system has many choices, which the traders should clearly know and analyze before opting for them.

Overall, each participant should have clarity regarding which option strategy is best for them, as per their risk profile and objective of trading. They can select the best strategy that helps them to achieve their financial goal through proper risk management techniques. It is important to track the market for monitoring the trends and any changes that may affect their position.

Source

Examples

Let us study some examples to understand the concept better.

Example #1

Imagine a scenario where Jane, an investor, wishes to buy call options on a small, privately held technology startup, Company Y. Since Company Y's shares are not publicly traded, there are no standardized exchange-traded options available. Jane approaches Company Y directly and negotiates a customized call option agreement. They agree that she will have the right to buy 1,000 shares of Company Y at a strike price of $20 per share, and the option will expire in six months.

Jane pays a negotiated premium directly to Company Y for this tailored call option. This OTM option allows her to profit if Company Y's value increases. However, it also involves unique risks and requires a direct agreement with the company, given the absence of a centralized exchange for these specific options. This shows that in the absence of specific regulators and markets with defined options market size, options trading can be quite risky.

Example #2

Consider another hypothetical example: John works for a tech company, XYZ Corp. As part of his employment agreement, the company grants him 1,000 stock options with a strike price of $50 per share. These options vest gradually over four years, with a one-year cliff and monthly vesting over the following three years. At the time of the grant, the market price of XYZ stock was $45 per share.

Over the years, as XYZ Corp's stock price rises, the value of John's stock options appreciates. Suppose after four years, the stock price reaches $70 per share. At this point, John can exercise his options, purchasing shares at the earlier agreed-upon strike price of $50 and potentially selling them on the open market at a higher price, realizing a profit.

In this example, the options are not traded on the open market but serve as a key element of John's compensation, designed to motivate him and boost his commitment to the company, rewarding him for its success.

Example #3

A MarketWatch report published in September 2023 highlights how options and options expiry affect volatility in the US stock markets. A chart presented by Goldman Sachs Group outlines the short-gamma hedging strategies adopted by many traders, resulting in a $3.3 billion market exposure. Short-gamma trading strategies indicate a negative gamma, meaning when stock prices increase, returns decline, and as stock prices dip, returns increase. However, many market participants believe the chart is not representative of every options trader’s strategy in the market.

The report discusses varied factors affecting the prominent indices in the US and the general market outlook in the coming months. Thus, we can say that tracking the options market is crucial to identifying the tentative direction in which stock markets seem to be moving in a given period and determining the general health of an economy.

Options Market vs Futures Market

The differences between the options and the futures market are given below.

Basis	Options Market	Futures Market
Contact Type	In the options market, traders deal with options contracts, which provide the right (but not the obligation) to buy or sell an underlying asset at a specified price within a specific time frame.	In the futures market, traders deal with futures contracts, which obligate both parties to buy or sell the underlying asset at a set price and date in the future.
Flexibility	Options market trading provides greater flexibility for hedging and speculation. It can be tailored to specific risk profiles and market views.	Futures contracts expose both parties to significant risk, as the price of the underlying asset can move considerably against their positions. However, these contracts offer unlimited profit potential if the market moves in their favor.

Frequently Asked Questions (FAQs)

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