CFA Level 1

Derivatives - Exchange Traded Options

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.

If weather derivatives have caught your eye, check out the following article: Introduction to Weather Derivatives

Another option gaining popularity is real options. These options are not actively traded. The real-options approach applies financial options theory to large capital expenditures such as manufacturing plants, product line extensions and research and development. Where a financial option gives the owner the right, but not the obligation, to buy or sell a security at a given price, a real option gives companies that make strategic investments the right, but not the obligation, to exploit these opportunities in the future.

Again, for your upcoming exam, all you need to know regarding these instruments is that they exist.



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