An option is a contract in which the option seller grants the option buyer the right to enter into a transaction with the seller to either buy or sell an underlying asset at a specified price on or before a specified date. The specified price is called the strike price or exercise price and the specified date is called the expiration date. The option seller grants this right in exchange for a certain amount of money called the option premium or option price.

The option seller is also known as the option writer, while the option buyer is the option holder. The asset that is the subject of the option is called the underlying. The underlying can be an individual stock, a stock index, or another derivative instrument such as a futures contract. The option writer can grant the option holder one of two rights. If the right is to purchase the underlying, the option is a call option. If the right is to sell the underlying, the option is a put option.

An option can also be categorized according to when it may be exercised by the buyer. This is referred to as the exercise style. A European option can only be exercised at the expiration date of the contract. An American option, in contrast, can be exercised any time on or before the expiration date.

The terms of exchange are represented by the contract unit, which is typically 100 shares for an individual stock and a multiple times an index value for a stock index. The terms of exchange are standard for most contracts. In 1993, however, the CBOE introduced a FLexible EXchange Option™ (FLEX™) in response to growing investor demand for customized terms. FLEX options were originally introduced on index options, but have since been expanded to include listed equity options. These equity FLEX options or E-FLEX allow the investor to customize equity options in the same way as FLEX options to better manage an investment strategy and to structure risk exposure. The contract terms can be customized along four dimensions: underlying, strike price, expiration date, and settlement style. These options are discussed further below.

The option holder enters into the contract with an opening transaction. Subsequently, the option holder then has the choice to exercise or to sell the option. The sale of an existing option by the holder is a closing sale.

Basic Features of Listed Options

The basic features of listed options are summarized in Table 14.1. The table is grouped into four categories with each option category presented in terms of its basic features. These include the type of option, the underlying, strike price, settlement information, expiration cycle, exercise style, and some trading rules.

Stock Options

Stock options refer to listed options on individual stocks or American Depositary Receipts (ADRs). The underlying is 100 shares of the designated stock. All listed stock options in the United States may be exercised any time before the expiration date; that is, they are American-style options.

Index Options

Index options are options where the underlying is a stock index rather than an individual stock. An index call option gives the option buyer the right to buy the underlying stock index, while a put option gives the option buyer the right to sell the underlying stock index. Unlike stock options where a stock can be delivered if the option is exercised by the option holder, it would be extremely complicated to settle an index option by delivering all the stocks that constitute the index. Instead, index options are cash settlement contracts. This means that if the option is exercised by the option holder, the option writer pays cash to the option buyer. There is no delivery of any stocks.

Index options include industry options, sector options, and style options. The most liquid index options are those on the S&P 100 index (OEX) and the S&P 500 index (SPX). Both trade on the Chicago Board Options Exchange (CBOE). Index options can be American or European style. The S&P 500 index option contract is European, while the OEX is American. Both index option contracts have specific standardized features and contract terms. Moreover, both have short expiration cycles.

The dollar value of the stock index underlying an index option is equal to the current cash index value multiplied by the contract's multiple. That is,

Equation 14.1. 

For example, suppose the cash index value for the S&P 500 is 1,410. Since the contract multiple is $100, the dollar value of the SPX is $141,000 (= 1,410 × $100).

For a stock option, the price at which the buyer of the option can buy or sell the stock is the strike price. For an index option, the strike index is the index value at which the buyer of the option can buy or sell the underlying stock index. The strike index is converted into a dollar value by multiplying the strike index by the multiple for the contract. For example, if the strike index is 1,400, the dollar value is $140,000 (= 1,400 × $100). If an investor purchases a call option on the SPX with a strike index of 1,400, and exercises the option when the index value is 1,410, then the investor has the right to purchase the index for $140,000 when the market value of the index is $141,000. The buyer of the call option would then receive $1,000 from the option writer.

LEAP and FLEX Options

LEAPS and FLEX options essentially modify an existing feature of either a stock option, an index option, or both. For example, stock option and index option contracts have short expiration cycles. Long-Term Equity Anticipation Securities (LEAPS™) are designed to offer options with longer maturities. These contracts are available on individual stocks and some indexes. Stock option LEAPS are comparable to standard stock options except the maturities can range up to 39 months from the origination date. Index options LEAPS differ in size compared with standard index options having a multiplier of 10 rather than 100.

FLEX options allow users to specify the terms of the option contract for either a stock option or an index option. The process for entering into a FLEX option agreement is well documented by the CBOE. The value of FLEX options is the ability to customize the terms of the contract along four dimensions: underlying, strike price, expiration date, and settlement style. Moreover, the exchange provides a secondary market to offset or alter positions and an independent daily marking of prices. The development of the FLEX option is a response to the growing OTC market. The exchanges seek to make the FLEX option attractive by providing price discovery through a competitive auction market, an active secondary market, daily price valuations, and the virtual elimination of counterparty risk. The FLEX option represents a link between listed options and OTC products.

Table 14.1. Basic Features of Listed Equity Options

Stock Options
Option Type	Call or Put
Option Category	Equity
Underlying Security	Individual stock or ADR
Contract Value	Equity: 100 shares of common stock or ADRs
Strike Price	21/2 points when the strike price is between $5 and $25, 10 points when the strike price is over $200. Strikes are adjusted for splits, recapitalizations, etc.
Settlement and Delivery	100 shares of stock
Exercise Style	American
Expiration Cycle	Two near-term months plus two additional months from the January, February or March quarterly cycles.
Transaction Costs	$1-$3 commissions and 1/8 market impact
Position and Size Limits	Large capitalization stocks have an option position limit of 25,000 contracts (with adjustments for splits, recapitalizations, etc.) on the same side of the market; smaller capitalization stocks have an option position limit of 20,000, 10,500, 7,500 or 4,500 contracts (with adjustments for splits, recapitalizations, etc.) on the same side of the market.

Index Options
Option Type	Call or put
Option Category	Indexes
Underlying Security	Stock index
Contract Value	Multiplier × index price
Strike Price	Five points. 10-point intervals in the far-term month.
Settlement and Delivery	Cash
Exercise Style	American
Expiration Cycle	Four near-term months.
Transaction Costs	$1-$3 commissions and 1/8 market impact
Position and Size Limits	150,000 contracts on the same side of the market with no more than 100,000 of such contracts in the near-term series.

LEAP Options
Option Type	Call or Put
Option Category	LEAP
Underlying Security	Individual stock or stock index
Contract Value	Equity: 100 shares of common stock or ADRs
	Index: full or partial value of stock index
Strike Price	Equity: same as equity option
	Index: Based on full or partial value of index. 1/5 value translates into 1/5 strike price
Settlement and Delivery	Equity: 100 shares of stock or ADR
	Index: Cash
Exercise Style	American or European
Expiration Cycle	May be up to 39 months from the date of initial listing, January expiration only.
Transaction Costs	$1-$3 commissions and 1 /8 market impact
Position and Size Limits	Same as equity options and index options

FLEX Options
Option Type	Call, put, or cap
Option Category	Equity: E-FLEX option
	Index: FLEX option.
Underlying Security	Individual stock or index
Contract Value	Equity: 100 shares of common stock or ADRs
	Index: multiplier × index value
Strike Price	Equity: Calls, same as standard calls
	Puts, any dollar value or percentage
	Index: Any index value, percentage, or deviation from index value
Settlement and Delivery	Equity: 100 shares of stock
	Index: Cash
Exercise Style	Equity: American of European
	Index: American, European, or Cap
Expiration Cycle	Equity: 1 day to 3 years
	Index: Up to 5 years
Transaction Costs	$l-$3 commissions and 1/8 market impact.
Position and Size Limits	Equity: minimum of 250 contracts to create FLEX
	Index: $10 million minimum to create FLEX No size or position limits

A futures contract is an agreement between two parties, a buyer and a seller, where the parties agree to transact with respect to the underlying at a predetermined price at a specified date. Both parties are obligated to perform over the life of the contract, and neither party charges a fee. Once the two parties have consummated the trade, the exchange becomes the counterparty to the trade, thereby severing the relationship between the initial parties. The terms of futures contracts are standardized, which means the contracts are known in advance of a transaction and it makes the contracts interchangeable or fungible. In addition, standardized contracts traded on an exchange created a viable secondary market for futures contracts.

Each futures contract is accompanied by an exact description of the terms of the contract, including a description of the underlying, the contract size, settlement cycles, trading specifications, and position limits. The fact is that in the case of futures contracts, delivery is not the objective of either party because the contracts are used primarily to manage risk or costs.

The nature of the futures contract specifies a buyer and a seller who agree to buy or sell a standard quantity of the underlying at a designated future date. However, when we speak of buyers and sellers, we are simply adopting the language of the futures market, which refers to parties of the contract in terms of the future obligation they are committing themselves to. The buyer of a futures contract agrees to take delivery of the underlying and is said to be long futures. Long futures positions benefit when the price of the underlying rises. Since futures can be considered a substitute for a subsequent transaction in the cash market, a long futures position is comparable to holding the underlying without the financial cost of purchasing the underlying or the income that comes from holding the underlying. The seller, on the other hand, is said to be short futures and benefits when the price of the underlying declines.

The designated price at which the parties agree to transact is called the futures price. The designated date at which the parties must transact is the settlement date or delivery date. Unlike options, no money changes hands between buyer and seller at the contract's inception. However, the futures broker and the futures exchange require initial margin as a "good faith" deposit. In addition, a minimum amount of funds referred to as maintenance margin is required to be maintained in the corresponding futures account. The initial margin and the maintenance margin can be held in the form of short-term credit instruments.

Futures are marked-to-the-market on a daily basis. This means that daily gains or losses in the investor's position are accounted for immediately and reflected in his or her account. The daily cash flow from a futures position is called variation margin and essentially means that the futures contract is settled daily. Thus, the buyer of the futures contract pays when the price of the underlying falls and the seller pays when the price of the underlying rises. Variation margin differs from other forms of margin because outflows must be met with cash.

In Table 14.2 we trace the cash flows of a daily margin account for 100 March 2007 S&P 500 futures contracts. We assume a long position is initiated by a speculator on February 20 and held through March 12. The initial margin requirement at the time was $17,500 per contract and the maintenance margin was $14,000. Thus, the total margin requirements for 100 contracts is $1,750,000, which is reflected in the margin account. Whenever the margin account falls below $1,400,000, the investor will be required to restore the account to the maintenance margin level. Thus, the margin account is not allowed to fall below that amount.

The value of the position is the product of the futures price, the S&P 500 futures contract multiplier of $250, and the number of contracts. The daily profits and losses reflect the daily marking to the market of the futures contracts. The margin cash flows are the amount the investor must raise to satisfy the maintenance margin requirement when the price moves against the position. For example, on February 27, the market experienced a significant decline of 3.95%, which resulted in a daily loss of $1,432,500, a margin cash flow of $1,312,500 was necessary.

Over the course of the futures contract, the net sum of the variation margin adjusted for financing costs and interest income ought to approximate the difference between the initial futures price and the spot price at the settlement date, when the futures price converges to the spot price. The difference between the initial futures price and the spot price at final settlement would already have been tallied across the life of the contract.

The vast majority of equity futures contracts use a stock index as the underlying. However, there are several exchanges outside the United States that list futures contracts on individual stocks.

Unlike options, both parties to a futures contract are exposed to counterparty risk. That is, there is bilateral counterparty risk. The clearinghouse for the futures exchange becomes the counterparty to the trade once a futures transaction is consummated by the initial transacting parties.

Futures contracts have a settlement cycle and there may be several contracts trading simultaneously. The contract with the closest settlement is called the nearby futures contract and is usually the most liquid. The next futures contract is the one that settles just after the near contract. The contract with the furthest away settlement is called the most distant futures contract.

Stock Index Futures Contracts

The underlying for a stock index futures contract can be a broad-based stock market index or a narrow-based index. Examples of broad-based stock market indexes that are the underlying for a futures contract are the S&P 500, S&P Midcap 400, Dow Jones Industrial Average, Nasdaq 100 Index, NYSE Composite Index, Value Line Index, and the Russell 2000 Index.

A narrow-based stock index futures contract is one based on a subsector or components of a broad-based stock index containing groups of stocks or a specialized sector developed by a bank. For example, Dow Jones MicroSector Indexes^SM are traded on OneChicago. There are 15 sectors in the index.

The dollar value of a stock index futures contract is the product of the futures price and a "multiple" that is specified for the futures contract. That is,

Equation 14.2. 

For example, suppose that the futures price for the S&P 500 is 1,410. The multiple for this contract is $250. (The multiple for the S&P 500 futures contract is $250.) Therefore, the dollar value of the S&P 500 futures contract would be $352,500 (= 1,410 × $250).

If an investor buys an S&P 500 futures contract at 1,410 and sells it at 1,430, the investor realizes a profit of 20 times $250, or $5,000. If the futures contract is sold instead for 1,360, the investor will realize a loss of 50 times $250, or $12,500.

Stock index futures contracts are cash settlement contracts. This means that at the settlement date, cash will be exchanged to settle the contract. For example, if an investor buys an S&P 500 futures contract at 1,410 and the futures settlement price is 1,430, settlement would be as follows. The investor has agreed to buy the S&P 500 for 1,410 times $250, or $352,500. The S&P 500 value at the settlement date is 1430 times $250, or $357,500. The seller of this futures contract must pay the investor $5,000 ($357,500 – $352,500). Had the futures price at the settlement date been 1360 instead of 1,430, the dollar value of the S&P 500 futures contract would be $340,000. In this case, the investor must pay the seller of the contract $12,500($352,500 – $340,000). (Of course, in practice, the parties would be realizing any gains or losses at the end of each trading day as their positions are marked to the market.)

Clearly, an investor who wants to short the entire market or a sector will use stock index futures contracts. The costs of a transaction are small relative to shorting the individuals stocks comprising the stock index or attempting to construct a portfolio that replicates the stock index with minimal tracking error.

Listed equity options and futures contracts provide the foundation for the proliferation of derivative products that have developed over the last two decades. Listed equity derivatives are exchange-traded standardized contracts where the exchange takes the other side of every contract. Listed equity futures are contractual agreements between a party and the exchange where the short party agrees to make or take delivery of the underlying index, stock or fund. Index futures contracts are used to manage risk exposure and are not designed to take delivery of the underlying asset, but are based on cash delivery. Single-stock futures, in contrast, are physical delivery. Whereas futures contracts are obligations, listed equity options are contractual agreements where the buyer purchases the right to buy or sell an asset at an agreed upon price on or before a specific date. The advent of the modern OTC market prompted options exchanges to develop long-dated options (LEAPS) and options with more flexible structures (FLEX and E-FLEX). Whether the investor is hedging an existing position or wants to speculate on a pair of stocks, listed equity derivatives can serve as a useful tool. These contracts can play a pivotal role in risk management, returns enhancement, cost management, and regulatory management for institutional and individual investors alike.

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