2-Financial Markets Page 65 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 65An option is also categorized according to when the option buyer may
exercise the option. There are options that may be exercised at any time up
to and including the expiration date. Such an option is referred to as an
American option. There are options that may be exercised only at the
expiration date. An option with this feature is called a European option.
There are no margin requirements for the buyer of an option once
the option price has been paid in full. Because the option price is the
maximum amount that the investor can lose, no matter how adverse the
price movement of the underlying asset, there is no need for margin.
Because the writer of an option has agreed to accept all of the risk (and
none of the reward) of the position in the underlying asset, the writer is
generally required to put up the option price received as margin. In
addition, as price changes occur that adversely affect the writer’s posi-
tion, the writer is required to deposit additional margin (with some
exceptions) as the position is marked to market.
Options, like other financial instruments, may be traded either on
an organized exchange or in the over-the-counter market. An exchange
that wants to create an options contract must obtain approval from
either the Commodities Futures Trading Commission or the Securities
and Exchange Commission. Exchange-traded options have three advan-
tages. First, the exercise price and expiration date of the contract are
standardized. Second, as in the case of futures contracts, the direct link
between buyer and seller is severed after the order is executed because
of the interchangeability of exchange-traded options. The clearinghouse
associated with the exchange where the option trades performs the same
function in the options market that it does in the futures market.
Finally, the transaction costs are lower for exchange-traded options
than for OTC options. The higher cost of an OTC option reflects the
cost of customizing the option for the many situations where an institu-
tional investor needs to have a tailor-made option because the standard-
ized exchange-traded option does not satisfy its investment objectives.
Some commercial and investment and banking firms act as principals as
well as brokers in the OTC options market. OTC options are sometimes
referred to as dealer options.
OTC options can be customized in any manner sought by an institu-
tional investor. Basically, if a dealer can reasonably hedge the risk asso-
ciated with the opposite side of the option sought, it will create the
option desired by a customer. OTC options are not limited to European
or American type expiration designs. An option can be created in which
the option can be exercised at several specified dates as well as the expi-
ration date of the option. Such options are referred to as limited exer-
cise options, Bermuda options, and Atlantic options.