Options Are Standardized Contracts

The reason that options are inflexible as to the number of shares is because options are standardized contracts. A standardized contract means there is a uniform process that determines the terms, which are designed to meet the needs of most traders and investors. By using standardized contracts, we lose some flexibility in terms (such as the number of shares, strike prices, and expiration dates) but increase the ease, speed, and security in which we can create the contracts.
 
In fact, if the exchanges find there is not sufficient demand for options on a stock, they will not even list those options. Most of the well-known companies have options available. If a stock has listed options, it is an optionable stock. Microsoft and Intel, for example, are optionable. There are currently more than 2,300 optionable stocks, so the list is quite large.
 
Another limitation of standardized contracts is the fixed strike price increments. If the stock price is below $50, you will find options available in $2.50 increments. If the stock price is between $50 and $200, options will be in $5 increments. And if the stock price is over $200, you will find option strikes in $10 increments. Notice that the strike price increments have nothing to do with the current price of the stock. The increments are based on the stock’s price at the time the options start trading. If a stock’s price has been greatly fluctuating, you might find different increments for different months. For instance, you may find $2.50 increments for the first two expiration months and $5 increments in later expiration months. This just tells you that the stock’s price was above $25 when the later months started trading.
 
By having standardized strikes, we can quickly bring new contracts to market that meet the needs of the vast majority of people. Imagine how overwhelming the task would be if the exchanges tried to meet everybody’s needs by creating strike prices at every possible price such as $30, $30.01, $30.02, etc. and then matched those with every possible expiration date such as June 1, June 2, June 3, etc. It would be a near impossibility. To solve these problems, the exchanges created standardized contracts so that we can have some flexibility while still keeping the list manageable.
 
What if you really want a customized contract? Is it possible to get one? Technically, there is nothing illegal about two people having a contract drawn up by an attorney that specifies the terms on which they agree to buy and sell stock. You could therefore have an attorney write a contract for you and another trader, thus creating your own call or put option. A contract drawn in this manner is completely flexible — but it is also very time consuming and costly. In addition, even though you may have a legally binding contract, it is possible that the seller decides to not fulfill his obligation if the buyer wishes to exercise his option. If that happens, now you’ve got your hands tied up in court trying to get the seller to conform to the terms of the contract. In other words, customized contracts are subject to performance risk. That is, will the seller perform his part of the agreement if the buyer decides to exercise?
 
Standardized options solve the performance risk problem too since the OCC acts as the buyer to every seller and the seller to every buyer. If you exercise an option, the OCC uses a random process to decide who will be assigned. When you enter an options contract, you do not know who is on the other side of the trade. Nobody knows. It is strictly the person who ends up with the random assignment. Standardization increases confidence and influences the progress toward a smoothly running, liquid market.
 
Besides having an attorney draw up a contract, there is another way to get flexible contracts. You can buy FLEX contracts through the Chicago Board Options Exchange (CBOE) that are totally customizable, but they also require an extremely large contract size – usually more than one million dollars. Because FLEX options are traded through the OCC they are not exposed to performance risk despite their large contract sizes. Because of the size requirements though, FLEX options are mostly used by institutions such as banks, mutual funds, and pension funds. The standardized market is the solution for the rest of us.
 
Key Concepts
 
1.      Options are derivative assets. Their prices are derived from the price of the underlying stock.
2.      Your “lock in” price is called the “strike price” or the “exercise price.”
3.      If you decide to use your option, you must submit exercise instructions.
4.      You are not ever required to buy or sell stock if you buy options.
5.      Your last trading day for options is the third Friday of the expiration month.
6.      Options trade in units called “contracts.”
7.      The exercise price multiplied by the strike price equals the total contract value, or exercise value.
8.      Options are standardized. You can only get them in a limited number of “flavors.”
 
 
Understanding a Real Call Option
Now that you know how call and put options work, let’s take a look at some real call and put options. Let’s pull up some quotes and see if we can make some sense of what we’re looking at.
 
You can obtain option quotes for any optionable stock by going to www.cboe.com. That’s the homepage for the Chicago Board Options Exchange (CBOE), which is one of the largest option exchanges in the world. Bear in mind that the options market is open from 9:30am to 4:02pm ET (it is open until 4:15pm ET for index options). If you are pulling up quotes after 4:02pm, you’re looking at closing prices rather than live quotes. Also, most options go through what is called an opening rotation every morning. This is simply an open outcry system that establishes option prices based on the current stock price openings. For this reason, you may not see live option quotes until 9:35 or 9:40 even though the options market is technically open at 9:30. As electronic trading increases, the opening rotation times will diminish and eventually disappear.
 
If you click on “Quotes” and then “Delayed Quotes” you will find a box where you can type your stock ticker symbol. If you are looking for options on eBay, for example, just type the ticker symbol “EBAY” and hit enter. At this time, the shortest-term options on eBay were July ’05 (26 days until expiration) and the longest term was January ’08 (943 days to expiration). The lowest strike is $22.50 and the highest is $80. So even though option contracts are standardized, there are many to choose from. Table 1-1 shows some of the shorter-term options available at the time of this writing:
 
Click image to enlarge
Click image to enlarge

To be continued…

 

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