In Hong Kong, HKEx operates a market for trading options on individual stocks. Anybody wishing to trade options should in the first instance approach a broker registered to deal in securities in Hong Kong. There are no statutory legal restrictions on who can trade options but brokers are required to ensure that their clients properly understand how options work and understand the risks. In fact, before opening a client account, the broker should enquire about your investment objectives.
Exchange Participants who are eligible to execute option trades on the Exchange are known as “Options Trading Exchange Participants”. Exchange Participants who are eligible to execute option trades for clients by entering into matching trades (as principal) with an Options Trading Exchange Participant are known as “Options Broker Exchange Participants”. A list of Options Trading Exchange Participants and Options Broker Exchange Participants is available from HKEx. To trade options through either an Options Trading Exchange Participant or an Options Broker Exchange Participant, it is necessary for clients to enter into an options client agreement.
Once an account has been opened for trading options, a client gives instructions to the broker in much the same way as he or she would when dealing in stocks. But a major difference between trading in the stock market and trading in the options market is that once stock delivery and payment is completed, the contractual relationship (in respect of that deal) between broker and client is completed. With options, an ongoing relationship continues between the client and broker until the option position no longer exists which may be a period of a few hours or several months.
This can make trading options more complex than trading stocks.An option is a contract entered into between two parties, a buyer and a seller. The buyer has the right, but not the obligation, to trade an underlying asset with the seller at a predetermined price, within a certain time. We commonly refer to the buyer as the holderand the seller as the writer. The position of a holder is referred to as a long position and that of a writer as a short position.
There are two types of options: a call and a put. A call option gives the holder the right to buy the underlying asset. A put option gives the holder the right to sell the underlying asset. Therefore, an option holder really has an “option” to exercise the right.
While holders have no obligations to exercise their rights, writers are obliged to honour the contracts if the holders choose to exercise - however disadvantageous this may be to the writers. When writing options, the writers risk incurring a loss or forgoing a profit. In return, they receive a “premium” from the buyers. For this reason, the price at which an option trades is generally known as the “premium”. The options buyer’s exposure is limited* to the premium paid to buy the option.
A stock option contract has three important defining elements: these are the underlying stock, strike price and exercise period.
Underlying StockEvery option is issued on an underlying instrument which can be one of a wide range of products - for example, a stock, a stock index, a commodity futures contract, a currency and etc. In this case, the underlying instruments are exchange-traded stocks. Your broker can inform you which stocks have options traded on them.
Strike PriceThe strike price, also known as the exercise price, is the price at which the option buyer and seller agree to trade the underlying stock, if the option is exercised.
* After exercise, an option holder’s exposure could change in certain circumstances to become greater than the premium paid. See
4Section D.
A call option whose strike price is below the market price of the underlying stock is in-the-money. Such an option allows the call holder to buy the shares for less than the current market price. A call whose strike price is above the underlying market price is out-of-the-money. Conversely, a put whose strike price is above the underlying price is in-the-money. This means the put holder can sell the asset for more than the current market price. A put whose strike price is below the underlying price is out-of-the-money.
It can be seen from this that only in-the-money options would generally be exercised by their holders because otherwise the holders can buy or sell directly in the market at a better price.
If an option’s strike price equals the price of its underlying asset, the option is said to be at-the-money (sometimes this term is applied to options whose strike price is very close to the underlying market but not exactly equal).
Exercise Period (expiry date)Stock options have an exercise period which limits their validity. After the expiry date of that exercise period, the option can no longer be traded or exercised. At the date of publication, option contracts with five different lengths of exercise periods were available for trading at HKEx: at any one time, there will be an expiry in the three nearest months and then the next two quarterly months (see Contract Specifications).
There are conventionally two categories of options in relation to exercise - American style and European style. An American style option can be exercised any time from its issuance up to its expiration. A European style option can only be exercised on the expiration day. An American style option offers more flexibility to its holders in terms of exercise, therefore it can command a higher premium than its equivalent European style option. At the date of this publication, stock options at HKEx were all American style.
All the above features are specified and defined in the option contract and in normal circumstances will not change during the life of the option. The premium, however, varies from option to option and fluctuates from time to time. The option premium is quoted on a “per share” basis and options are traded in “contracts” (or “lots”) of, for example, 1,000 underlying shares per contract. The total cost of the option contract will be the premium multiplied by the number of shares the contract entitles the holder to buy or sell. (The premium is determined by a number of factors, which are described under Pricing of Stock Options below.) So, for example, if the premium is $1.50 and there are 1,000 underlying shares in a contract, the cost of one option contract will be $1,500.
Other TerminologyTwo additional terms which are frequently used are option class and option series. An option class is all call and put options on the same underlying stock e.g. all the options on HSBC Holdings plc constitute one option class. “Option series” is the term used to identify a unique options contract in an option class, i.e. an option of the same type (i.e. put or call), the same strike price, and the same expiration date.
A standard form of identifying a particular option series has evolved. This is to describe the option series in terms of its class, its expiry date, its strike price and then its option type
- in that order. So a call option giving the right to buy XYZ stock for $80 a share at any time up to the October expiry date will generally be abbreviated to “XYZ Oct 80 call”.
Two other terms that will often be encountered are open position and open interest. An open position in a particular series is one where the result of an investor’s trades is such that he is either long of a particular option series, or short of that series. The sum of all the long positions in the market must equal the sum of all the short positions, since every holder of an option must have a corresponding option writer against whom he can exercise. The open interest in a given option series is simply the sum of all investors’ long open positions in that series (or, if you prefer, the sum of all the short open positions in that series, which is the same number).
The price at which an option trades is generally called the “premium”. Just like any other market prices, the premium is determined by market forces but there are more factors affecting the market view of the option premium than is the case with the underlying stock market. The option premium is determined by the following factors.
Underlying Stock PriceThe underlying stock price is normally the most significant factor affecting the price of an option. As mentioned earlier, in-the-money options enable holders to buy or sell the underlying shares at a better price than the prevailing market price. They therefore cost more than the equivalent at-themoney and out-of-the-money options because there is more value in them. And whether an option is in-the-money depends solely on the underlying price because the strike price is fixed. The difference between the strike price of an in-the-money option and the market price of the underlying stock is called the intrinsic value. For example, a call option with a strike price of $45 when the underlying market price is $50 has an intrinsic value of $5. However, it is possible that the option in this case will be traded above (or below) $5. Even out-of-the-money and at-the-money options, which have no intrinsic value, will normally have some value. This is because there are other factors determining the value of the option. These are called “extrinsic” factors (or sometimes “time value” factors). The extrinsic factors are time until expiration, dividend expectation, interest rate and volatility.
Time Until ExpirationAll other things being equal, the value of an option will diminish as the option approaches expiry, and the rate at which it diminishes will be faster the closer it gets to expiry so that close-to-expiry, out-of-the-money options can lose their value very quickly. It is for this reason that an option is often referred to as a “wasting asset”.
DividendThe dividend factor generally only applies to stock options because most other underlying assets do not pay dividends. All other things being equal, a cash dividend will lower the share price by the present value of the dividend on the day the stock first trades “ex-dividend”. The larger the dividend, the more the share price is expected to fall. This change in the share price in turn affects the option premium. For a call option, a fall in the underlying share price will move the option out-of-the-money, or less in-the-money, and hence cause a drop in the premium. The same fall in the underlying share price will move a put option in-the-money or more so, resulting in a higher premium for the put.
For this reason, call option holders will often exercise their options just before a stock goes ex-dividend, rather than see the value of the option fall without gaining the benefit of the dividend.
Interest RateFor stock options, a higher interest rate is likely to raise the premium of calls and lower that of puts although, unlike options on some other underlying products, the interest rate is normally the least influential extrinsic factor for stock options.
VolatilityAt any point in time, the above four factors - underlying price, time to expiration, dividends and interest rate - are all either known objectively or can generally be estimated within a reasonable margin of error. Nevertheless, two option series for which all these factors are identical can, and generally will, trade at different - sometimes significantly different - premiums. Why should this be?
The answer lies in the concept of “risk”. If one option series trades at a different premium from another, it is likely that the more expensive one represents more risk to the option writer than the other. The degree of risk is the probability that the price of the underlying stock will move, within the life of the option, from its present value to a point where the option writer incurs losses. The greater the probability that this will happen, the greater the risk and hence the higher the premium.
The degree of expected fluctuation in the underlying stock price determines the extent of the risk. The measure of this fluctuation is most commonly referred to as “volatility”. Implicit in any option premium are assumptions about the likely volatility of the stock. For this reason, one generally speaks of the “implied volatility” of the option premium, i.e. the likely volatility of the underlying stock is “implied” by the option premium. Expressed as a percentage, volatility is closely monitored by option market users as a vital indicator.
Risk
The most important characteristic of an option is in the nature of its risk and it is inadvisable to trade options until that risk is understood.
Section D of this booklet provides more details on options risk and the reader who is considering trading in options should read it carefully.
Profit OpportunityWith options, profit opportunities might exist no matter whether one believes the market is going to rise or fall. Moreover, there are a variety of ways in which those opportunities can be taken, by buying and/or writing options. In simple terms, a call holder and a put writer will expect to benefit from a rising market while a put holder and a call writer will expect to benefit from a falling market.
Some of the more sophisticated (but generally somewhat risky) strategies even benefit from a stagnant market. By writing options and exploiting the fact the option is a wasting asset whose value may simply evaporate over time, gains can be made as a result of the underlying market standing still. Such strategies are however only generally suitable for experienced options investors (see Section D).
HedgingOptions can provide hedges to shareholders or potential shareholders. For example, suppose a shareholder intends to hold some shares for a period of time. However, the shareholder fears the share price might fall and depreciate the value of the shareholding. This investor can then buy a put which gives the right to sell the shares at a fixed price. The strike price becomes the “floor” price of the shares and no matter how low the price falls in the market, the holder can (prior to the option’s expiry) sell the shares at that price. At the same time, if the share price rises, the investor can still gain from holding the shares, thus participating in the upward share price movement. Hence, the investors may enjoy upside potential with downside protection.
Income EnhancementOptions can be used to earn income against an existing portfolio of stocks through writing options and earning premium. Investors can write calls to be covered by the shares in their portfolio, i.e. giving the right to the call buyer to buy the shares in the investor’s portfolio. If the calls are not eventually exercised, the premium received becomes additional income. Of course, if the share price does rise above the strike price, the call may be exercised and the writer must sell the shares at the strike price and forgo any profit above the strike price other than whatever was earned in premium income when the option was written.
LeverageAn option is a leveraged instrument. In the case of a long call option, an investor pays a premium to acquire the right to buy shares at a fixed price at a future date. The premium is only a portion of what the investor would pay if he buys the shares outright. If a share price rises by a certain percentage, most long call options on that share will rise by a greater percentage (of the option’s premium). The money amount of the profit in options may be smaller than that arising from an outright investment in the share itself, but the rate of return may be much greater and the amount of money put at risk can be much less.
Of course, the leverage effect also has its downside implications. If the share price drops and makes the call far out-of-the-money, the value of the premium will suffer a larger percentage drop than the share price, notwithstanding that the extent of the loss is limited to the cost of the premium. In addition, the leverage effect can compound geometrically the losses that can occur in relation to short options.
Buying options should not be viewed simply as another form of “buying on margin” where an investor pays the broker an initial deposit which is a fraction of the purchase price of the share. With margin buying, if the share falls sufficiently, the investor can be called upon to pay more or forfeit his margin deposit. In contrast, a long call option position can be retained (up to its expiration date) to benefit from any subsequent recovery in the stock price or the call option may be sold for its remaining value.
The same strategy can be used in buying put options to achieve a leveraged return from a falling market.
Options are traded at HKEx via an automated electronic trading system. The people who have direct access to this system for the purpose of trading are Exchange Participants who are registered as Options Trading Exchange Participants.
HKEx operates a surveillance system that is able to monitor every order that is entered and every trade that occurs thus providing an audit trail of activity which helps maintain an orderly and fair market.
Market MakersIn order to promote liquidity, HKEx also operates a market maker system for the stock options market. Certain Options Trading Exchange Participants are designated as Market Makers. Market Makers are bound by HKEx rules to provide a firm quote for a minimum number of lots in a particular option series and within a maximum bid-ask spread, whenever requested to do so by another Options Trading Exchange Participant. Options investors are therefore provided with some comfort that they can obtain a price for any option series that is currently trading. However, it should be noted that in certain cases - for example for very low value options that are close to expiry - it may be difficult to obtain a quote.
Central Clearing HouseAll stock option contracts traded at HKEx will be cleared through a central clearing house - The Stock Exchange of Hong Kong Options Clearing House Ltd.(SEOCH), a wholly owned subsidiary of HKEx. By novation, SEOCH acts as a counterparty to its Participants in relation to each option contract traded on HKEx and manages counterparty risk by, amongst other things, margining those Participants daily. It may also impose limits on the size and types of positions the SEOCH Participants may keep. SEOCH is solely engaged in the business of managing risk and contract performance and has no other business function.
However, the Clearing House’s role as a counterparty only extends to the SEOCH Participants and not to any clients or other counterparties. If an Options Trading Exchange Participant or Options Broker Exchange Participant defaults on any of its obligations to its clients, the client’s only recourse is to the Options Trading Exchange Participant or Options Broker Exchange Participant itself; there is no relationship in regard to options contracts between SEOCH and entities who are not SEOCH Participants, such as a Participant’s client.
No Options Broker Exchange Participants are Participants of SEOCH. Not all Options Trading Exchange Participants are Participants of SEOCH. To become a Participant of SEOCH it is necessary to be an Options Trading Exchange Participant and to meet additional financial and operational requirements.
Role of SEOCH in Marking to Market and Calling Margin and Holding CollateralAfter the close of trading each day, SEOCH values all open positions (as well as pending stock positions arising from the exercise and assignment of its Participants) with the settlement prices of each option series and assesses a margin requirement based on this valuation. This process is called Marking to Market. The SEOCH collects this mark-tomarket margin on a daily basis but may collect margin at other times as it sees necessary.
The mark-to-market margin represents SEOCH’s estimate of the cost of liquidating the open position at current market levels. In addition, in order to provide a buffer against any further adverse movements in the market that may occur before the next margin calculation, SEOCH also collects an additional amount, over and above the mark-to-market margin. This is called additional margin.
SEOCH may accept as margin collateral cash, letters of credit, bank guarantees, securities, Exchange Fund Bills and Notes, etc. as may, from time to time, be so designated by the Board and in such form as may be required by the Board. You should ask your broker about the forms of collateral the broker will accept.
Stock Options Series Available for TradingAt any one time, HKEx will provide many strike prices for investors to choose from, some in-the-money, some out-ofthe-money and perhaps some at-the-money for five different expiry months. HKEx reviews the options series daily after the market close to ensure that there are at least two in-themoney, one at-the-money and two out-of-the-money options series are available or added (if necessary) for trading on the next trading day following the intra-day movement of the underlying stock. These choices in strike prices and duration enable investors to select an option series most suited to their market views.
Placing Orders for Stock OptionsHKEx’s options trading system accepts a number of different type of orders to buy or sell stock options. For example, a limit order is an order to buy or sell an option at a specific price or better. Your broker can provide you with further information on placing orders to buy or sell stock options as well as the types of stock options orders accepted by the trading system.
Options Broker Exchange ParticipantBefore trading through an Options Broker Exchange Participant, you should check whether the broker is prohibited by its terms of participantship from carrying short option positions. When trading through such a broker, you will only be able to open and close long option positions; you will not be able to write options through this broker.
In practice, it may happen that most option positions are either closed out in the options market before expiry or they expire unexercised. Nevertheless, exercising an option rather than closing it out may be a sensible course for option holders.
Options holders and writers therefore need to be sure they are familiar with the process.
An option holder must instruct his or her broker to exercise a stock option. The broker firm itself will have a deadline every day after which the Clearing House will not accept exercise instructions and so the broker will most likely impose an earlier time deadline on clients.
Although SEOCH has a facility whereby certain deep in-themoney options are automatically exercised upon expiry, the broker is able to over-ride this feature. It is therefore important for you to inform your broker that you wish to exercise.
When an option is exercised, SEOCH selects, on a random basis, the short open positions against which to exercise. If the accounts of the Exchange Participant’s clients are assigned, the Exchange Participant must in turn assign, on a random basis, the short open positions of the clients. The assigned clients are then required to deliver (in case of a call option writer) or buy the underlying stock (in case of a put option writer). Stock transactions resulting from the exercise of options are cleared under the Continuous Net Settlement System of Hongkong Clearing. This arrangement not only smooths the settlement process, but also strengthens the cross-market risk management measures, by combining all the stock settlement positions resulting from the exercise of options and transactions from the stock market into the same portfolio for risk management purposes.
Stock options at HKEx are American style. Option writers therefore need to be prepared for assignment at any time, including on the same day the option is written.
An option position which is exercised or assigned will require the parties to deliver or pay for the underlying stock within the required stock settlement period (the second business day after exercise). It should be noted that the exercise of stock options results in the physical delivery of stock in contrast to other types of options exercise, which result in cash settlement.
When a company makes changes to its capital structure by way of rights issues, bonus issues, etc., the price at which the share trades changes as soon as the share trades exentitlement or on the effective date. This can affect open option positions.
All other things being equal, the value of a shareholder’s portfolio will not change on the ex-date. But the same is not true of the holder (or writer) of an option on those shares, unless an appropriate adjustment is made to the terms of the option contract. Without a change to the strike price and/ or the number of shares in the option contract, the share price adjustment will arbitrarily and unfairly affect the value of the option position.
SEOCH calculates the adjustment ratio that it believes is required to maintain the fair value of the option contracts. The strike prices of all series in that class are multiplied by the ratio and the number of shares in each contract are divided by the ratio.
These adjustments will only be made for substantial changes, not for ordinary dividends. Options Trading Exchange Participants and Options Broker Exchange Participants are required to inform their clients of these changes.