CHAPTER 5

Over-the-Counter Options

Over-the-counter options are options traded between two parties that are nonstandardized so that the option can be tailored for any business or individual need. Most of the time, one of the parties, and it’s usually the writer of the option, is a well-capitalized institution such as a bank or an online broker. The option types that are mainly traded over the counter are as follows:

These are the types of options that you will be able to trade or invest in on your chosen online option brokers’ platform.

Trading Stock Options

Stock options can be traded on most online brokers’ platforms. As with all trading, before you trade with your own money, make sure that you understand the characteristics of stock options and the fundamentals that drive a stock’s price. The trading screen for a stock option will look very similar to the screen shown in Table 5.1.

Let’s assume that the market price of a Facebook share is $180 and you believe that the share price will appreciate over the next 30 days. To potentially take advantage of your belief, you decide to buy 10 call option contracts at a price of $5.98 each. The price is the premium per contract you pay for the right to buy Facebook shares at a strike price of $185 per share. As each option contract is worth 100 of the underlying Facebook shares, you have effectively bought the right but not the obligation to buy 100 Facebook contracts before or on the 18th October at a cost of $598 instead of a cost of $180,000 (10 contracts × 100 shares × $180) for purchasing the shares for cash.

Table 5.1 Stock option trade

Stock	Market price	Trade date	Strike price	Expiry date	Call/put	Sell	Buy	Contracts	Contracts value
Facebook	$180	19th Sep	$185	18th Oct	Call	5.84	5.98	10	$598.00

Let’s look at what happens if the price of Facebook shares do the opposite of what you expected and fall to $178 per share (out of the money). You would let the option expire worthless and forfeit the premium you paid of $598 (Table 5.2). If you had purchased the 1,000 shares for cash at the market price of $180 per share instead of purchasing the call option, you would have lost $2 per share for a total of $2,000. So by purchasing the call options, you reduced your potential losses by $1,402 (Table 5.3).

Table 5.2 Call stock option trade allowed to expire (out of the money)

Instrument	Strike price	Contracts	Expiry date	Call/ put	Underlying stock price at expiry	Loss is premium paid
Facebook	$185	10	18th Oct	Call	$178	$598

Table 5.3 Facebook stocks purchased for cash

Instrument	Share price	Shares	Share price at Oct 18th	Potential loss per share	Total potential loss	Potential reduction on losses
Facebook	$180	1,000	$178	$2	$2,000	$1,402

However, if before or on 18th October, the price of Facebook shares has increased in value to say $188 per share (in the money), you could exercise the option at the strike price of $185 per share giving you a profit of 10 × 100 × $3 = $3,000 less the premium you paid of $598, leaving you with a profit of $2,402 on the trade.

Table 5.4 is an example of the option exercised in the money on or before expiry. You don’t actually have to buy the shares at the strike price and then sell them into the market at the market price to realize your profit. It is assumed that this is a given so the option writer (the seller) will always pay you your profit less the premium you paid him at inception of the contract.

Table 5.4 Call stock option trade exercised (in the money)

Instrument	Strike price	Contracts	Expiry date	Call/put	Underlying stock price at expiry	Profit per share	Net Profit after options exercised
Facebook	$185	10	18th Oct	Call	$188	$3	$2,402

Of course, if you predict that Facebook stock would decline in the coming months and you wanted to hedge your risk you would purchase a put option. The workings would be similar except that instead of the price needing to be above the strike price to make a profit, with a put option it needs to be below the strike price (Table 5.5).

Table 5.5 Put stock option trade exercised (in the money)

Instrument	Strike price	Contracts	Expiry date	Call/put	Underlying stock price at expiry	Profit per share	Net profit after options exercised
Facebook	$185	10	18th Oct	Put	$182	$3	$2,402

Now, what if you were the writer of the Facebook call option expiring on the 18th October with a strike price of $185 and not the purchaser of the call? As a writer, you would want the opposite result of the purchasers’ prediction and be hoping that the call option would expire worthless so you could pocket the premium of $598, which would be your profit. The call option would expire worthless only if the buyer’s call option was out of the money on the expiry date (Table 5.6).

Table 5.6 Writer’s side of call stock option allowed to expire (out of the money)

Instrument	Strike price	Contracts	Expiry date	Call/put	Underlying stock price at expiry	Profit per share	Net Profit after options expire
Facebook	$185	10	18th Oct	Call	$182	$3	$598

Table 5.7 Writer’s side of call stock option exercised (in the money)

Instrument	Strike price	Contracts	Expiry date	Call/put	Underlying stock price at expiry	Profit per share	Net loss after options exercised
Facebook	$185	10	18th Oct	Call	$182	$3	$2,402

However, as a writer, if the stock option was exercised in the money, it would cost you the $3,000 you would have to pay to the buyer of the option, less the premium of $598 you received from the buyer at the inception of the option contract, leaving you with a net loss of $2,402 (Table 5.7).

Not quite your shirt but significant nevertheless.

Stock options can be used for speculation on the direction of the market as in the examples in Table 5.7 or as a hedging tool. An example of a hedge is where you had a long stock position in ABC shares and was not sure where the market was going but didn’t want to sell the shares. You could open a long-put position to match the number of shares held. In this way, if the market went down, the loss on the shares you held would be matched by the gain made on the “in the money” put options; in this case, a perfect hedge. However, if the market continued to gain, all you would lose is the premium paid for the put options purchased.

Trading Foreign Currency Options

Foreign currency options have the same characteristics as other options that are tradable in the over-the-counter markets, such as stocks and indexes. Most currency option contracts are traded over the counter with little regulation but a few contracts are traded on exchanges that are highly regulated. Over-the-counter options can be traded through a broker’s trading platform. Foreign currency options are slightly different from traditional options in that with traditional options you pay for the right to buy or sell a given underlying asset, but with a currency option you buy or sell the right to an underlying asset denominated in another currency.

As we have mentioned earlier, there are four positions that you can take depending on your options strategy and whether you are bullish or bearish on a particular asset (Table 5.8).

Table 5.8 Option strategy

Option type	Strategy
Buy call	Bullish
Buy put	Bearish
Sell/write put	Bullish
Sell/write call	Bearish

Long Call

For example, suppose you were bullish on the price of the USD/CAD. You decide to buy a long call at a strike price of USD/CAD 1.2300 paying a premium of USD 0.005/CAD with an expiry date 2 months into the future. At expiry, you will not exercise the call if the spot rate is below USD/CAD 1.2300 because the long call would be out of the money. You would, however, exercise the call if the spot rate is above USD/ CAD 1.2300 (in the money). The break-even point is at the spot rate of USD/CAD 1.2350. If the spot rate is USD/CAD 1.2450, you purchase the USD/CAD at the strike price of USD/CAD 1.2300 and sell them on the current spot market at a rate of USD/CAD 1.2450. Because you paid a premium of USD 0.005/CAD, you earn a profit of USD 0.01 per CAD purchased (Table 5.9). For this transaction, the profits can be computed as:

Table 5.9 Option long call profit calculation

Spot rate	−	Strike price + premium	=	Profit/pips
1.245	−	(1.2300 + 0.005) = 1.2350	=	0.0100

So your overall profit if you had bought a standard lot of 100 options (typical size 1,000 units of base currency) would be 100 × 1,000 × 0.0100 = $1,000 less the premium you paid of 100 × 1,000 × 0.005 = $500, which leaves you with a net profit of $500.

However, if the spot price was below USD/CAD 1.2300 at expiry and you would simply let the option expire without exercising it, and you would only lose the premium you paid of USD 0.005/CAD or $500.

So, as you have seen, the profit potential for a long call is unlimited and the potential loss is limited to no more than the premium paid.

Short Call

On the other hand, if you were the writer of the above call (short call), you would be hoping that the spot rate at maturity is out of the money, in other words, below USD/CAD 1.2300 (the strike price). As we have seen in Table 5.8, the payoffs to the writer are the opposite of the payoff to the holder. In other words, the premium − (spot rate − strike price) = profit. For the writer of the call, the potential gain is limited to the premium but the potential loss is infinite.

Long Put

Let’s look at another strategy. Suppose you were bearish on the price of the USD/CHF but didn’t want to take the risk of entering a straightforward forex transaction and being wrong on the outcome. So you decide to buy a USD/CHF long put. This is a gamble that the spot rate at maturity is below the strike price (you are selling the U.S. dollar).

You purchase a put option contract on the USD/CHF at a strike price of USD/CHF 0.9950 (at the money option) and pay a premium of USD 0.004/CHF. At maturity, you would not exercise the option if the spot rate is above USD/CHF 0.9950. However, you would exercise the option if the spot rate is below USD/CHF 0.9950. The break-even point is the spot rate of USD/CHF 0.9910. If the spot rate is USD/CHF 0.9840 when the option is due to expire, you buy the USD/CHF on the current spot market at the rate of USD/CHF 0.9840 and sell them at the strike price of USD/CHF 0.9950. As you paid a premium of USD 0.004/CHF, you will earn a profit of USD 0.007 per CHF sold (Table 5.10). For this transaction, the profits can be computed as.

Table 5.10 Long-put option profit calculation

Strike price	−	Spot rate + premium	=	Profit/pips
0.995	−	(0.9840 + 0.004) = 0.9880	=	0.007

As with the long call, the potential gain is unlimited but the maximum loss is only the premium you paid.

Short Put

However, if you were the writer of the above put, you would be betting that the spot rate is above the strike price at maturity. As we can see from Table 5.8, the payoffs to the put writer are the exact opposite to the holder of a long put because the writer’s profit is the premium when the option is left to expire and not exercised. That is, premium − (strike price − spot rate) = profit. As with a short call, your potential gain is limited to the premium and the maximum loss is unlimited.

There are essentially only two currency option strategies you could employ:

The examples we have discussed earlier are straightforward investment strategies; however, a hedging strategy is slightly more complicated. To hedge a position, you have to open an opposite currency option position to the spot position you hold.

For example, if you held a long spot currency position, you would open a long-put currency option to match the value of the spot currency position held. If your long spot position gained value in your favor, you would allow the long put to expire worthless, so your net profit would be the increase in value of your long spot position less the premium you paid for the long put. If the value of your long spot position fell, the loss on that position would be offset by the gains you made on your long put.

Let’s assume you are holding a GBP/USD long spot position at a spot rate of GBP/USD 1.3430 and you believe that the GBP/USD will increase in value over the next couple of months. To hedge your spot position, you would purchase a 2-month-long put GBP/USD currency option to match the exact value of your spot currency position, with a strike price of GBP/USD 1.3430, paying a premium of GBP 0.0020/ USD. If at the maturity date of the long-put option the spot price of GBP/USD is higher than GBP/USD 1.3450 (spot price 1.3430 + 0.0020 premium paid), you would allow the long put to expire worthless and sell your spot position and take your profit. However, if the value of your spot currency position had fallen below 1.3430 to, for example, 1.3400 (a loss of GPB 0.0030/USD), you would exercise the long-put option and sell GBP/USD at 1.3430 (the strike price) and purchase GBP/USD in the spot market at GBP/USD 1.3400, making a profit of 1.3430 (strike price) − 1.3400 (spot price) + 0.0020 (premium paid) = 0.0010 profit. This profit would partially offset the reduction in value of your spot position at GBP/USD 1.3400 (a loss of GBP 0.0030/USD) and you would end up making an overall loss of GBP 0.0020/USD, a far better result than taking a risk on your spot position without hedging it.

Trading Stock Index Options

Index options are the same as stock options, except the underlying asset is a stock/share index instead of a single stock. An index call or put option is a simple and popular tool used by investors, traders, and speculators to profit on the general direction of an underlying index while putting very little capital at risk. The profit potential for long index call options is unlimited, while the risk is limited to the premium amount paid for the option, regardless of the index level at expiration. For long index put options, the risk is also limited to premium paid, and the potential profit is topped at the index level, less the premium paid, as the index can never go below zero.

Exactly like any call option, an index call option gives the owner the right to buy the underlying index at a future date at a specified price. For this privilege, the index call owner pays the writer of the call a premium. Similarly, just like any put option, an index put option gives the owner the right to sell the underlying index at a future date at a specified price. For this privilege, the index put option owner pays a premium to the put option writer. Once owned, you have the choice of whether you want to exercise the option and take a position on the underlying asset. If the current market index price is lower than the strike price for a call or the market index price is higher than the strike price for a put, you can simply let the option expire worthless.

Most online broker platforms facilitate the trading of stock index options and you should choose the one that meets your own personal trading goals. The platforms that facilitate index options normally have the major stock indexes as tradable assets, although some do allow trading the lesser indexes. The most popular indexes for trading index options are listed in Table 5.11.

Table 5.11 Popular Indexes

Index	Country
Standard & Poor’s 500	USA
Dow Jones 30	USA
NASDAQ	USA
FTSE 100	UK
DAX	Germany
Hang Seng	Hong Kong
CAC 40	France
Nikkei 500	Japan
FTSE MID 250	UK
Russel 3000	USA

Table 5.12 Index options screenshot

Index	Strike price	Expiry date	Put/call	Sell/write premium	Buy premium
SPX	2,480	Oct	Call	35.72	36.52
SPX	2,480	Oct	Put	14.59	15.16
SPX	2,490	Oct	Call	28.20	28.80
SPX	2,490	Oct	Put	16.92	17.57
SPX	2,500	Oct	Call	24.08	25.41
SPX	2,500	Oct	Put	14.48	15.56

Take a look at Table 5.12 for an example of a typical trading platform’s index option screen.

The first column shows index option SPX, which is the designation for the underlying asset Standard & Poor’s Index. The second column shows an array of strike prices. The third column is the expiry month for the option. The fourth column designates whether the strike price is for a put or a call. The fifth column is the premium on the sell/write side of the option. The sixth column indicates the premium on the buy side of the option.

Index Option Long Call Example

You observe that the current value of the S&P 500 is at the 2,490 level. You believe that the index will rise over the next weeks so you decide to buy an SPX long call with a strike price as near to the current price as possible. You choose the strike price of 2,500, which has a premium of $25.41 and an expiry date in October a few weeks from now. With a contract multiplier of 100, the premium you have to pay to hold the call option is $2,541. On the expiration date, the underlying S&P 500 index has risen by 5 percent and stood at 2,614.50. With the S&P index significantly higher than the strike price, the option is very much in the money. You exercise the option and receive a cash settlement figure that is computed as follows: ($2,614.50 expiration price − $2,500 strike price) × 100 = $11,450 from the option transaction. Deduct the premium of $2,541 and your net profit is $8,909 from the long call strategy. As with the settling of all option contracts, it is not necessary to exercise the option to take your profit, you can simply close out the option by selling it back into the market.

The obvious advantage from the long call strategy is that your loss is limited to a known specific amount but your profits are unlimited. If the S&P 500 had fallen by 5 percent to 2,375 instead of rising, which is a long way from the strike price of 2,500, you would have only lost $2,541, the cost of your premium paid.

A long-put strategy on the same index option would work in exactly the same way as the long call strategy except that you would want to see the underlying asset fall below the strike price to make a profit. If the underlying asset rose above the strike price, you would lose the premium you had paid. Writing or selling put and call index options exposes you to the possibility of unlimited losses if you get it wrong. Recall that when writing or selling a put index option, your expectation is that the underlying asset will rise above the strike price. Conversely, when writing a call index option, you are expecting the underlying price to fall below the strike price.

Keep in mind that long call or put strategies can lead to unlimited profits but limited losses if you get it wrong; however, short call or put strategies can lead to limited profits but unlimited losses if the market goes against you.