CBOE

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CBOE

• Products and Option Trading

Amit Agarwal Lu Fang Wenbo Hu
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Contents

• Introduction to CBOE
• People involved
• Types of orders
• Trading system/ process
• Technology
• Products

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Introduction

• The world's largest options marketplace.
• Located on the corner of LaSalle and Van Buren
  streets in Chicago, IL.
• Lists options on approximately 1500 equities and
  forty indexes.

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Brief History

• Founded by CBOT in 1973, trading call options on
  16 underlying stocks then.
• Put options were introduced in 1977.
• The first index option, OEX was introduced on
  March 11, 1983.
• Moved into its own building in 1984 due to
  increased volume.
• Options on Interest Rates were introduced in June
  1989.
• Innovations made a lot of options available every
  year in the early 90s.

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5 types of person involved
5 types of person involved

• Investors
• Broker
• Floor Broker
• Market Maker
• DPMs

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Investor

• Investors realize that options give more
  investment alternatives, and add diversity to
  their investment portfolio.
• Investors give broker and the trading details via
  phone or website.

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Broker

• The broker takes order over the phone or through
  an online brokerage website and this information
  is relayed via computer to be filled at CBOE.
• The broker may receive different types of orders.

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Floor Broker

• The floor broker is an agent for the investor.
• He trades for the investor and has the investors
  best interest in mind at all times.
• He cannot trade for himself because of a possible
  conflict of interest with the investor.
• Those representing a firm are called Firm Floor
  Broker.
• Independent traders are called Crowd Floor
  Brokers.

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Market-Maker

• Market-makers are entrepreneurs who risk their
  own capital in order to compete with other
  market-makers for options orders.
• They are not allowed to to represent public
  investors and traders.
• They earn money by making tiny profits on each
  trade, and, thus, are interested in trading as
  many options as possible.
• Market makers are necessary for a liquid trading
  market.

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DPM

• The DPM (Designated Primary Market Maker) is an
  exchange appointed organization, who acts a
  specialist for an option.

• This combines the strengths of the market-maker
  with those of the specialist in one entity.

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Function of OCC

• The Options Clearing Corporation (OCC) is
  approved by SEC as the central clearing
  corporation for exchange-listed options.
• By acting as guarantor, OCC ensures that the
  obligations of the contracts are fulfilled.
• OCC is equally owned by 5 participant exchanges
  that trade options CBOE, ASE, ISE, PE and PSE.
• OCC operates as an industry utility and obtains
  most of its revenues from clearing fees charged
  to its members.

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Types of Orders

• Market Order
• Limit Order
• Spread Order
• Contingency orders
• Request for Quote (RFQ)

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Market Order

• A customer order for immediate execution at the
  best price available when the order reaches the
  marketplace.
• This is the most common type of order, it has the
  advantage of nearly always being filled, since no
  price is specified.

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Limit Order

• Executes a transaction only at a specified price
  (the limit) or better .
• If the prices do not match, the system will store
  the order in the book in the appropriate
  price/time sequence.
• If the prices match, the orders are executed
  against each other. Any remaining quantity will
  stay in the book.

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Spread Order

• A Spread order is in fact 2 option orders in 1.
• A spread ticket instructs the floor broker to
  execute the order only when the combined prices
  of the two options are equal to or better than
  the spread orders stated prices.
• Both sides of the spread are to be executed
  simultaneously.

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Contingency Orders

• Contingency orders, except IOC, are put last in
  execution priority, regardless of their position
  in time.
• A contingency order received ahead of a limit
  order at the same price will be treated as though
  it was received behind the limit order.

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Types of Contingency Orders

• AON - All or none
• FOK - Fill or kill
• IOC - Immediate or Cancel

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AON - All or none

• Orders of this type instruct the floor broker to
  either trade the entire order (e.g., 50
  contracts) at one price or do not trade at all.
• This strategy is used to keep an order from being
  split up and filled at, for example, 10 contracts
  at a time at different prices.

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FOK - Fill or kill

• An order that is sent to the floor for immediate
  execution.
• If it cannot be filled immediately, it is
  automatically cancelled.
• This strategy is also used to avoid a partial
  fill, by canceling the entire order unless all
  200 options requested trade right now, so as to
  avoid several different trade times.

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IOC - Immediate or Cancel

• Time contingent
• Must be filled within 5 seconds
• remainder is automatically cancelled
• Accepted only during the Open state
• price and quantity disseminated to OPRA as part
  of the best bid/ask
• Execution priority same as limit order

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Request for Quote (RFQ)

• Any trader --- market maker, retail firm broker,
  or non-market maker professional trader may
  initiate an RFQ for a series.
• Size may be specified
• The interest (to buy or sell) is not specified
• Sent to the market makers-- assigned to that
  class and those who subscribed to receiving RFQs
  for that class.
• 30 second expiration period

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Trading System
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Trading System- History

• CBOE Trading System was the best when it started
  operating in 1973.
• There were two main types of trading systems at
  that time, specialist and NASDAQ.
• Chicago Board Options Exchange started as a blend
  of both, specialist, and NASDAQ.

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Specialist Trading System

• Each stock is assigned to a member firm known as
  a specialist which uses its own money to trade.
• The specialist is required to provide a two-sided
  market in the stock.
• He also maintains the customer order book for
  that stock.
• The specialist is responsible for providing a
  fair and orderly market for the stock.

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Disadvantages

• The specialist has monopoly power can easily
  control trading in a stock.
• Advantage of trading on the bid-ask spread.
• The specialist is also a broker--combination of
  the agency and principal function.
• Can use the customer order book to his own
  advantage.

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The NASDAQ System

• It relies on a computer system linking a vast
  network of dealers.
• No physical exchange, no building.
• A dealer makes market in one or more stocks
  listed on the system.

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Disadvantages

• A stock often did not open at a single price.
• A broker was under no obligation to trade at the
  best price.
• Difficulty in executing a market order
• Did not completely solve the Principal and agent
  problem.

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CBOE Trading System

• A combination of both the systems
• Physical Exchange
• Competing members, not one specialist
• Statutory separation of principal and agent
• A central order book for customer orders
• Central clearing house eased settlement and
  almost eliminated default risk.

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Classic Trading Process

• Open Outcry

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Open Outcry Process

• The order is telephoned from the broker's office
  to its booth at the exchange.
• A runner delivers the order to the floor broker.
• The broker runs to the pit where the option is
  being traded.

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Open Outcry Process

• Through the use of hand signals, he offers the
  position to the crowd.
• Market makers answer with a price at which they
  will buy and sell.
• The floor broker trades with the one who offers
  the best price.

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CBOE Today

• The pit-trading method is supplemented by an
  electronic screen-based trading system.
• Even though floor brokers still use hand signals
  to communicate information of orders, technical
  innovation has changed option trading.

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Technology at CBOE
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Technology at CBOE

• ORS (Order Routing System) replaces the telephone
  call.
• BART (Booth Automated Routing Terminal) replaces
  the runner.
• PAR (Public Automated Routing ) replaces hand
  signals.
• RAES (Retail Automated Execution System)
  automatically executes orders.
• EBOOK

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ORS (Order Routing System)

• It is a network of communication lines from
  retail member firms computers to the exchange.
• It collects and routes orders to either booth,
  crowd, Electronic Book or RAES.
• Handles orders of up to 20,000 contracts.

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BART (Booth Automated Routing Terminal)

• It is a dynamic, PC based, touch screen
  workstation located in the firms booth at the
  exchange where the orders are displayed.
• BART allows each firm to customize order-flow to
  the booth.
• BART allows the customer orders to be
  electronically forwarded to a destination of the
  firm's choice.

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PAR (Public Automated Routing )

• PAR is a PC based, touch screen, order routing
  and execution system used by floor brokers.
• Floor brokers can also carry mobile PAR.
• The Mobile PAR enables a Floor Broker to receive
  the orders, move to the appropriate trading
  crowd, and execute the order from a Mobile PAR
  order screen.

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RAES

• RAES (Retail Automated Execution System) executes
  smaller transactions.
• The price of the order should be marketable.
• The routing system premium and quantity
  limitations are determined by the DPM for that
  option .

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EBOOK (Electronic Book)

• EBOOK is the automated public customer order book
  at CBOE.
• A depository for public customer orders away from
  the market.
• It automatically sorts and files orders in price
  and time sequence.
• Most orders received during pre-opening period
  are routed to EBOOK for efficient price
  discovery.
• Floor brokers can also send all orders from their
  PAR workstation to EBOOK.

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Order Flow Summary
Brokerage sends the order to Order Routing System
(ORS)
Sent to floor broker
.otherwise (Depending on the price and volume
parameters set by the brokerage and CBOE)
Order meets volume price criterion
Gets printed at the firms booth
Sent to Electronic Book (EBOOK)
Executed thru Retail Automatic Execution System
(RAES)
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An Example
PAR
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CBOE Products

• Equity Options
• Index Options
• Options on Exchange Traded Funds and HOLDRssm
• Exchange Traded Funds
• Interest Rate Options
• Structured Products
• Equity Index LEAPS
• Equity Index FLEX Options

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Equity Options?

• CBOE lists equity options on approximately 1,500
  stocks and ADRs. An equity option is a securities
  contract which conveys to its owner the right to
  buy or sell a particular stock at a specified
  price on or before a given date.

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More about Equity Option

• The Options ToolBox v5.0
• You can download it from http//www.cboe.com/Le
  arnCenter/RCMain.asp

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Index Options

• Just as stock options are defined as contracts
  that give the buyer the right to buy or sell a
  stock at a stated price, so do cash-settled index
  options give buyers similar rights. However, the
  underlying asset covered by index options is not
  shares in a company but rather an underlying
  dollar value equal to the index level multiplied
  by 100.

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Options on Exchange Traded Funds

• Exchange Traded Funds, or ETFs, are index-based
  investment products that allow investors to buy
  or sell shares of entire portfolios of stock in a
  single security

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Options on Exchange Traded Funds(continued)

• ETF baskets of securities that are traded, like
  individual stocks, on an exchange
• There are a number of different ETFs on the
  market currently, including Qubes, SPDRs, sector
  SPDRs, MidCap SPDRs, HOLDRs, iShares, and
  Diamonds. All of them are passively managed,
  tracking a wide variety of sector-specific,
  country-specific, and broad-market indexes.

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Options on Exchange Traded Funds and HOLDRssm

• HOLDRs(holding company depository receipts) are
  trust-issued receipts that represent an
  investor's beneficial ownership of a specified
  group of stocks. HOLDRs allow investors to
  benefit from the ownership of stocks in a
  particular industry, sector or group.

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Interest Rate Options

• Interest rate Options are European-style,
  cash-settled options on the yield of U.S.
  Treasury securities. Available to meet your needs
  are options on short-, medium-, and long-term
  rates. These options give you an opportunity to
  invest based upon your views of the direction of
  interest rates.

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Interest option example IRX

• Underlying 13-Week Treasury Bill discount rate
• Multiplier 100
• Strike Price Intervals2 1/2 points. A 1-point
  interval represents 10 basis points.
• Expiration Months Three near-term months plus
  two additional months from the March quarterly
  cycle

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Structured Products

• Structured Products at the Chicago Board Options
  Exchange represent a new type of investment
  vehicle. They are similar to all options in that
  they have an expiration date and like index
  options are cash-settled. Structured Products
  trade like a stock via the stock system and
  require stock qualifications. Structured Products
  are cleared through the National Securities
  Clearing Corporation (NSCC)

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Equity Index LEAPS

• Long Term Equity Anticipation Securities (LEAPS)
  are long term options available on approximately
  450 equities and 10 indexes. LEAPS provide
  investors with a longer term(Up to 3 years) view
  of the market as a whole or on an individual
  stock

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Leaps- difference with conventional option

• Expiration MonthsMay be up to 39 months from
  the date of initial listing, January expiration
  only. Jan/03 Jan/04 Jan/05

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Equity Index FLEX Options

• FLEX options allow users to custom tailor most
  contract terms and enjoy expanded position limits
  for exchange listed Equity and Index options.
  FLEX options offer investment professionals,
  holders of restricted stock, large stockholders,
  corporations and other types of investors the
  newest in risk management instruments, especially
  designed to extend access to customized
  derivative products

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Equity FLEX Product Specifications

• Minimum Size 250 contracts new FLEX
• Expiration Date Any business day up to 3 years
  from trade date excluding 5 business days
  centered on the 3rd Friday.
• Exercise Style American or European.

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References

• www.cboe.com
• www.firsttraders.com
• www.optionsclearing.com
• www.ptidirect.com
• www.keystone-web.com