JOHANNESBURG STOCK EXCHANGEEquity Options

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Options Explained

Three main types of futures

You can trade options on the JSE's Equity Derivativesmarket that are based on three main types of futures:

Single Stock Futures

Index Futures

Can-Do Futures

are futures contracts. Onefutures contract is usually based on 100 underlyingshares (also called a nominal of 100). These contractscan be physically settled or cash settled meaning thatthe buyer will either buy the agreed shares at theagreed price on expiry or just receive the equivalentamount in cash without taking delivery of theunderlying shares.

An is based on a basket of shares. Themost traded contract on SAFEX is the ALSI contractwhich is based on the FTSE/JSE TOP40 Index orTOPI. It is always cash settled with a nominal value ofR10 per point movement.

are options based on customisedbaskets or non-standardised futures.

Mathematical modelling of financial markets can betraced back to Louis Bachelier's 1900 dissertation onspeculation in the Paris markets. Financial economics,however, only came of age in 1973 with the publicationof the preference-free option pricing formula by FischerBlack, Myron Scholes and Robert Merton. Their modelestablished the everyday use of mathematical modelsas essential tools in the world of finance, both in theclassroom and on the trading floor.

The Black-Scholes option valuation formula wasdeveloped as an attempt to determine the faireconomic value of an option for both buyer and seller,that is, to determine at what price (exclusive ofcommissions) both a buyer and seller would break

Single Stock Futures

Index Future

Can-Do Options

The Black-Scholes model for option pricing

SAFEX Options are future style options, based on the Chicago Mercantile Exchange (CME) model. The option is

therefore based on the futures contract and the premium is paid over the life of the option. These concepts are

explained in this brochure; which is aimed at investors who know the basics of options, and are looking to further their

understanding of SAFEX Options. For a beginner’s look at options, please refer to Part 1 in this series, titled: A Brief

Introduction to Options.

Futures

SAFEX Options are based on Futures. SAFEX Optionsare based on Equity Futures contracts, which mean thatthe purchaser of the equity option buys the right but notthe obligation to buy or sell an equity future and not theshare on the JSE. By owning the Future, the purchaserwill ultimately be able to buy or sell the physical share.

A futures contract is an agreement between two partiesto buy or sell an asset at a certain time in the future for apredetermined price. The pricing of a futures contract isbased on what it would cost to buy the underlying assettoday and holding that asset until the contract expires.The cost of holding the asset is called the carry cost.Futures that are traded on an exchange are marginedand standardised.

When trading in futures contracts there are two positionsthat an investor can take:

Long Position – Go Long – Buy Future

Short Position – Go Short – Sell Future

When you 'go long' you are buying exposure to theunderlying share because you believe the price of theunderlying share will increase. If it does so by the timethe contract expires (or before the contract expires) youwill realise a profit. If you are long (bought) the futurescontract the seller will pay you for each day's increase ofthe underlying share, and vice versa.

You will 'go short' if you believe the price of theunderlying share will decrease, thereby realising a profitif the futures price goes down over the life of thecontract. If you are short (sold) the futures contract, thelong holder will pay each time the price decreases, andvice versa.

At the expiry of the contract you will pay the market priceof the future which is that day's spot price. Because youhave received the net difference between the openingprice of the contract and the expiry price ofthe contract, the economic effect is as if you had boughtthe underlying equities at the initial price.

Part 2 in a series of Options brochures, brought to you by the JSE.

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even on the option (and thus lose only theircommissions). It uses probability theory, discountedcash flows, and expected value calculations. While theBlack-Scholes model does not perfectly describe real-world options markets, it is a popular model and is oftenused in the valuation and trading of options.

One fact we constantly have to remember is that theBlack-Scholes model is just a model, an abstraction ofreality. Modelling, however, is not merely a collection oftechniques but an art in blending the relevant aspectsof a problem and its unforeseen consequences with adescriptive and useful mathematical methodology.Building and analysing models are important inunderstanding and pricing financial instruments.

How should the Black-Scholes model then be used? Agood start is to comprehend its limitations andapplicability to the case at hand. By consideringpracticalities like transaction costs, liquidity andfrequency of hedging, we will be guided on how tooverlay these problems onto the actual bare-bonesprice of the model and decide whether that's a price wecan live with. Trading with a model is definitely not thesimple and clinical procedure many people imagine.

Let's look at the Black-Scholes environment createdwhen the formula was developed. They assumed:

stock prices diffuse through timelinearly proportional to the spot price i.e. constantvolatility. The price in the future is unpredictable but willmost likely be close to some mean or expected value.

markets areliquid, have price-continuity, are fair, are complete andall players have equal access to information

they requireno compensation for taking risk. There are no arbitrageopportunities and the expected return is the risk-freeinterest rate. This was perhaps their most importantinsight leading them to construct a self-financingriskless hedge: in a portfolio of three securities (anoption, the underlying stock and a riskless moneymarket security) any two could be used to exactlyreplicate the third by using a trading strategy.

The underlying stock price follows a continuousrandom walk –

The efficient market hypothesis holds –

Investors live in a risk-neutral world –

Delta hedging is done continuously –

F/ K

for the returnon the hedge portfolio to remain riskless, the portfoliomust continuously be adjusted as the asset pricechanges over time.

Now, let F be the futures price and K the strike price ofan option. We assume the option expires after a timeinterval T. At expiration (at close-out) an option isalways worth its intrinsic value given by

SAFEX Options are based on futures. We thus makeuse of the so-called Modified Black Formula tocalculate the premium thereof. The formula is used tocalculate the value of the options each night whichforms the basis to the premium variation margin.

The Black Formula is

with

Here we use a binary variable such that ø = 1 for acall and ø = -1 for a put. The quantity N(øx) is calledthe “Standard Cumulative Normal Distribution”.

This quantity can be calculated using the Excelfunction 1n and is called the moneyness of theoption. It shows how much the option is in-the-moneyor out-the-money. The volatility is represented by thevariable .

A modified Black calculator is freely available in theCalculators Section of the SAFEX Options webpage:http://www.safex.co.za/ed/options.asp

σ

V(T) = [F – K,0]call max

put [F – K,0]max

V = ø [F N(øx) – K N(øy)]

x =

y = x –

11n + T

K 2

F2

T

T

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Initial margin

The role of the exchange is to organise trading so thatoption contract defaults are avoided. The exchangetherefore requires from each option participant anamount of money at the time the option contract isentered, known as the initial margin. The initial margin isdetermined by considering the possible risk of loss onthe option position(s) over a one day period. Given thatany option is mainly sensitive to the underlying priceand its volatility, the initial margin calculation involvesstress testing the underlying price and volatility.

Stress testing the underlying volatility and price is amethod of estimating the risk of loss on the optionposition(s) under some of the most extreme historicalunderlying market movements. The worst casescenario is the underlying price volatility stress test thatincurred the biggest option position(s) loss, and this lossamount is taken as the initial margin.

The Initial Margin Requirements (IMR) for SAFEXOptions is calculated on a daily basis by using amethodology that creates 18 scenarios. These 18scenarios are used to create risk arrays which are tablessetting out the maximum likely loss for both the buyerand the seller of the option. Below is a description of howthese risk-arrays are created.

At the end of each trading day, the Exchangeindependently calculates a fair value (or closingprice) for each contract. This is known as the Marked-to-Market (MtM) price. The 18 scenarios arecalculated using 9 Futures Prices (1 Marked-to-Market, 4 Higher and 4 Lower). This range of 9Futures Prices is calculated by taking the JSE'spublished Fixed Initial Margin per Futures contractinto account.

The range of 9 values is the MtM price plus or minusthe Fixed Initial Margin per Contract in 25% intervalsup to 100% positive and 100% negative. This isknown as the Price Range.

For the seller of the option, a set of 9 higher volatilitiesare used to generate the worst case scenario and forthe buyer of the option a set of 9 lower volatilities willbe used. The set of 18 volatilities are calculated usingthe RPVE and VSR.

The 9 Futures Prices and volatility combinations arethen put through the Modified Black Option Pricingformula. This generates 9 upper volatility scenariosand 9 lower volatility scenarios.

The worst case scenario e.g., the maximum loss ofthe upper volatility scenario gives the IMR for theseller and maximum loss of the lower volatilityscenario gives the IMR for the buyer.

Range Price Volatility Effect (RPVE): The RPVEmeasures the effect that a large price movement willhave on volatilities.

Volatility Scanning Range (VSR): This refers to themaximum increase or decrease in the volatility used todetermine the volatility scenarios. A full list of the VSRvalues associated with the different SAFEX Optionscan be found at the following URL: http://www.safex.co.za/pub/margin_requirements/

The initial margin is set such that any one day marketchange will be covered by the initial margin 99.95%(3.5 standard deviations) of the time. This means thereis only a 0.05% chance that the initial margin will not beenough to cover losses. The JSE's initial margincalculator is a web-based application linking andretrieving accurate data from the JSE's Productiondatabase. It allows you to add multiple positions ondifferent underlyings, and provides you with the at-the-money Futures price and Volatility for that instrument.This calculator can be used for Options and Futures.Required inputs are: Instrument, type (call, put, future),number of contracts, expiry, and strike. Greeks (delta,gamma, theta, vega) are calculated and displayed foreach position. You may manually input a volatility, oruse the one inferred by the system. This calculator willalso calculate the premium of your option. Offsetsbetween different positions are included in thecalculations.

An initial margin calculator is freely available in theCalculators section of the SAFEX Options webpage:http://www.safex.co.za/ed/options.asp

The full margining specifications are published on thefollowing URL: http://www.safex.co.za/ed/margining_methodology.asp

Please refer to the cash flow section in this documentfor an example of the initial margin calculation.

Options Explained

The prices of deep in-the-money options and deep out-the-money options are relatively insensitive tovolatility. This is because deep in-the-money and deepout-the-money option prices are nearly equal to theirintrinsic values. At-the-money options are verysensitive to changes in volatility.

ATM volatility refers to the volatility level for an optionstrike price which is equal to the underlying futuresprice.

At-the-money (ATM) Volatility

Volatility

The most important parameter of any option pricingmodel is the volatility of the underlying security. In fact,the price of an option is basically the intrinsic valueweighted by probabilities that strongly depend on thevolatility. We will discuss two types of volatility –historical and implied volatility.

The historic volatility of the underlying price is astatistical measure of the dispersion of the underlyinghistoric price returns about a central tendency. In otherwords, suppose we have a time series of prices

, we can obtain n logarithmic price returns denotedby such that

The volatility is then defined as the standard deviationof the time series. Mathematically the volatility isdefined by

Where is the mean or average of the time series, h

is an annualisation factor, and is the number ofobservations. If one has daily data, ; if one hasweekly data, and if the data is monthly data, then

. .

The implied volatility is the volatility implied by themarket prices of options. If one knew the optionpremium, one can use the Modified Black formula toback out the volatility that is deemed the impliedvolatility.

This volatility is interesting to option participantsbecause it can be used to monitor the market opinionabout the volatility of the underlying.

n+1

F i

u

u

n

h = 252

h = 52

h = 12

i

iũ

Historical volatility

Implied volatility

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u =i 1nFi-1

Fi

=n – 1

1( – )u ui

2

h~*

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Options Explained

Single Stock Options (SSOs)

On a daily basis, SAFEX attempts to calculate a newATM volatility for all Single Stock Options by manuallyapplying the following methodologies:

For Single Stock Options, SAFEX estimates a termstructure based on trades. Generally, a normal termstructure is assumed i.e. downward sloping as shownin the example below (37, 35, 33, 32). However ifthere is an inverse term structure trading e.g. JUN2010 higher than DEC 2009, SAFEX will move thevolatility into line with traded levels.

If the option trades during the day, the JSE marksthe volatility to market.

average volatility up by 8% to 55%, SAFEX willgradually move the implied volatility up by 1% perday to 45% over the 8 next trading days. However ifa trade occurs at a volatility of 42% before thechange is complete, the system locks in a newrelationship between historic and implied volatilitiesof -13%.

Most of the time SAFEX ATM Volatility is an estimate

based on traded data. However when an overdue

volatility adjustment is made, SAFEX endeavours to

move the volatilities at about a maximum of 5% a day to

limit large capital calls. If there is no open interest in a

particular expiry, SAFEX will use wherever it traded

with a once off adjustment- e.g. can move it 15% as no

open interest is affected and there is a market there.

The above methodologies are applied in the sequencelisted above, i.e. if a new ATM volatility could not becalculated using point 1, SAFEX would revert to point 2.

Thus if the near (June in this example) contract movesup (based on traded data), SAFEX will move up theother expiries in line.

If there are no trades on a particular day, arelationship between implied and historicalvolatility is locked in and maintained until there isa trade.

SAFEX makes use of a smoothed historical volatility-90 day volatility averaged over 120 days. Therelationship between the historic and the impliedvolatility is then examined. If the historic volatilityaverage on AGLQ is 47% but traded volatility is 37%,a relationship of 10% beneath the historic volatilitynumber is locked in. The system will then move theimplied volatility up or down based on the historicvolatility movement; at a maximum of 1% per day. Inpractice, if Anglo American scraps their dividend andthe share price plummets taking the historical

Anglo American PLC Spot Price Futures Price Bid Offer New Vol Current Vol(AGLQ)

37.00

35.00

33.00

32.00

17 Dec 2009 263.00 266.18 266.18 266.18 38.00

18 Mar 2010 263.00 266.58 266.58 266.58 36.00

17 Jun 2010 263.00 271.40 271.40 271.40 34.00

06 Sep 2010 263.00 274.23 274.23 274.23 33.00

Figure 1: Excerpt from the MtM spreadsheet published daily at the following URL: www.safex.co.za/pub/mtmdata

Indices

On a daily basis, SAFEX calculates ATM volatilities for all index options by applying the process below:

For ATM volatilities of indices, SAFEX makes use of a sticky strike skew. This volatility skew consists of 9 strikes (the

middle one being ATM) on the x-axis and volatility on the y-axis. A sticky delta skew is then created, with moneyness

on the x-axis and relative volatility on the y-axis. Between 17h00 and 17h05 daily, the JSE calculates the ALSI MtM

futures price. This futures price is used as the ATM strike. Using the ATM strike, the system returns the corresponding

ATM volatility from the sticky strike skew. The relative volatility in the sticky delta skew then enables the system to

recalculate the new volatility for each strike.

The relative volatility is the difference in volatility from the ATM volatility and is obtained by taking “volatility of strike –

ATM volatility”. The relative volatility of the ATM strike is 0%.

This results in a parallel shift of the entire skew (either up or down). The following examples illustrate this process:

For example if the ALSI ATM volatility moves from, say 30% to 29% we calculate the new volatility for each strike with

the following formula: New volatility = New ATM volatility + Relative Volatility of that strike. For a strike with moneyness

of 95% and relative volatility of 2%, the New Volatility = 29% + 2% = 31%.

• Relative volatility = Volatility of strike – ATM Volatility• If ATM volatility moves from 30% to 29%

New volatility = New ATM + Relative volatility• Net result: skew has moved down by 1%

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ALSI Volatility Skew Example

25 000

0%

5%

10%

15%

20%

25%

45%

40%

35%

30%

24 000 23 000 22 000 21 000 20 000 19 000 18 000 17 000

Vola

tility

Strike

Strikes Newvolatility

21 000 29%

25 000 39%

24 000 37%

23 000 35%

22 000 31%

20 000 26%

19 000 24%

18 000 21%

17 000 19%

Strikes Volatility Moneyness Relativevolatility

21 000 30%

25 000 40% 84% 10%

24 000 38% 88% 8%

23 000 36% 91% 6%

22 000 32% 95% 2%

100% 0%

20 000 27% 105% -3%

19 000 25% 111% -5%

18 000 22% 117% -8%

17 000 20% 124% -10%

Volatility Skew

Since the market crash of 1987 the demand for out-the-money cheap puts has always exceeded the demandfor out-the-money cheap calls. For this reason, out-the-money puts trade at higher implied volatilities than out-the-money calls. This inverse relationship between theimplied volatilities and strikes is called the volatilityskew. The volatility skew is a downward sloping curvewith inflection point being the at-the-money volatility asshown in Figure 2.

A market related volatility surface is crucial to accuratelydetermine option values. The official SAFEX volatilitysurfaces for options on the ALSI, DTOP and FNDI ispublished on a monthly basis at the following URL:http://www.safex.co.za/pub/mtmdata/Vol Skew Indices/

Previously, SAFEX polled the market on a monthlybasis in order to calculate an averaged volatility skew forIndex Options. With the introduction of the NutronTrading System in August 2008, volatility became acompulsory field when trading on SAFEX.

After investigating several approaches and consultingwith international experts on how to use the tradedvolatilities, a deterministic volatility framework waspostulated and tested and found to be the appropriatemodel for the South African index options market.Deterministic volatility models are models requiring noassumptions about the dynamics (statistical behaviour)of the underlying asset generating the volatility e.g., it isnot dependent on the underlying index being driven by astochastic process. Other benefits of modelling thevolatility skew as a deterministic process are:

ALSI 40 Volatility Skew

30%

0%

10%

20%

30%

40%

50%

60%Figure 2

50% 70% 90% 110% 130% 150% 170%

Vola

tility

Moneyness

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that we can model volatility separately in expiry timeand strike. This means that each expiry's skew isindependently calibrated minimising compoundingerrors across expiries. This property is useful inmodelling volatility surfaces in illiquid markets.

the no-spread-arbitrage market condition ispreserved.

The deterministic approach in modelling the volatilitysurface evolved from studying the dynamics of thevolatility surface. Researchers found that thedynamics of the volatility skew for index options (for theFTSE100 and S&P500 options) is driven mainly bythree factors: parallel shifts, tilts, and curvature. Theyalso found that many conventional parameterisationsof volatility surfaces are quadratic. These models arewidely used by market players as they are based on thedata without too many biased assumptions. They arealso simple to replicate and implement compared tosome of the stochastic models we examined and thusmore robust to changing market conditions.

The ALSI options market can be very illiquid at timeswith few, if any, at-the-money trades. The market iseven more illiquid in long-term option trades.

The sparseness of market data makes the volatilitycalibration prone to significant model errors. This holdsespecially if the market implied skew and the termstructures are estimated jointly with the risk of errorsbeing compounded. In this light, the deterministicmodel is appropriate as it models the volatility surfaceseparately in skews (strikes) and in term structures(expiry times). This approach is suitable for modellingvolatility surfaces using sparse option trades, becauseit indirectly accommodates for the fact that therelationship of volatility on the strikes and through timecan change independently with different statisticalerrors.

The ALSI volatility surface is obtained by firstlycleaning the input data and secondly by performing acalibration (optimization) of the deterministic functionalform – a simple way to put this is drawing a line of bestfit through the traded data points. The statistical errorsassociated with the skew calibration are usually lessthan 1.5%. The model developed to construct themarket volatility surface, is a volatility model that isconsistent with the general dynamics of the surface,and it captures the volatilities traded in the market withaccuracies to within 1.5%. See Figure 3.

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Options Explained

Figure 2: ALSI volatility skew.

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The relative/floating (moneyness) volatility skews arethen calculated. The at-the-money volatility termstructure is determined as a mean reverting process.The statistical errors with the term structure calibrationusually differ by no more than 2% from the polled data,as shown in Figure 4. Essentially this means themodelled and polled skews were found to be verysimilar.

It is a well-known fact that volatility surfaces generatedfrom models need to be stable in order to achievereliable valuations and sound risk managementcalculations. In this light, the deterministic volatilitymodel parameters are constrained and it can be shownthat these parameters are unique. In order to keep thewings from vibrating, an exponentially weightedmoving average is used over the last couple of days.

ALSI Top 40 Model and Traded Vols

ATM Term Structure

0%

-2

0%

19%

10%

21%

20%

23%

30%

25%

40%

27%

50%

29%

31%

60%

33%

Figure 3: ALSI model volatility skew. The average error(market-model volatilities) is 0.26%.

Figure 4: An example of the ALSI volatility model and SAFEX polledat-the-money term structure, with an average error of 0.28%.

50%

3 8

100%

13 18

150%

23

200%

28

Vola

tility

Vola

tility

Moneyness

Months to Expiry

Model

SAFEXModel

Traded

More detailed information is contained in the document“Generating a South African volatility surface” that canbe found on the Options webpage: www.safex.co.za/ed/options.asp

Currently Single Stock Options on the JSE don't havevolatility skews. As a result, both in the money and outthe money options are valued at the same volatility.SAFEX is currently testing models for creating volatilityskews on single stock options.

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Cash flow example

The following example indicates the cash flows for aone year in-the-money call option. It illustrates how thepremium of the option is paid over the life of the optionand also how the initial margin changes (initial variationmargin) as the value of the option changes (in or out-the-money).

SAFEX will calculate the value (premium) and initialmargin of the options on a daily basis and as a resultthere might be daily cash flows. The example alsoindicates that when you add up all the cash flows overthe contract term, it will add up to the original agreedpremium.

In the call option example on page 10, the buyer of theoption received the right, but not the obligation, to buyone futures contract in an underlying company forR100 in one year's time. On the date of the agreement(trade date) the futures price of the underlying share istrading at R100.

The seller agreed to sell this right to the buyer at apremium of R1,350. Remember that SAFEX Optionsare based on a Future contract and that the nominal(number of shares) of a Single Stock Future contract isusually equal to 100 shares of the underlying.

Options Explained

Closeout price and process

A futures closeout is the day on which all futures andoptions for that term will expire. On closeout day thefutures price must converge with the equity spot or cashmarket as that is where final hedging will take place.When the closing price for future contracts have beencalculated all the futures for that expiry cease to exist.They are then booked the next day by SAFEX asreported trades at the closeout price as trades thathappened the previous day. For example if Stock XYZ'scloseout price was R120 per share at the closeout, itwould be booked the next day as a reported tradebetween the delivering and receiving parties of thefutures contracts as a trade between their nominatedcash/spot equity brokers. If the option ended in-the-money, the call option holder would receive a long futureand the put option holder would receive a short future.

The closeout prices for Indices and for Single StockFutures index constituents are based on an average of100 trades that have taken place in the underlyingequities market. SAFEX uses the last traded price perminute over 100 minutes between 12h01 and 13h40 onthe third Thursday of March, June, September andDecember. The 100 equity trades are averaged and thataverage price for all the constituents is then used tocalculate the index value for that particular expiry.

SAFEX publishes the closeout prices of the indexusually at or just before 2pm. If the underlying SingleStock Future is not a constituent of a Futures Indexlisted on SAFEX, it will close out at that day's equityclosing price.

From the time the closeout prices arepublished, all option holders (buyers) have 20 minutesto exercise or abandon options that would not beautomatically exercised by the exchange.

The exchange will automatically exercise all options thatare 1 cent or greater in the money unless you abandonyour option within this 20 minute period. If your optionexpires slightly out the money and you would still like toexercise it, you must also do so within the 20 minuteperiod.

In the days leading up to and on closeout day, theExchange publishes the live minute-by-minutecalculations in the Calculators section of the optionswebpage: http://www.safex.co.za/ed/options.asp

20 minute rule:

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Date Option Futures Vol Closing Buyer Seller Buyer Seller Buyer Seller Buyer SellerTrade Price Prem Prem Prem Initial Initial Initial Initial Cash CashPrem (MtM) Var Var Margin Margin Var Var Flows Flows

Margin Margin Margin Margin

Trade Date 1,350 100 35 1,350 0 0 600 800(2009/03/17)

3 Months 106 34 1,500 700 850Later(2009/06/17)

6 Months 115 32 1,900 800 960Later(2009/09/17)

9 Months 117 31 1,830 830 980Later(2009/12/17)

12 Months N/A 120 30 0 0 0Later –Close out(2010/03/17)

Total 0 0

-600 -800 -600 -800

-150 -100 -50 -200

-400 -100 -110 -510

-70 -30 -20 -100

-1,830 -1,000

-1,350 -1,350

150 50

400 300

70 50

1,830 830 980 2,810

1,350 1,350

Figure 5: Cash flow table

Cash flow example explained

Date

Option trade premium

Futures price

Exchange traded derivatives are valued on theexchange on a daily basis which might result in dailycash flows. To keep the example simple and clearwe've calculated snapshot cash flows every threemonths as opposed to daily.

This premium is the price the buyer agreed to pay theseller in order to obtain the right without the obligation.This price is the original premium agreed to by thebuyer and seller.

As SAFEX Options are Future Style Options, theunderlying security of the option will always be afuture contract. This column indicates the price of theunderlying future contract at every three monthsnapshot.

Volatility

Closing premium (M-t-M)

Margin

This column refers to the implied volatility calculated/maintained by SAFEX as explained in the ATMVolatility section of this brochure.

During the end-of-day Marked-to-Model process, theJSE calculates the closing premium by using themodified Black options valuation formula.

Options are margined to reduce the risk of default. Byhaving to pay the gains or losses each day the financialrisks are greatly reduced as the cash-flows are smallerand more manageable. The risks are further mitigatedby a process called “Novation” where the clearinghouse becomes the counterparty to every trade anduses its financial assets to guarantee each trade. TheJSE's futures clearing house is called SAFCOM. Thereare three types of margin associated with options forthe buyer and seller: premium variation margin, initialmargin and initial variation margin.

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Options Explained

Buyer/seller premium variation margin

This refers to the cash flow premiums paid or receivedby the counterparties to the option transaction each day.Each night, SAFEX calculates the value of the positionusing the Modified Black Option pricing formula. This isessentially an estimate of what the position is worthevery day. For example, a rise or a fall in the price of theunderlying future will cause the option to be worth moreor less on the day.

The counterparties will therefore either pay or receivepremium variation margin. The total premium variationmargin at the end of the contract will add up to theoriginally agreed premium of the option. Premiumvariation margin is the difference between every day'sclosing premium (marked-to-model). If the premiumgoes up from day one to day two the buyer's option isworth more and he will therefore receive the differencein premium from the seller. If the premium goes down,the buyer's option is worth less and as a result he willhave to pay the difference in premium to the seller.

Buyer/seller initial margin

This is a deposit which is calculated by the exchange'sestimate of the maximum one day's loss and is used toreduce the risk of default. Both the buyer and seller arerequired to deposit initial margin.

It is also sometimes referred to as a performance bondor a good faith deposit. Participants will earn acompetitive interest rate on it and it will be returnedupon the expiry or closure of the contract.

Unlike futures, options' initial margins are recalculatedand adjusted daily by the exchange.

A Portfolio Initial Margin calculator for Futures andOptions is available in the Calculators Section of theSAFEX Options webpage: http://www.safex.co.za/ed/options.asp.

Note: This initial margin calculator includes offsets.

Figure 6: Screenshot of portfolio options initial margin calculator

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If the option was based on a physical delivered future, the buyer of the call option will have to go the next day into theunderlying equity market and buy the physical 100 shares in the spot market at the closeout price of R120 per share.This is achieved with a trade report that has a trade type of OX. His profit will therefore be the profit from the future lesspremium paid for option (R2,000 – R1,350) = Overall Profit of R650 or a profit of R6.50 per share.

Date Future Closeout Variation Buyer SellerTrade Price Margin Cash CashPrice (MtM) Flows Flows

Close out 100.00 120.00 2,000.00 2,000.00 2,000.00

(2010/03/17)

The example's expiry explained

It's important to note that on the expiry date of theoption the option's premium will be made zero as it isworthless on this day. If the option buyer decides hewants to exercise his right he will receive a futurecontract at the agreed strike price.

If we go back to our example, on closeout the optionholder (buyer) will exercise his option as it is deep inthe money.

As a result he will receive a future at the strike price ofR100. That night the option holder is nowa future holder and as a result will receive R2,000((R120 – R100) X 100) variation margin during the endof day future's M-t-M process as indicated in the tablebelow.

Buyer/seller initial variation margin

Buyer/seller cash flows

This is the difference between every day's buyer andseller's initial margin calculation. If the initial margingoes up from day one to day two the buyer or sellerneeds to pay in more initial margin to the exchange.If the initial margin goes down from day one to day twothe buyer or seller will receive initial margin back fromthe exchange.

This column indicates the net economic effect of thebuyer/seller premium variation margin and thebuyer/seller initial variation margin columns. It alsoindicates that when you add up all the cash flows it willadd up to the original agreed premium which the buyeragreed to pay the seller.

Figure 7: Cash flow example – closeout

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Options Explained

Contact information

For additional information contact:

Tel: +2711 520 7000

Email: options@jse.co.za

www.jse.co.za

JSE Limited – Derivatives Trading Division

Summary of references to the web

SAFEX Equity Options Homepage http://www.safex.co.za/ed/options.asp with links to:

• ATM Volatility Guidelines

• Generating a South African volatility surface

• JSE Modified Black Calculator

• JSE Portfolio Initial Margin Calculator

• Booking Fees Calculator

• Minute-by-minute Futures Close Out Results

Brochures: • A brief introduction to options

• Option Trading Strategies

• The Option Greeks

Contract specific Initial Margin Requirements http://www.safex.co.za/pub/margin_requirements/

JSE Equity Derivative market daily Futures / http://www.safex.co.za/PUB/mtmdata/MTM%20All.xls

Options MtM and ATM Vol Stats:

JSE Equity Derivative market daily Futures / http://www.safex.co.za/pub/EdmStats/

Options MtM and Volatility Stats

SAFEX full margining specifications http://www.safex.co.za/ed/margining_methodology.asp

SAFEX Broker/Member list http://www.safex.co.za/ed/list_members.asp

SAFEX booking fees http://www.safex.co.za/ed/docs/trading_info/Booking%20Fees.xls

Can-Do brochure http://www.jse.co.za/cdo/brochure.jsp

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Compiled: November 2009.