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SECOND CITY OPTIONS: A Case Study on Index Options[1]

Don M. Chance and Michael L. Hemler

(Version: August 30, 2011)

Second City Options (SCO) is a small firm that specializes in option trading. Employing 35 people, SCO is located on LaSalle Street in the Chicago financial district. It is a member firm of the Chicago Board Options Exchange (CBOE), where it trades options on stocks and stock indices. It is also a member firm of the Chicago Mercantile Exchange Group (CME Group), where it trades options on futures and the underlying futures contracts.

SCO trades for itself and a number of corporate and individual clients. In addition, it provides general advice to other clients who trade for themselves. SCO was founded in 1975, two
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Consequently, SCO has significantly upgraded and modernized its computer system. Furthermore, it has hired Carla Shilling, a derivatives specialist who recently graduated from a major Midwestern business school. Her mandate is to improve the firm's trading profits by utilizing her expertise in option valuation.

The Market Outlook

Before making any recommendation regarding strategies, Shilling must finalize her opinion of how the economy and stock market will perform over the next few months. The date is July 2, 2007. Over the last six months the S&P 500 has ranged from 1374.12 to 1539.18, closing at 1503.35 at the end of June. Investors seem worried about an impending credit crunch, even though problems at two Bear Stearns hedge funds that own collateralized debt obligations (CDOs) based on subprime mortgage debt appear to be contained. The economy has slowed with consumer pessimism high, reflecting a weak housing market combined with credit worries. For the last two months personal income has declined after adjusting for inflation. The Federal Reserve has focused on rising inflation. The Federal Open Market Committee, the Fed's policy-setting arm, left interest rates unchanged in its June 27–28 meeting, keeping the Fed funds target level at 5.25% for the ninth time in the past twelve

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