Options Clearing Corporation: Guaranteeing Our Options Trades
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Options were originally traded in the over-the-counter OTC marketwhere the terms of the contract were negotiated. The trading strategies involving options clearinghouse of the OTC market over the exchanges is that the option contracts can be tailored: However, transaction costs are greater and liquidity is less. Option trading really took off when the first listed option exchange—the Chicago Board Options Exchange CBOE —was organized in to trade standardized contracts, greatly increasing the market and liquidity of options.
Most options sold in Europe are traded through electronic exchanges. Other exchanges for options in the United States include: Options are traded just like stocks—the buyer buys at the ask price and the seller sells at the bid price.
However, to trade options, an investor must have a brokerage account and be approved for trading options and must also receive a copy of the booklet Characteristics and Risks of Standardized Options. The option holder, unlike the holder of the underlying stock, has no voting rights in the corporation, and is not entitled to any dividends. Brokerage commissionswhich are a little higher for options than for stocks, must also be paid to buy or sell options, and for the exercise and assignment of option contracts.
Most brokerages offer lower prices to active traders. Here are some examples of how option prices are quoted:. The OCC issues, guarantees, and clears all option trades involving its member firms, which includes all U. The OCC is jointly owned by its member firms — the exchanges that trade options — and issues all trading strategies involving options clearinghouse options, and controls and effects all exercises and assignments.
To provide a liquid market, the OCC guarantees all trades by acting as the other party to all purchases and sales of options. The OCC, like other clearing companies, is the direct participant in every purchase and sale of an option contract. When an option writer or holder sells his contracts to someone else, the OCC serves as an intermediary in the transaction.
The OCC publishes, at optionsclearing. Under its SEC jurisdiction, OCC clears transactions for put and call options on common stocks and other equity issues, stock indexes, foreign currencies, interest rate composites and single-stock futures. When an option holder wants to exercise his option, he must notify his broker of the exercise, and if it is the last trading day for the option, the broker must be notified before the exercise cut-off timewhich will probably be earlier than on trading days before the last day, and the cut-off time may be different for different option classes or for index options.
Trading strategies involving options clearinghouse policies differ among brokerages, it is the duty of the option holder to notify his broker to exercise the option before the cut-off time. When the broker is notified, then the exercise instructions are sent to the OCC, which trading strategies involving options clearinghouse assigns the exercise to one of its Clearing Members who are short in the same option series as is being exercised.
The Clearing Member will then assign the exercise to one of its customers who is short in the option. The customer is selected by a specific procedure, usually on a first-in, first-out basis, or some other fair procedure approved by the exchanges.
Thus, there is no direct connection between an option writer and a buyer. To ensure contract performance, option writers are required to post margin, the amount depending on how much the option is in the money. If the margin is deemed insufficient, then the option writer will be subjected to a margin call. Option holders don't need to post margin because they will only exercise the option if it is in the money.
Options, unlike stocks, cannot trading strategies involving options clearinghouse bought on margin. Because the OCC is always a party to an option transaction, an option writer can close out his position by buying the same contract back, even while the contract buyer retains his position, because the OCC draws from a pool of contracts that have no connection to the original contract writer and buyer.
The OCC buys the contract, adding it to the millions of other option contracts in its pool. Sarah Call-Buyer buys a contract that has the same terms that John Call-Writer wrote—in other words, it belongs to the same option series. However, option contracts have no name on them. She instructs her broker to exercise trading strategies involving options clearinghouse call; her broker forwards the instructions to the OCC, which then assigns the exercise to one of its participating members who provided the call for sale; the participating member, in turn, assigns it to an investor who wrote such a call; in this case, it happened to be Trading strategies involving options clearinghouse brother, Sam Call-Writer.
John got lucky this time. Sam, unfortunately, either has to turn over his appreciated shares of Microsoft, or he'll have to buy them in the open market to provide them. This is the risk that an option writer has to take—an option writer never knows when he'll be assigned an exercise when the option is in the money. John Call-Writer decides that Microsoft might climb higher in the trading strategies involving options clearinghouse months, and so decides to close out his short position by buying a call contract with the same terms that he wrote—one that is in the same option series.
Sarah, on the other hand, decides to maintain her long position by keeping her call contract until April. This can happen because there are no names on the option contracts. John closes his short position by buying the call back from the OCC at the current market price, which may be higher or lower than what he paid, resulting in either a profit or a loss.
Sarah can trading strategies involving options clearinghouse her contract because when she sells or exercises her contract, it will be with the OCC, not with John, and Sarah can be sure that the OCC will fulfill the terms of the contract if she should decide to exercise it later on.
When the assigned option writer must deliver stock, she can deliver stock already owned, buy it on the market for delivery, or ask her broker to go short on the stock and deliver the borrowed shares. However, finding trading strategies involving options clearinghouse shares to short may not always be possible, so this method may not be available. If the assigned call writer buys the stock in the market for delivery, the writer only needs the cash in his brokerage account to pay for the difference between what the stock cost and the strike price of the call, since the writer will immediately receive cash from the call holder for the strike price.
Similarly, if the writer is using margin, then the margin requirements apply only to the difference between the purchase price and the strike price of the option. Full margin requirements, however, apply to shorted stock. An assigned put writer will need either the cash or the margin to buy the stock at the strike price, even if he intends to sell the stock immediately after the exercise of the put. When the call holder exercises, he can keep the stock or immediately sell it.
However, he must have the margin, if he has a margin account, or cash, for a cash account, to pay for the stock, even if he sells it immediately. He can also use the delivered stock to cover a short in the stock. Both the exercise and assignment incur brokerage commissions for both holder and assigned writer. Generally, the commission is smaller to sell the option than it is to exercise it.
However, there may be no choice if it is the last day of trading before expiration. Often, a writer will want to cover his short by buying the written option back on the open market. However, once he receives an assignment, then it is too late to cover his short position by closing the position with a purchase.
Assignment is usually selected from writers who are still short at the end of the trading day. A possible assignment can be anticipated if the option is in the money at expiration, the option is trading at a discount, or the underlying stock is about to pay a large dividend.
A customer may not want to exercise an option that is only slightly in the money if the transaction costs would be greater than the net from the exercise. In spite of trading strategies involving options clearinghouse automatic exercise by the OCC, the option holder should notify his broker by the exercise cut-off timewhich may be before the end of the trading day, of an intention to exercise.
Exact procedures will depend on the broker. Any option that is sold on the last trading day before expiration would likely be bought by a market maker. Because a market maker's transaction costs are lower than for retail customers, a trading strategies involving options clearinghouse maker may exercise an option even if it is only a few cents in the money.
Thus, any option writer who does not want to be assigned should close out his position trading strategies involving options clearinghouse expiration day if there is any chance that it will be in the money even by a few pennies.
Sometimes, an option will be exercised before its expiration day—called early exerciseor premature exercise. Because options have a time value in addition to intrinsic value, most options are not exercised early.
However, there is nothing to prevent someone from exercising an option, even trading strategies involving options clearinghouse it is not profitable to do so, and sometimes it does occur, which is why anyone who is short an option should expect the possibility of being assigned early. When an option is trading below parity below its intrinsic valuethen arbitrageurs can take advantage of the discount to profit from the difference, because their transaction costs are very low. An option with a high intrinsic value will have very little time value, and so, because of the difference between supply and demand in the market at any given moment, the option could be trading for less than its true worth.
An arbitrageur will almost certainly take advantage of the price discrepancy for an instant profit. Anyone who is short an option trading strategies involving options clearinghouse a high intrinsic value should expect a good possibility of being assigned an exercise.
Option discounts will only occur when the time value of the option is small, because either it is deep in the money or the option will soon expire. When a large dividend is paid by the underlying trading strategies involving options clearinghouse, its price drops on the ex-dividend date, resulting in a lower value for the calls.
The stock price may remain lower after the payment, because the dividend payment lowers the book value of the company. This causes many call holders to either exercise early to collect the dividend, or to sell the call before trading strategies involving options clearinghouse drop in stock price. When many call holders sell at the same time, it causes the call to sell at a discount to the underlying, thereby creating opportunities for trading strategies involving options clearinghouse to profit from the price difference.
However, there is some risk that the transaction will lose money, because the dividend payment and drop in stock price may not equal the premium paid for the call, even if the dividend is more than the time value of the call. So an arbitrageur decides to buy the call and exercise it to collect the dividend. It might be profitable if the stock does not drop as much on the trading strategies involving options clearinghouse or it recovers after the ex-date sufficiently to make it profitable.
But this is a risk for the arbitrageur, and this transaction is, thus, known as risk arbitragebecause the profit is not guaranteed. Even though this statistic is more than a decade old, it is still representative of the fate of options.
All option writers who didn't close out their position earlier by buying an offsetting contract made the maximum profit—the premium—on those contracts that expired. Option writers have lost at least something when the option is exercised, because the option holder wouldn't exercise it unless it was in the money. The more the exercised option was in the money, the greater the loss is for the assigned option writer and the greater the profits for the option holder.
A closed out transaction could be at a profit or a loss for both holders and writers of options, but closing out a transaction is usually done either to maximize profits or to minimize losses, based on trading strategies involving options clearinghouse changes in the price of the underlying security until expiration.
Scenario 2—Closing Out an Option Position by Buying Back the Contract John Call-Writer decides that Trading strategies involving options clearinghouse might climb higher in the coming months, and so decides to close out his short position by buying a call contract with the same terms that he wrote—one that is in the same option series.
Thus, the OCC allows each investor to act independently of the other.