Series 7

AAA

Derivatives - Trading Options

Listed Options
A listed option is one that trades on an exchange. The most important option exchanges for financial securities are the:


Standardized Option Features and Benefits
You need to remember that the asset underlying an option can be just about anything, and some of the more exotic derivatives will be covered later. For now, the discussion will be confined to stock options trading on the CBOE.

Listed stock options have the benefit of being standardized in terms of the following:

  • number of shares of underlying common stock,
  • delivery dates, and
  • range of exercise prices.

Benefits

  • Standardization allows the exchange to operate efficiently as a secondary market for these options which were strictly a principals-only business until the 1970s.

  • The secondary market provides greater liquidity for options in general and thus greater value for each of the instruments individually.

  • Prices and volumes can be reported more accurately, so the market is transparent.

  • Regulators hold some real oversight power, so all the players can be assured that trading in listed options is a reasonably fair game.

  • Potential Consequences
    • The CBOE is just a place to trade options, not a guarantor that all parties and counterparties will act honorably and play by the rules.
    • As you might guess from the example above, the person who writes an option to sell a $36 stock at $25 might not be happy about it. He might try to renege.
    • This is a risk that one would have to accept to do business in the options market.


The Options Clearing Corporation (OCC)
If a writer breaches contract, the guarantor of all CBOE-traded options - the OCC - will step in. Organizationally independent of the exchange, yet virtually its conjoined twin, the OCC requires option sellers to post margin to guarantee that they will fulfill their contracts.

  • Technically, the OCC is the issuer of all exchange-listed options, so the buyer is insulated from any malfeasance on the part of the seller.
  • In fact, there is more insulation than that. The buyer and seller generally have brokers; these brokers generally work through clearing members who participate directly in trading at the exchange, and the clearing members are the ones who deal directly with the OCC.


Calls and Puts
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