What Is an Escrow Receipt?
The term escrow receipt refers to a bank or clearinghouse statement written to guarantee that an options writer has a sufficient amount of the underlying security available for delivery, should the need arise to complete the requirements of the contract. Sellers (writers) of options are at risk of assignment (having to deliver the security) if the option goes in the money (ITM). Call writers would have to deliver shares to the long while writers of puts would need enough liquid funds to purchase shares put to the long.
- An escrow receipt is a bank or clearing statement that is part of an options contract.
- The escrow receipt guarantees that the option writer has enough of the underlying security to satisfy a potential assignment or to actually deliver the security if the option is exercised.
- An escrow receipt is most often used when a client's options account is held at a bank rather than a registered broker-dealer.
- It may not be needed if the short position isn't assigned, such as if it expires out of the money.
- The escrow receipt must be written in a way that makes it acceptable to the exchange and the Options Clearing Corporation or another similar regulatory body.
Understanding Escrow Receipts
An escrow receipt is a guarantee provided by a bank or clearing firm that certifies an option writer holds enough of the underlying security on deposit and it is readily available for delivery if the holder of that option chooses to exercise it. This ensures that the option holder is able to receive delivery of exercised options on time and without any issues.
This guarantee is commonly used when a client's options account is held at a bank rather than with a registered broker-dealer. The escrow receipt must be written in such a way to be acceptable to the exchange and the Options Clearing Corporation (OCC) or any other similar regulatory body. The use of escrow accounts and receipts provides written evidence and assurance that the securities are available to complete the transaction.
Some institutional clients, such as pensions or insurance companies, maintain their assets at a custodian bank, rather than at a registered broker-dealer. An options exchange's margin rules may allow a broker-dealer to accept an escrow receipt (or escrow agreement) with respect to short options positions, in lieu of posted cash or securities.
Since it only guarantees the potential for delivery, the escrow receipt may never be needed. For instance, if the short options position is never assigned, it expires out of the money (OTM). As such, the escrow receipt will not be invoked.
In options trading, the difference between in the money and out of the money is a matter of the strike price's position relative to the market value of the underlying stock. An ITM option is one with a strike price that has already been surpassed by the current stock price. An OTM option is one that has a strike price that the underlying security has yet to reach.
The term escrow is also associated with other concepts in the financial industry. It is commonly used to describe an agreement in which a third party holds an asset or money for two others until they complete a transaction. The parties involved go into escrow when one party's ability to go through with a transaction is uncertain. You'll generally find escrow in real estate transactions. Funds are placed into an escrow account to guarantee that the buyer will be able to secure financing and/or close on the sale of a piece of real estate.
Examples of Escrow Receipts
An escrow receipt related to a short equity call option states that the option seller's bank promises to deliver the underlying stock to the broker-dealer in the event their customer's account (the long options position) is assigned. For a short equity put option, the bank promises to deliver cash in the amount of the equivalent short stock position.
The OCC also allows banks to write escrow receipts for short index options positions. For a short index call option, the bank promises that it will hold one of the following:
It may also guarantee that it will hold a combination of the three.
The total value of the assets held by the bank must equal the aggregate underlying index value on the trade date. An escrow receipt with respect to a short index put option must be backed by cash or cash equivalents at the bank that equal the aggregate put exercise amount. The escrow receipt must also give the bank the authority to liquidate assets held under the agreement if necessary to meet an assignment.
What Is "In the Money"?
In the money is an expression that refers to an option that possesses intrinsic value as opposed to an out of the money option, which possesses no intrinsic value. ITM indicates that an option has value in a strike price that is favorable in comparison to the prevailing market price of the underlying asset.
An in-the-money call option means the option holder has the opportunity to buy the security below its current market price. An in-the-money put option means the option holder can sell the security above its current market price.
What Does "Out the Money" Mean?
Out of the money means that an option has no intrinsic value because the underlying security has not yet reached the strike price of the option contract. A call option (to buy) is OTM if the underlying price is trading below the strike price of the call. A put option (to sell) is OTM if the underlying security's price is above the put's strike price.
What Is OTM, ATM, and ITM?
OTM, ATM, and ITM all refer to the status of options—specifically, the relationship of the option's strike price (the agreed-upon amount at which the option can be exercised) to the price of the security on which it's based. OTM means out of the money or when the option's strike price isn't better than the underlying security's. ITM means in the money. This happens when the option's strike price is favorable compared to the security's. ATM means at the money or when option's strike price is identical to the current market price of the underlying security