Like most securities we’ve discussed, options contracts are issued and then traded between investors in the secondary market. Options markets have a few unique features, especially around who issues contracts and how trades are cleared. This chapter explains how issuance and secondary market trading generally work.
Normally, the issuer of a security is the organization directly tied to that security. Options are different: there is only one issuer for listed options - the Options Clearing Corporation (OCC). The OCC is responsible for issuing options, standardizing contracts, and guaranteeing performance.
Regardless of who issued the underlying security, options are always issued by the OCC. For example, the OCC issues a McDonald’s Corp. (ticker: MCD) stock option - not McDonald’s. In other words, the OCC creates the standardized contract terms, and then investors trade those contracts in the secondary market.
Each option contract is standardized, which makes trading much easier. Later in this unit, you’ll learn the specific standardized terms options use. If contracts were customizable, trading would be much harder because every buyer and seller would have to negotiate (and verify) different contract details. You’d spend more time reviewing contract specifications than analyzing the underlying security.
The OCC also guarantees option performance, meaning the OCC helps ensure the transaction occurs if an option is exercised. For example, if you exercise a long option and the writer doesn’t fulfill their obligation, the OCC steps in to make sure the exercise is completed (you don’t need the mechanics here).
Last, the OCC is a clearinghouse (sometimes called a clearing agent) for the options markets. Clearinghouses help ensure options transactions are processed correctly after a trade is made.
After the OCC issues options, investors trade those contracts in the secondary market. Options trading primarily takes place on the Chicago Board Options Exchange (CBOE). You can think of it as a major exchange where investors buy and sell options contracts with each other. Premiums are determined by market demand, similar to stock prices: higher demand generally means a higher premium (and vice versa).
When an investor buys or sells an option contract, the trade settles in one business day (T+1). If an equity option is exercised, a stock transaction occurs. Stock transactions also settle in one business day (T+1).
Holders must exercise their contracts before they expire. Standard options expire within nine months of issuance, and contracts are identified by their expiration month. For example, a Coca-Cola Inc. (ticker: KO) January stock option expires on the third Friday of January, technically at 11:59pm ET (10:59pm CT). The expiration date is typically referred to as “Expiration Friday.”
In addition to expiration, there are a few key times to know. The options market closes at 4:00pm ET (3:00pm CT), which matches the normal closing time for most stock markets (open from 9:30am - 4:00pm ET Monday through Friday). This 4:00pm ET close is also the trading cutoff for options on Expiration Friday. Although options can’t be traded after 4:00pm ET on the expiration date, option holders have until 5:30pm ET to contact their broker-dealer and request that their contract be exercised.
When an options trade occurs, it will be either an opening or a closing transaction. There are four types of options transactions to be aware of:
When an investor establishes an options position, they engage in an opening transaction. Opening transactions represent the start of a contract between two parties. Investors who establish long options positions execute opening purchases, while those who establish short options positions execute opening sales.
Let’s look at an example:
An investor opens an options account at their broker-dealer and immediately establishes 1 long Mar 50 call at $5. What type of options transaction was performed?
Do you know the answer?
Answer = opening purchase
It is an opening purchase for two reasons. First, the investor is establishing a new options position, so it’s an “opening” transaction. Second, the investor is buying (going long) the option, so it’s a “purchase” transaction. Putting both together, we have an opening purchase.
Let’s try one more:
An investor opens an options account at their broker-dealer and immediately establishes 1 short Oct 90 put at $8. What type of options transaction was performed?
Do you know the answer?
Answer = opening sale
It is an opening sale for two reasons. First, the investor is establishing a new options position, so it’s an “opening” transaction. Second, the investor is selling (going short) the option, so it’s a “sale” transaction. Putting both together, we have an opening sale.
Investors can exit an options position before it is exercised or expires by trading their position to another investor. It helps to separate this into two cases:
When an investor buys (goes long) an option, they can later sell that same contract. For example, if you own an option that gives you the right to sell stock at $50 (long 50 put), another investor might want that contract. You could sell it at the option’s current premium. This is a closing sale. It’s “closing” because you’re exiting the position, and it’s a “sale” because you’re selling the contract.
The opposite logic applies to option writers. Suppose you initially establish a short position that creates an obligation to buy stock at $50 (short 50 put). You can exit that obligation by returning to the market and buying the same option contract.
When you buy the same contract in the market, the investor who sells it now takes over the obligation. This is a closing purchase. It’s “closing” because you’re exiting the position, and it’s a “purchase” because you’re buying an option to close out the contract.
Closing purchases and sales can be confusing, so keep the core idea in mind: opening transactions start a position, and closing transactions end a position. Option holders (the long side) close by selling, while option writers (the short side) close by buying.
Let’s go through a few examples to reinforce what we’ve learned:
An investor opens an options account at their broker-dealer and immediately establishes 1 short Dec 25 call. One week before expiration, the investor requests to exit the position. What options order must be submitted to execute the transaction?
Do you know the answer?
Answer = closing purchase
Initially, the investor established the short call through an “opening sale.” However, the question is asking about exiting (closing) the position.
It is a closing purchase for two reasons. First, the investor is exiting a current options position, so it’s a “closing” transaction. Second, the investor must buy the option to exit the short position, so it’s a “purchase” transaction. Putting both together, we have a closing purchase.
Last one!
An investor opens an options account at their broker-dealer and immediately establishes 1 long Jun 65 put. One week before expiration, the investor requests to exit the position. What options order must be submitted to execute the transaction?
Do you know the answer?
Answer = closing sale
Initially, the investor established the long put through an “opening purchase.” However, the question is asking about exiting (closing) the position.
It is a closing sale for two reasons. First, the investor is exiting a current options position, so it’s a “closing” transaction. Second, the investor must sell the option to exit the long position, so it’s a “sale” transaction. Putting both together, we have a closing sale.
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