Issuance & the market

Like most securities we’ve discussed, options contracts are issued, then traded between investors in the secondary market. However, there are some unique characteristics relating to the options markets. This chapter will cover how issuance and secondary market trading generally occur.

Issuance

Normally, the issuer of a security is the organization directly tied to the security. There is only one issuer with options - the Options Clearing Corporation (OCC). The OCC is responsible for issuing options, standardizing contracts, and guaranteeing performance.

Regardless of the issuer of 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. Essentially, the OCC creates the structure for options (when issuing contracts), and then investors trade them in the secondary market.

Each option contract is standardized, which allows for easy trading. Later in this unit, you’ll learn more about the consistent structure of options. If contracts were customizable, it would be tough to negotiate trades with other investors. Imagine the difficulty of trading if every contract had different specifications and requirements. You would spend most of your time examining contract specifications instead of researching the underlying securities.

The OCC also guarantees option performance, which assures a transaction will occur if an option is exercised. What if you exercised a long option and the writer didn’t fulfill their obligation? The OCC’s job is to ensure that option contracts work as they should. If a writer doesn’t do their part, the OCC makes sure the exercise still happens (don’t worry about the specifics).

Last, the OCC is a clearinghouse (sometimes called a clearing agent) for the options markets. Clearinghouses ensure options transactions execute properly after a trade is made.

Secondary market

Investors trade options contracts in the secondary market after their initial issuance by the OCC. Trading in the options markets primarily takes place on the Chicago Board Options Exchange (CBOE). It’s like the “New York Stock Exchange of options,” where traders buy and sell options contracts with other investors. Premiums are determined by demand in the market, just like stock prices. If there’s more demand for an option, its premium will rise (and vice versa).

When an investor buys or sells an option contract, the trade settles in one business day (T+1). During an equity option exercise, a stock transaction occurs. If you recall, stock transactions also have a settlement time of one business day (T+1).

Holders must exercise their contracts before they expire. If you recall, standard options expire within nine months of their issuance. Options contracts reference the month they expire. 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 options expiration, there are a few other times to be aware of. The options market closes at 4:00pm ET (3:00pm CT), the normal closing time for most stock markets (open from 9:30am - 4:00pm ET Monday through Friday). This time is also the trading cutoff for options on Expiration Friday. Although options cannot be traded after 4:00pm ET on the expiration date, option holders have until 5:30pm ET to contact their broker-dealer and request their contract be exercised.

Opening & closing transactions

When an options trade occurs, it will either be an opening or closing transaction. There are four types of options transactions to be aware of:

• Opening purchases
• Opening sales
• Closing purchases
• Closing sales.

When an investor establishes an options position, they engage in an opening transaction. Opening transactions represent the beginning of a contract between two parties. Investors that establish long options positions are executing opening purchases, while those that establish short options positions are executing 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?

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?

Investors can exit an options position before it is exercised or expires by trading their position to another investor. We’ll need to think about this from two separate perspectives:

• Closing long options
• Closing short options

When an investor buys (goes long) an option, they can sell the contract later. If you owned an option that gave you the right to sell stock at $50 (long 50 put), another investor might be interested in your contract. You could sell the contract for the option’s current premium, known as a closing sale. It’s ‘closing’ because you got out of the position; it’s a ‘sale’ because you sold your contract to another investor.

The exact opposite occurs with option writers. Assume you initially establish a short position that results in an obligation to buy the stock at $50 (short 50 put). You can get out of the contract by finding another investor to take over your obligation. This can be accomplished by returning to the market and buying the same option contract from another investor.

When you buy the same contract in the market, the investor selling the option now takes over your obligation. This transaction would be considered a closing purchase. It’s ‘closing’ because you got out of the position; it’s a ‘purchase’ because you bought an option to exit the contract.

Closing purchases and sales can be confusing, but keep it simple. When an investor buys or sells an option as an initial transaction, they can close the position out before exercise or expiration. Option holders (the long side) sell their contracts to close their positions, while option writers (the short side) buy their contracts to close their positions.

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?

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?