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, though. This chapter explains how options are issued and how secondary market trading typically works.
Normally, the issuer of a security is the organization directly tied to that security. With listed options, there is only one issuer: the Options Clearing Corporation (OCC). The OCC issues options, standardizes contracts, and guarantees performance.
No matter 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 at issuance, 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 used in options. If contracts were customizable, trading would be much harder because every trade would require negotiating and verifying unique contract details. You’d spend more time reviewing contract specifications than analyzing the underlying securities.
The OCC also guarantees option performance, meaning the contract will be honored if an option is exercised. Without this guarantee, you’d have to worry about whether the writer would fulfill their obligation after you exercise. The OCC’s role is to make sure the exercise is completed even if the writer fails to perform (don’t worry about the mechanics).
Last, the OCC acts as a clearinghouse (sometimes called a clearing agent) for the options markets. A clearinghouse helps ensure that 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 the “New York Stock Exchange of options,” where investors buy and sell options contracts with each other.
Premiums are determined by supply and demand, similar to stock prices. If demand for an option increases, its premium tends to rise (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, and stock transactions also settle in one business day (T+1).
Option 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). This date is typically called “Expiration Friday.”
In addition to the expiration time, there are a few other key times to know. The options market closes at 4:00pm ET (3:00pm CT), which is also the normal closing time for most stock markets (open from 9:30am-4:00pm ET Monday through Friday). On Expiration Friday, 4:00pm ET is also the trading cutoff for options. 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.
Every options trade is either an opening transaction or a closing transaction. There are four types of options transactions to be aware of:
When an investor establishes an options position, they enter an opening transaction. Opening transactions create a new position.
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, which makes it an opening transaction. Second, the investor is buying (going long) the option, so it is a purchase. Put together, it’s 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, which makes it an opening transaction. Second, the investor is selling (going short) the option, so it is a sale. Put together, it’s 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 look at this from two perspectives:
When an investor buys (goes long) an option, they can later sell that same contract in the market. 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. If you sell it at the option’s current premium, that transaction is a closing sale. It’s “closing” because you’re exiting the position, and it’s a “sale” because you sold the contract.
The opposite 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. That transaction is a closing purchase. It’s “closing” because you’re exiting the position, and it’s a “purchase” because you bought an option to close it.
Closing purchases and closing sales can be confusing, so keep the core idea in mind:
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 with an opening sale. The question asks about exiting the position, so we need a closing transaction.
It is a closing purchase for two reasons. First, the investor is exiting an existing options position, which makes it a closing transaction. Second, the investor must buy the option to eliminate the short position, so it is a purchase. Put together, it’s 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 with an opening purchase. The question asks about exiting the position, so we need a closing transaction.
It is a closing sale for two reasons. First, the investor is exiting an existing options position, which makes it a closing transaction. Second, the investor must sell the option to eliminate the long position, so it is a sale. Put together, it’s a closing sale.
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