Like most securities we’ve discussed, options contracts are issued first 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 generally works.
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 issues options, standardizes contracts, and guarantees performance.
No matter who issued the underlying security, the option itself is 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 more about the consistent structure of options. If contracts were customizable, investors would have to negotiate and verify different terms for every trade. Trading would slow down because you’d spend more time reviewing contract specifications than analyzing the underlying securities.
The OCC also guarantees option performance. That means if an option is exercised, the OCC helps ensure the transaction occurs even if the writer fails to meet their obligation (you don’t need the mechanics here - just the role the OCC plays).
Finally, the OCC acts as a clearinghouse (sometimes called a clearing agent) for the options markets. Clearinghouses help 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 an exchange where investors buy and sell options contracts with each other.
Option Premiums are set 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. 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. Options 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 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 the normal closing time for most stock markets (open from 9:30am - 4:00pm ET Monday through Friday). This 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.
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 contract 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 is an ‘opening’ transaction. Second, the investor is buying (going long) the option, so it is 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, which is an ‘opening’ transaction. Second, the investor is selling (going short) the option, so it is 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’s helpful to separate this into two cases:
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. You could sell it at the option’s current premium. That sale is a closing sale - it’s “closing” because you’re exiting the position, and it’s a “sale” because you sell 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 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 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 buy an option to close out the contract.
Closing purchases and 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 through an ‘opening sale.’ However, the question focuses on the investor exiting (closing) the position.
It is a closing purchase for two reasons. First, the investor is exiting a current options position, which is a ‘closing’ transaction. Second, the investor must buy (go long) the option to exit the position, so it is 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 focuses on the investor exiting (closing) the position.
It is a closing sale for two reasons. First, the investor is exiting a current options position, which is a ‘closing’ transaction. Second, the investor must sell (go short) the option to exit the position, so it is a ‘sale’ transaction. Putting both together, we have a closing sale.
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