With an over-the-counter option, institutions enter into “private” option arrangements with brokerage firms or other dealers. The striking price, life of the option, and premium are negotiated between the parties involved. Over-the-counter options are subject to counterparty risk and are generally not fungible.
Exchange-traded options are fungible. For a given company, all options of the same type with the same expiration and striking price are identical
In April 1973, standardized options began trading on the Chicago Board Option Exchange. These had the following characteristics:
- Completely standardized option contracts
- Few (3 or 4) maturities
- No paper certificates (electronic book entries)
- Higher trading volumes and liquidity, lower transaction costs
- All contracts are with the Option Clearing Corporation. No risk of default (from perspective of buyers)
Some of the major options exchanges in the U.S. are:
- Chicago Board Options Exchange (CBOE)
- American Stock Exchange (AMEX)
- Philadelphia Stock Exchange (Philly)
- Pacific Stock Exchange (PSE)
- International Securities Exchange (ISE)
- Foreign options exchanges also exist
Opening and Closing Transactions in an Option Contract
The first trade someone makes in a particular option is an opening transaction for that person.
When the individual subsequently closes that position out with a second trade, this latter trade is a closing transaction.
When someone buys an option as an opening transaction, the owner of an option will ultimately do one of three things with it:
-
Sell it to someone else
-
Let it expire
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Exercise it
For example, buying a ticket to an athletic event
When someone sells an option as an opening transaction, this is called writing the option
No matter what the owner of an option does, the writer of the option keeps the option premium that he or she received when it was sold
The Role of the Options Clearing Corporation (OCC)
The Options Clearing Corporation (OCC) contributes substantially to the smooth operation of the options market.
It positions itself between every buyer and seller and acts as a guarantor of all option trades.
It sets minimum capital requirements and provides for the efficient transfer of funds among members as gains or losses occur.
