Remember when Wimpy would tell Popeye, “I’ll gladly pay you Tuesday for a hamburger today.How does a trader know the party on the other side of an option contract will in fact do that? That’s where the Options Clearing Corporation (OCC) comes into play.The OCC ultimately guarantees every options trade. In 2010, that was almost 3.9 billion listed-options contracts. The OCC accomplishes this through many clearing members.
Here’s how it works: When Trader X buys an option through a broker, the broker submits the trade information to its clearing firm. The trader on the other side of this transaction, Trader Y, who is probably a market maker, submits the trade to his clearing firm. The two clearing firms (one representing Trader X’s buy, the other representing Trader Y’s sell) each submit the trade information to the OCC, which“matches up” the trade.
If Trader Y buys back the option to close the position, how does that affect Trader X if he wants to exercise it? It doesn’t. The OCC, acting as an intermediary, assigns one of its clearing members with a customer that is short the option in question to deliver the stock to Trader X’s clearing firm, which in turn delivers the stock to Trader X. The clearing member then assigns one of its customers who is short the option.
The clearing member will assign the trader either randomly or first in, first out.Effectively, the OCC is the ultimate counterparty to both the exercise and the assignment.Standardized Contracts:Exchange-listed options contracts are standardized, meaning the terms of the contract, or the contract specifications, conform to a customary structure.Standardization makes the terms of the contracts intuitive to the experienced user.
To understand the contract specifications in a typical equity option, consider an example:Buy 1 IBM December 170 call at 5.00 Quantity In this example, one contract is being purchased. More could have been purchased, but not less—options cannot be traded in fractional units.Option Series, Option Class, and Contract Size All calls or puts of the same class, the same expiration month, and the same strike price are called an option series.
For example, the IBM December 170 calls are a series. Options series are displayed in an option chain on an online broker’s user interface. An option chain is a full or partial list of the options that are listed on an underlying.Option class means a group of options that represent the same underlying.Here, the option class is denoted by the symbol IBM—the contract represents rights on International Business Machines Corp. (IBM) shares.
Buying one contract usually gives the holder the right to buy or to sell 100 shares of the underlying stock. This number is referred to as contract size.Though this is usually the case, there are times when the contract size is something other than 100 shares of a stock. This situation may occur after certain types of stock splits, spin-offs, or stock dividends, for example.
In the minority of cases in which the one contract represents rights on something besides 100 shares, there may be more than one class of options listed on a stock.A fairly unusual example was presented by the Ford Motor Company options in the summer of 2000. In June 2000, Ford spun off Visteon Corporation.
Then, in August 2000, Ford offered shareholders a choice of converting their shares into (a) new shares of Ford plus $20 cash per share, (b) new Ford stock plus fractional shares with an aggregate value of $20, or (c) new Ford stock plus a combination of more new Ford stock and cash. There were three classes of options listed on Ford after both of these changes:
F represented 100 shares of the new Ford stock; XFO represented 100 shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24; and FOD represented 100 shares of new Ford, 13 shares of Visteon, and $2,001.24. Sometimes these changes can get complicated.
If there is ever a question as to what the underlying is for an option class, the authority is the OCC.A lot of time, money, and stress can be saved by calling the OCC at 888-OPTIONS and clarifying the matter.Expiration Month:Options expire on the Saturday following the third Friday of the stated month, which in this case is December.
The final trading day for an option is commonly the day before expiration—here, the third Friday of December.There are usually at least four months listed for trading on an option class. There may be a total of six months if Long-Term Equity AnticiPation Securitiess or LEAPSs are listed on the class. LEAPS can have one year to about two-and-a-half years until expiration. Some underlyings have oneweek options called WeeklysSM listed on them.