The Mechanics of the Options Markets

The Mechanics of the Options Markets

Options Traders

In the over-the-counter market, certain institutions which may be banks or brokerage firms, stand ready to make markets in options. Exchange listed options are created on an exchange, which is a legal corporate entity whose members are individuals or firms. Each membership is referred to as a seat. Although the organizational structures of the various exchanges differ somewhat, membership generally entitles one to physically go onto the trading floor and trade options.

The Market Maker

With reference to the largest options exchange in the world, an individual who has purchased a seat on the CBOE can apply to be either a market maker or a floor broker. The market maker is responsible for meeting the public's demands for options. When someone from the public wishes to buy (sell) an option and no other member of the public wishes to sell (buy) it, the market maker completes the trade. The market maker is essentially an entrepreneur. To survive, the market maker must profit by buying at one price and selling at a higher price. One way this is done is by quoting a bid price and an ask price. The bid price is the maximum price that the market maker will pay for the option. The ask price is the minimum price that the market maker will accept for the option. The ask price is set higher than the bid price. The difference between the bid price and the ask price is called the bid-ask spread.

The Floor Broker

The floor broker is another type of trader on the exchange. The floor broker executes trades for members of the public. If someone wishes to buy or sell an option, that individual must first establish an account with a brokerage firm. That firm  must either employ a floor broker or have an arrangement whereby it contracts with either an independent floor broker or a floor broker of a competing firm. The floor broker executes orders for non-members and earns either a flat salary
or commission on each order executed.

The Order Book Official

A third type of trader at the CBOE is the order book official (OBO) or board broker, an employee of the exchange. To see how the OBO works, suppose you place a limit order - an order specifying a maximum price to be paid on a purchase or minimum acceptable price on a sale - to buy a call option at a maximum price of $3. The floor broker handling your order determines that the best quote offered by a market maker is $2.75 bid and $3.25 ask. This means that the lowest price at which a market maker will sell the call is $3.25. If your floor broker has other orders to execute, the OBO takes your limit order and enters it into the computer along with all the other public limit orders. The market makers are informed of the best public limit orders. If conditions change such that at least one market maker is willing to quote an ask price of $3 or lower, the OBO will execute your limit order.