The Mechanics of Trading

The Mechanics of Trading

Placing an Opening Order

An individual who wants to trade options must first open an account with a brokerage firm. The individual then instructs the broker to buy or sell a particular option. The broker sends the order to the firm's floor broker on the exchange on which the options trade. All orders must be executed during normal trading hours. Trading is performed within the trading pit designated for that particular option.

An investor can place several types of orders. A market order instructs the floor broker to obtain the best price. A limit order, as indicated earlier, specifies a maximum price to pay if buying and a minimum price to accept when selling. Limit orders can be day orders or good-till-cancelled orders. A good-till-cancelled order remains in effect until cancelled. A day order stays in effect for the remainder of that day.

Finally, an investor holding a particular option might place a stop order at a price lower than the current price. If the market price falls to the specified price. the broker is instructed to sell the option at the best price available. In addition to specifying the option the investor wishes to buy or sell, the order must indicate the number of contracts desired. An all or none order allows the broker to fill part of the order at one price and part at another. An all or none, same price order requires the broker to either till the whole order at the same price or not fill the order at all.

Role of the Clearinghouse

After the trade is consummated, the clearinghouse enters the process. The clearinghouse, formally known as the Options Clearing Corporation (OCC), is an independent corporation that guarantees the writer's performance. The OCC is the intermediary in each transaction. A buyer exercising an option looks not to the writer but to the clearinghouse. A writer exercising an option makes payment
for or delivery of the stock to the clearinghouse.

Each OCC member has an account with the OCC. Each market maker must clear all trades through a member firm, as must every brokerage firm, although in some cases a brokerage firm is also a clearing firm.

The total number of option contracts outstanding at any given time is called open interest. The open interest figure indicates the number of closing contracts that might be made before the option expires.

Placing an Offsetting Order

Suppose an investor holds a call option. The stock price recently has been increasing and the call's price is now much higher than the original purchase price. The liquidity of the options market makes it possible for the investor to take the profit by selling the option in the market. This is called an offsetting order, or simply an offset. The order is executed in the same manner as an opening
order.

In over-the counter markets, there is no facility for selling back an option previously bought or buying back an option previously sold. These contracts are created with the objective of being held till expiration.

Exercising an Option

Suppose you elect to exercise the options that you are currently holding. You notify your brokerage firm, which in turn notifies the clearing firm through which the trade originally was cleared. The clearing firm then places an exercise order with the OCC, which randomly selects a clearing firm through which someone has written the same option. The clearing firm, using a procedure established
and made known to its customers in advance, selects someone who has written that assigned.
option. The chosen writer is said to be assigned.

If the option is a call option on an individual stock, the writer must deliver the stock. You then pay the exercise price, which is passed on to the writer. If the option is a put option on an individual stock, you would have to deliver the stock. The writer pays the exercise price, which is passed on to you. For either type of option, however, the writer who originally wrote the contract might not be the one who is assigned the exercise.

Because an index represents a portfolio of stocks, exercise of the option ordinarily would require the delivery of the stocks weighted in the same proportions as they are in the index. This would be quite difficult and inconvenient. Instead, an alterative exercise procedure called cash settlement is used.

With this method, if an index call option is exercised, the writer pays the buyer the contract multiple times the difference between the index and the exercise price. Option prices are available daily in The Wall Street Journal and in many daily newspapers in Australia such as the Financial Review. Singapore, Hong Kong and Osaka also present large options exchanges.