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Options 102: The How's and The Where'sDec 21 '00 Write an essay on this topic.Following a suggestion from some members, months ago I have begun what was meant to be a multi-part piece on option trading. Unfortunately, all I?ve managed to do back in the spring was one introductory piece that covered most of the definitions and basic information (see it at http://moneymatters.epinions.com/srvc-review-634B-E8A39D-39083504-prod1). This is a second one the series that I?m now planning to continue. Here I will continue with some of the basic information that, however, is not apparent, but necessary for investors to be aware of. Disclaimer: Please be advised that options can potentially carry more risk than any other investment. All materials presented here or in my other articles on the subject are presented for informational purposes only. Investors should refer to the official SEC publication Characteristics of Options and Their Risks before investing. I assume that the reader has read my first piece or is familiar with this information from another source. Now, that the definitions are out of the way, let us consider the mechanics of an options trade. The Parties To An Options Trade Just like in stock transactions, there are two parties to an options trade. There is the party who buys the option; and there is the party who sells the option. The party who sells the option is the writer. The party who writes the option has the obligation to fulfill the terms of the contract should it be exercised. Another words, if 1 call contract of SMPLE stock is sold with November expiration and the strike of $100, and SMPLE stock is at $105 at the expiration, the writer must sell 100 shares of SMPLE stock to the buyer at $100. The Options Exchanges Similar to stocks, all options trading takes place on an exchange. There are four option exchanges in the US today: Chicago Board of Exchange (aka CBOE), the American Exchange (AMEX) in New York, Philadelphia Exchange and the Pacific Exchange in San Francisco. CBOE is by far the largest of the four and is the only one devoted entirely to options ? the other three trade stocks as well. All trades on these exchanges are governed by their own regulations, which are superceded by the Securities and Exchange Commission?s (SEC) rules. The Options Clearing Corporation The Options Clearing Corporation (OCC) is the guarantor of all exchange-traded options once an option transaction has been completed. Once a seller has written an option and a buyer has purchased that option, the OCC takes over. It is the responsibility of the OCC who oversees the obligations to fulfill exercises. If I want to exercise that SMPLE November 100 call option, I notify my broker. (Note that in-the-money options at expiration are exercised by default.) My broker notifies the OCC. The OCC then randomly selects a brokerage firm, which is short one SMPLE November 100 call option that it must come up with 100 shares of SMPLE stock. That brokerage firm then notifies one of its customer's who has written one SMPLE November 100 call option that he must produce 100 shares of SMPLE stock. His call has been exercised. The brokerage firm customer who is chosen can be chosen in one of two ways. He can be chosen at random. Or he can be chosen on a first in first out (FIFO) basis. Because the OCC has a certain risk that the seller of the option can't fulfill his contract, strict margin requirements are imposed on sellers. This margin requirement acts as a performance bond. It assures that the OCC will get its money. I will discuss margin requirements in more details in later articles. Listing Options on Exchanges Just like with stocks, in order for an options contract to be allowed trading on the exchange, it has to be listed first. Not all stocks have listed options with them as the underlying asset. In fact, less than 10% of all stocks do. New issues are not allowed to list their options for at least six months after their IPO. The final word on the listing comes from the exchange ? the CBOE, in most cases. All contracts receive a unique ticker symbol according to the four components of options: type (call/put), underlying stock, expiration date, and strike price. All options available for a stock are known as the options chain for this stock. In the older days (up until mid-90?s, that is), option chains used to be constructed in the following fashion. The first one to three letters of the option?s ticker symbol would be the underlying stock symbol on NYSE/AMEX or the first three letters of the NASDAQ-listed stocks. The next letter would identify the expiration and type, while the last letter would encode the strike price. Both are used in a way to provide each letter in alphabetical order to uniquely identify a component of an option in easy to remember order. The next to last letter A means ?call option expiring in January?; B ? February call, etc.; L ? December call, M ? January put; X ? December put. Similarly, the strike price is encoded by utilizing the one-to-one correspondence of letters in alphabetical order to the last two digits of the strike price in the ascending order. So, A would be mean the last two digits of the strike price are 05; B ? 10, and so forth with 5-point intervals. T means 00. Letters U, V, W, X, Y, and Z are used for strike prices of 7.5, 12.5, 17.5, 22.5, 27.5, and 32.5, respectively. So, for example, LUMD is January (2001) put option (because the next to last letter is M) on Lucent (ticker LU) with the strike of 20 (last letter is D). Listing Changes and Where To Look for Information. Given today?s market volatility, it?s easy to understand that the need has come up to change the above logic somewhat. Two options on the same stock with the same expiration and strikes of 150 and 250 would have had the same ticker under the old system. When the need for both to be listed had arisen, new options chains were created, for which purpose the new first three letters were chosen, and some other minor changes have occurred.. Sometimes the stock prices changed so dramatically so fast, that the option exchanges were not able to keep up with listings, and even at-the-money options were unavailable. So, several chains are often needed for the same stock symbols. To be sure, check the CBOE website (see my review at http://moneymatters.epinions.com/finc-review-5228-CDF64EB-3925C35D-prod3) for the stock symbol of interest. The site will list all option chains that exist right now. Remember, if it?s not listed, it can?t be traded. I hope that you found this piece informative. My next review will deal more with option trading strategies.  |
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