Insurance master

As briefly noted above, the Chicago Board Options Exchange was formed in 1973. Created as an extension of the Chicago Board of Trade, it became the first organization to offer a market for standardized options. In the United States, standardized options also trade on the Amex-Nasdaq, the Philadelphia Stock Exchange, and the Pacific Stock ~xchange.~
On a worldwide basis, standardized options are widely traded on such exchanges as LIFFE (the London International Financial Futures and Options Exchange) in London, Eurex in Frankfurt, and most other foreign exchanges. Note, perhaps surprisingly, that the leading options exchange is in Korea. As described in posts on futures, the exchange fixes all terms of standardized instruments except the price. Thus, the exchange establishes the expiration dates and exercise prices as well as the minimum price quotation unit. The exchange also determines whether the option is European or American, whether the exercise is cash settlement or delivery of the underlying, and the contract size. In the United States, an option contract on an individual stock covers 100 shares of stock. Terminology such as “one option” is often used to refer to one option contract, which is really a set of options on 100 shares of stock. Index option sizes are stated in terms of a multiplier, indicating that the contract covers a hypothetical number of shares, as though the index were an individual stock. Similar specifications apply for options on other types of underlyings.
The exchange generally allows trading in exercise prices that surround the current stock price. As the stock price moves, options with exercise prices around the new stock price are usually added. The majority of trading occurs in options that are close to being at-the-money. Options that are far in-the-money or far out-of-the-money, called deep-in-the-money and deep-out-of-the-money options, are usually not very actively traded and are often not even listed for trading.
Most exchange-listed options have fairly short-term expirations, usually the current month, the next month, and perhaps one or two other months. Most of the trading takes place for the two shortest expirations. Some exchanges list options with expirations of several years, which have come to be called LEAPS, for long-term equity anticipatory securities. These options are fairly actively purchased, but most investors tend to buy and hold them and do not trade them as often as they do the shorter-term options.
The exchanges also determine on which companies they will list options for trading. Although specific requirements do exist, generally the exchange will list the options of any company for which it feels the options would be actively traded. The company has no voice in the matter. Options of a company can be listed on more than one exchange in a given country.
In earlier posts, we described the manner in which futures are traded. The procedure is very similar for exchange-listed options. Some exchanges have pit trading, whereby parties meet in the pit and arrange a transaction. Some exchanges use electronic trading, in which transactions are conducted through computers. In either case, the transactions are guaranteed by the clearinghouse. In the United States, the clearinghouse is an independent company called the Options Clearing Corporation or OCC. The OCC guarantees to the buyer that the clearinghouse will step in and fulfill the obligation if the seller reneges at exercise.
When the buyer purchases the option, the premium, which one might think would go to the seller, instead goes to the clearinghouse, which maintains it in a margin account. In addition, the seller must post some margin money, which is based on a formula that reflects whether the seller has a position that hedges the risk and whether the option is in- or out-of-the-money. If the price moves against the seller, the clearinghouse will force the seller to put up additional margin money. Although defaults are rare, the clearinghouse has always been successful in paying when the seller defaults. Thus, exchange-listed options are effectively free of credit risk.
Because of the standardization of option terms and participants’ general acceptance of these terms, exchange-listed options can be bought and sold at any time prior to expiration. Thus, a party who buys or sells an option can re-enter the market before the option expires and offset the position with a sale or a purchase of the identical option. From the clearinghouse’s perspective, the positions cancel.
As in futures markets, traders on the options exchange are generally either market makers or brokers. Some slight technical distinctions exist between different types of market makers in different options markets, but the differences are minor and do not concern us here. Like futures traders, option market makers attempt to profit by scalping (holding positions very short term) to earn the bid-ask spread and sometimes holding positions longer, perhaps closing them overnight or leaving them open for days or more.
When an option expires, the holder decides whether or not to exercise it. When the option is expiring, there are no further gains to waiting, so in-the-money options are always exercised, assuming they are in-the-money by more than the transaction cost of buying or selling the underlying or arranging a cash settlement when exercising. Using our example of the SUNW options, if at expiration the stock is at 16, the calls with an exercise price of 15 would be exercised. Most exchange-listed stock options call for actual delivery of the stock. Thus, the seller delivers the stock and the buyer pays the seller, through the clearinghouse, $15 per share. If the exchange specifies that the contract is cash settled, the seller simply pays the buyer $1. For puts requiring delivery, the buyer tenders the stock and receives the exercise price from the seller. If the option is out-of-the-money, it simply expires unexercised and is removed from the books. If the put is cash settled, the writer pays the buyer the equivalent cash amount.
Some nonstandardized exchange-traded options exist in the United States. In an attempt to compete with the over-the-counter options market, some exchanges permit some options to be individually customized and traded on the exchange, thereby benefiting from the advantages of the clearinghouse’s credit guarantee. These options are primarily available only in large sizes and tend to be traded only by large institutional investors. Like futures markets, exchange-listed options markets are typically regulated at the federal level. In the United States, federal regulation of options markets is the responsibil- ity of the Securities and Exchange Commission; similar regulatory structures exist in other countries.