OPTIONS TRADERS

Lesson 03
• In OTC 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 member is referred to as a SEAT.
• Membership generally entitles one to physically go onto the trading
floor and trade options.
Types of Traders
(the system of traders is based on the market maker system used by the CBOE: Chicago Board Options
Exchange)

• Market Maker
• Floor Broker
• Order Book Official
• Other Option Trading Systems
• Off-Floor Option Traders
Market Maker
• The market maker is responsible for meeting the
public’s demand for options.
• When someone from the public wishes to buy(sell) an
option and no other member of the public is willing to
sell (buy) it, the market maker completes the trade.
• The market maker offers the public the convenience of
immediate execution of trade.
Market Maker
• 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 the market maker will pay for the
option.
• The ask price is the minimum price the market maker will accept for
the option.
• The ask price is set higher than the bid price.
• The difference between the ask and bid price is called the bid-ask
spread.
Market Maker
• Market Makers use a variety of techniques to trade
options intelligently and profitably:
• Many look at fundamentals: interest rates, economic
conditions, company performance
• Others rely on Technical Analysis
• Others rely simply on intuition and experience
Floor Broker
• 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.
Floor Broker
• The floor broker executes orders for nonmembers and
earns either a flat salary or a commission on each order
executed.
• The floor broker generally need not be concerned
about whether the price is expected to up or down;
however, a good broker will work diligently to obtain
the best price for the customer.
• The CBOE has a number of Designated Primary
Market Makers, or DPMs, who are allowed to be both
market makers and brokers
Order Book Official (OBO) or Board Broker
• An employee of the exchange and cannot trade for their own account.
• An order book official (OBO) is the trading floor participant
responsible for maintaining a list of public market or limit orders of a
specific option class using the "market-marker" system of executing
orders.
• The purpose is to maintain a fair and orderly market in the assigned
options, including executing orders sent in by member firms. The
OBO is compensated by a salary paid to him /her by the exchange.
• Limit orders allow you to set a maximum purchase price for your buy
order, or a minimum sale price for your sell orders. If the market
doesn't reach your limit price, your order will not be executed.
Other Option Trading Systems
• The CBOE uses the systems of competing market makers, here the
individual called a SPECIALIST is responsible for making bids and
offers on options.
• The specialist maintains and attempts to fill public limit orders but
does not disclose them to others.
• In addition to specialists are individuals called REGISTERED
OPTION TRADERS (ROTs), who buy and sell options for
themselves or act as brokers for others.
• Unlike the CBOE Market Makers, ROTs are not obligated to make a
market in the options; market making is the specialist’s task.
Cost and Profitability of Exchange
Membership
• An individual who decides to purchase a seat on an exchange
that has options trading can take one of several routes. The
most obvious is to purchase a seat from an existing member.
• Other ways to gain membership:
• Owners least their seats to others
• Rental (rental rates is about 0.50 to 0.75 percent of the seat’s price
per month.
• Allow trainees to trade and charge them a percentage of the trading
profits
Cost and Profitability of Exchange
Membership
• The price of a Seat is not the full cost of trading. It
only provides access to the floor.
• Other fees:
• Annual dues
• Capital requirement
Cost and Profitability of Exchange
Membership
• In terms of profitability, it is difficult to determine how
profitable option memberships are.
• A SEC study in 1978 showed that the average market
maker earned a respectable but not unusually large
amount of money.
Mechanics of Trading
• Placing an Opening Order
• Role of the Clearinghouse
• Placing an Offsetting Order
• Exercising an Option
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 option trades.
Placing an Opening Order
• An investor can place several types of orders.
• A market order instructs the floor broker to obtain the best price.
• A limit order specifies a maximum price to pay if buying or a minimum price
to accept if selling
• In addition to specifying the option the investor wishes
to buy or sell, the order must indicate the number of
contracts desired.
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.
Role of the Clearinghouse
• A buyer exercising an option looks not to the writer but to the
clearinghouse.
• The writer of an exercised option makes payment for or
delivery of the stock to the clearinghouse.
• Each OCC member, known as clearing firm, has an account
with the OCC.
• Each member 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.
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.
Types of Options
• Stock Options
• Index Options
• Currency Options
• Other Types of Options
• Real Options
Stock Options
• Options on individual stocks are sometimes called
stock options or equity options.
Index Options
• A stock index is a measure of the overall value of a
designated group of stocks.
Currency Options
• A foreign currency rate is the price at which a party
can exchange one currency for another currency.
• A currency option contract specifies an exercise price,
expressed in terms of an exchange rate, an expiration,
the identity of the underlying currency, the size of the
contract, and various other specifications similar to
those of stock and index options
Other Types of Options
• Options on bonds and related options are called
Interest Rate Options.
Real Options
• Real options are not options on real estate, nor does
the name real options suggests that other options are
somehow not real.
• Real options are options that are commonly found in
corporate investment decisions, which are themselves
often referred to as real investments.
Transaction Costs in Option Trading
• Floor Trading and Clearing Fees
• Commissions
• Bid-Ask Spread
• Other Transaction Costs
Thank you….