Trading Options on Exchange Listed Assets

By: Don Fishback

The following is an excerpt from Don Fishback’s Options for Beginners

The real world of commerce can often be “illiquid”. What we mean by “illiquid” is that it is often a time-sensitive process for a seller to find a buyer.  The same thing goes for sellers trying to find buyers who want to purchase.  Often, you have to search far and wide, using an agent, and then you have to spend time with attorneys and bankers, not to mention the negotiating process with the seller to finally come up with a transaction price.

There just isn’t any centralized marketplace where you can simply pick up the phone and say “sell” and have your inventory instantly sold.

When it comes to stocks and options, however, there are centralized locations to buy and sell instantly.  Those locations are called exchanges.  Most people have heard of Wall Street.  That’s the location of the New York Stock Exchange and the American Stock Exchange.

Chicago is the location of the biggest exchanges for commodity traders – The Chicago Board of Trade and the Chicago Mercantile Exchange.  Back in the early 1970’s, traders at the Chicago Board of Trade got together and decided to begin trading options on stocks.  This eventually led to the world’s busiest options exchange, The Chicago Board Options Exchange.

One reason that exchanges can provide you with instantaneous purchase and sale transactions is because the products available for purchase and sale are identical.  That is, one share of IBM is identical to another share of IBM.

Obviously, this could never be true of many other types of products, because each come with its own set of individual advantages and disadvantages.  Simply they are not identical, so you simply can’t buy and sell sight unseen.

But with exchange-trade products, you can buy and sell sight unseen because you know that every share of Ford is going to be exactly like every other share of Ford.  So when you want to sell, someone else can buy with confidence.

A market that offers the ability to instantly enter and exit positions at a reasonable price is said to have “liquidity”.

The other advantage to exchanges is that they eliminate counter-party risk.  Take for example the real estate transaction.  Typically you’ve got to set up a meeting, with an attorney present, sign dozens of contracts and forms, and make payments only with bank certified checks.  Then and only then does the property change ownership.  The reason for all of this is to prevent, as much as possible, one party to the transaction from defrauding the other party to the transaction.

Needless to say, when you pick up the phone to buy or sell a stock, you aren’t being asked to present a certified check.  That’s because the brokerage firm instantly acts upon your request, and the exchange guarantees the trade.

Let’s say a trader places an order to buy an option.  What happens is that the order goes to the exchange, and then someone sells the trader the option.  If the buyer then backs out of the trade, the seller has still sold the option.  That’s because the exchange and the broker guarantee that the trade has been executed and they both will stand behind it.  Essentially, the trader has bought the option.  But if the option buyer suddenly backs out of the trade, the brokerage firm has become the buyer of the option.  If for some unforeseen reason the brokerage firm can’t meet the obligation, then the exchange itself and its many members stand behind the trade.

This multiple level of redundancy on “listed” stocks and options is one of the key ingredients to having a successful marketplace.  Many traders take it for granted, but it is the one critical factor that gives traders around the globe enough confidence, so that when they pick up the telephone to place an order, they know that they are getting exactly what they ordered.  And they don’t have to worry about the performance of the person taking the other side of their trade.

A classic example occurred in 1987.  The stock market crashed in October of that year and many option traders got wiped out.  It was so bad that these traders were unable to meet their commitments.  That left the brokerage firms to make up the difference.  Some smaller firms were unable to handle the financial stress, which meant that the exchange members had to meet the commitment individual traders were unable to meet.  The next day, the Federal Reserve Board stepped in and strongly hinted, in a very carefully worded, prepared statement, that banks go ahead and loan as much money needed to exchange member firms, so that the exchange members could meet the financial obligations of all traders.  With those words, counterparty risk was eliminated and a crisis was averted.