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Explain how exchange-traded options are subject to commissions, margin requirements and exercise procedures, and what characterises how they trade.

FRM® Part I · Financial Markets and Products · Options Markets · FRM1.FM.12.d

The idea

Exchange-traded options are standardised in expiry, strike and contract size (100 shares for US stock options). They trade with market makers who quote bid and ask prices and earn the spread. The clearing house, the Options Clearing Corporation in the US, stands between buyer and seller and guarantees performance. Buyers pay the premium in full and post no margin. Writers of uncovered options must post margin, which is adjusted daily, because their potential loss exceeds the premium received. Brokers charge commissions on trading and exercise. To exercise, the holder tells the broker, who notifies the clearing house. The clearing house randomly selects a member with a short position, and that member assigns a writer. Open interest counts contracts outstanding, while volume counts contracts traded. A holder with time value left usually does better selling than exercising.

A practice question

From the question bank, with the reason each wrong option is wrong.

In US exchange-traded options, what is the role of the Options Clearing Corporation?

  1. It sets the premium that buyers must pay for each option series.Why not: Premiums are set by supply and demand among traders and market makers, not by the clearing house.
  2. It stands between buyer and writer and guarantees that the writer's obligations are met. - correct
  3. It issues new shares of the underlying company when a call is exercised.Why not: Exchange-traded options are settled with existing shares; issuing new shares is a feature of warrants and employee options.
  4. It matches each buyer with a specific writer who remains the buyer's counterparty until expiry.Why not: The clearing house becomes the counterparty to both sides, so buyers do not depend on one writer.

The clearing corporation becomes the counterparty to every trade, removing the buyer's exposure to the individual writer's default.

A harder one

The holder of an exchange-traded call tells the broker to exercise. What happens next?

  1. The broker contacts the original seller of the option, who must deliver the shares directly.Why not: Exchange-traded options are novated to the clearing house; the original seller is not the delivering party.
  2. The clearing house pays the holder the intrinsic value from its own capital and no writer is involved.Why not: A writer is assigned and must deliver the shares; the clearing house does not pay from its own capital.
  3. The broker notifies the clearing house through a clearing member, and a member with a short position is selected at random to assign a writer. - correct
  4. The company issues new shares to the holder at the strike price.Why not: Issuing new shares is how warrants and employee options work, not exchange-traded options.

Exercise runs through the broker and clearing member to the clearing house, which randomly selects a member with an outstanding short position; that member assigns a writer.

The hardest tier

An exchange requires the writer of a naked call to post the greater of (a) 100 percent of the premium received plus 20 percent of the stock price less any out-of-the-money amount, and (b) 100 percent of the premium plus 10 percent of the stock price. A trader writes 10 contracts (100 shares each) on a call with strike 50 and premium 2, with the stock at 48. What is the margin requirement?

  1. USD 6,800Why not: Uses only requirement (b), which is smaller; the requirement is the greater of the two.
  2. USD 11,600Why not: Omits the deduction of the 2.00 out-of-the-money amount in requirement (a).
  3. USD 9,600 - correct
  4. USD 7,600Why not: Leaves out the premium received in (a), i.e. 0.2 x 48 - 2 only.

(a) 2 + 0.20 x 48 - (50 - 48) = 9.60. (b) 2 + 0.10 x 48 = 6.80. The greater is 9.60 per share x 1,000 shares = USD 9,600.

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