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Frederic Ruffy, Optionetics.com
March 11, 2002

Compared to option trading, stock market investors have it easy.  In terms of the actual mechanics of how a stock trades, the process is relatively straightforward—i.e., open an account with a brokerage firm, find a stock to buy (or sell short), place the order, pay for the trade, and hope the stock in question moves in the right direction.  It’s not rocket science.  Option trading, on the other hand, requires a great deal more knowledge.  For example, the option strategist faces things like expiration, exercise, assignment, and other details that, when not properly understood, can lead to financial losses due strictly to ignorance.  

Just getting started trading options is more complex than stock trading.  Specifically, brokerage firms are required to have clients complete an options approval form in addition to the new account document.  The options approval form is designed to provide the brokerage firm with information regarding the customer’s experience and knowledge level.  The customer background data, in turn, is used to determine what specific strategies are appropriate for the investor.  For example, if the option approval form reveals little or no past options trading experience and the client loses large sums of money after undertaking highly speculative option strategies, the brokerage firm could potentially face regulatory and legal troubles.  In other words, each brokerage firm is required to understand the customer’s experience level and financial background to ensure that the customer is not trading outside of certain parameters of suitability.  Therefore, the first step in trading options—which is not at all required in stock trading—is to understand and complete the options approval form.

Once the account is set up and approved for options trading, the brokerage firm plays the same role whether client is trading stocks or options.  Namely, the customer submits the buy or sell order to the broker, who then routes the order to the appropriate exchange.  In stock trading, the order usually takes place on one of three exchanges—the New York Stock Exchange, the American Stock Exchange, or the Nasdaq Stock Market.  In options trading, however, there are five primary exchanges competing for orders.  The largest is the Chicago Board Options Exchange, followed by the American Stock Exchange, and then the new all-electronic International Securities Exchange.  The Pacific Stock Exchange and the Philadelphia Stock Exchange also list options.  Therefore, while there are three key players in the world of stock trading, the options market consists of five principal exchanges.  In addition, while a stock listed for trading on one exchange will be only listed on that exchange, one particular options contract can be listed on all five exchanges.  In other words, options are often listed on multiple exchanges, which is not true for stocks.  Therefore, when filling client orders, the brokerage firm might have to check quotes on all five exchanges before routing the order to get the client the best possible price.

Like stocks, option trading involves buyers making bids and sellers giving offers.  In the stock market, the bids and offers reflect prices for shares of stock.  In the options market, the trading unit is a contract, which gives the owner the right to buy (call) or sell (put) 100 shares of stock per 1 contract.  Orders for option contracts are executed on the exchange floors where trading is conducted in an open, competitive auction-style market.  The exception, of course, is the International Securities Exchange, which is similar to the Nasdaq Stock Market in that it links option market makers through an electronic network.  Like with stock exchanges, the Securities and Exchange Commission regulates the activity on the option exchanges.  However, in options trading, the Options Clearing Corporation [OCC] performs the role of issuer and registered clearing facility for exchange-listed options.  Therefore, as orders are routed to the various exchanges, where trades are executed, the activity is overseen by the SEC and cleared by the OCC.

The process of submitting orders to a broker is more complex when the investor is dealing with options rather than stocks.  While a stock order generally consists of the stock or symbol, the number of shares to be bought or sold, and perhaps a limit price, the option order ticket is more detailed.  For example, what is the strike price and the expiration date of the option?  Is it a buy or a sell?  Is the trade an opening or closing transaction?  

Once orders are executed, the positions appear in the trader’s brokerage account.  Settlement of an option trade takes place the day after the trade.  At that time, the order must be paid for in full.  Therefore, unlike stocks that have a three-day settlement, options have one-day settlement.  In addition, options expire.  Stocks do not.  For that reason, options are sometimes called “wasting assets.”  An option will expire on the Saturday following the third Friday of the option’s expiration month.  For example, the March 2002 XYZ call, will expire on March 16, 2002.  For that reason, the last day to trade that option will be on Friday, March 15, 2002.  

Options come in two types—European and American Style.  Stock options settle American-style.  Therefore, until the options expire, the buyer or holder has the right to exercise his or her option.  The option seller, or writer, on the other hand, faces the risk of assignment at any time until the option expires.  For instance, the buyer of a call option has the right to exercise, or buy the stock, at the strike price at any time until expiration.  The writer of the call, on the other hand, has the obligation to sell the stock at the strike price at any time prior to expiration.  With European-style options, on the other hand, exercise and assignment can only take place on the last trading day before expiration.   

Options provide traders with more versatility than stocks.  While a full understanding of the mechanics of option trading takes a bit more time, the flexibility afforded to option traders makes the entire process of learning options trading worth the effort.  Among other things, options can be used to hedge portfolios, create an income stream, make a leveraged bet on the rise and fall in a stock, and establish positions that profit regardless of market direction.  In fact, the opportunities to the creative option strategist are virtually limitless, which can make the entire investment process far more rich and rewarding than simply buying and selling stock.


Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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