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course material-Derivative Securities and Risk Managemen

# The bid price is the maximum price the market marker

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The bid price is the maximum price the market marker 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 . Bid-ask spread Ask price Bid price

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18 Transaction on an option Exchange (1) Assume you (the buyer) bought the Microsoft Sept 27.5 call options . You contacted your broker, who, through either his firm’s floor broker or an independent floor broker, found a seller. You bought ten contracts (contract size 100 shares) at a price of \$0.125 per option, which totals \$125 . The seller, whose identity you do not know, has an account with another brokerage firm. Your brokerage firm clears its trades through XYZ Trading Company, a clearing firm that is a member of the OCC. You pay your broker the \$125, and your broker pays XYZ Trading Company. XYZ pools the transactions of all its customers and, through a predetermined formula, deposits a sum of money with the OCC.

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19 Transaction on an option Exchange (2) Assume that the seller seller does not already own the stock, so she will have to deposit some additional money, called margin margin , with ABC. The amount of margin is 20 percent of the value of stock, which comes to (\$25.92)(100) (10)( 0.2 ) = \$5,184 \$5,184 . The seller delivers \$5,184 to the broker, who deposits it with ABC, which also keeps the \$125 \$125 premium. ABC, in turn, is required to deposit with the OCC an amount of money determined according to a formula that takes its outstanding contracts into account.
20 Transaction on an option Exchange (3) The OCC guarantees the performance of ABC, the seller’s clearing firm. Thus, you, the buyer, need not worry whether the shares will be there if you decide to exercise your option. If the shares are not delivered by the seller, the OCC will look to ABC who will look to the seller’s brokerage firm, which will look to the seller’s personal broker, who will look to the seller for payment or delivery of the shares.

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21 Role of the Clearinghouse After the trade is consummated, the clearinghouse enters the process. Clearinghouse is an independent corporation (or OCC) that guarantees the writer’s (seller’s) performance. A buyer exercising an options 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. The writer Cash Stock Clearinghouse
22 Placing an Offsetting Order Suppose an investor holds a call option . The stock price currently 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 . In the

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The bid price is the maximum price the market marker will...

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