HOW DO PUTS AND CALLS WORK?
6/13/2008 12:00:00 AM
Put and Call Equity Options. “Puts” and “calls” are options to buy and sell stock. They are a special kind of option called “equity options.” An equity option is not stock, it is a contract that allows the holder the right, but not the obligation to either buy the stock from someone else (i.e., to “call” the stock from someone) or to sell the stock to someone else (i.e., to “put” the stock on someone). The terms of the option contract specifies the period of time in which the holder of the option must “exercise the option” by either buying or selling the stock, as the case may be. If the option is not exercised within the specified period of time the option expires. Put and call options are usually sold in blocks representing 100 shares of the underlying stock.
Because equity options derive from stock and convey rights to purchase and sell stock under stated conditions, they are referred to as “derivative securities.” Furthermore, because equity options are considered securities, transactions involving equity options are regulated by securities laws and subject to oversight by the Securities and Exchange Commission (SEC), much like stocks are regulated. Equity options are bought and sold on various exchanges, such as the American Stock Exchange (AMEX), the Chicago Board Option Exchange (CBOE), Chicago Mercantile Exchange Holdings Inc. (CME), Chicago Board of Trade (CBOT) and several others.
The holder of a typical equity call option has the right, but not the obligation, to purchase 100 shares of the underlying stock, at a specific price per share, for a predetermined amount of time. The holder of an equity put option, on the other hand, has the right to sell 100 shares of the underlying stock, at a specific price per share, for a predetermined amount of time. The holder of the option is said to “exercise” the option if he or she elects to purchase the underlying stock, in the case of a call option, or to sell the underlying stock, in the case of a put option.
The person who purchases either a call or put option holds the right, but not the obligation to exercise the option. The person who sells the option is called the “writer.” The writer of the option is obligated in the event the option is exercised by the purchaser to either buy the underlying stock, in the case of a put, or sell the underlying stock, in the case of a call.
The Option Clearing Corporation (OCC). The Option Clearing Corporation (OCC) is the clearing entity, issuer, and guarantor for all U.S. exchange-traded equity options. Here is how the OCC works in the typical option exercise:
When the holder of a call or put equity option wishes to exercise an option, the holder notifies his or her brokerage firm, who then notifies the Option Clearing Corporation (OCC). OCC then randomly selects a brokerage firm from its list of member firms, who then assigns the exercise to one of its investors who has written an option that is identical to the option being exercised. The writer of the option typically has one business day after notification of the exercise to fulfill his or her obligation to buy the stock at the prescribed price in the case of a put or sell the stock at the prescribed price in the case of a call. Once the transaction has been completed and confirmed, it is considered “cleared,” after which all links between the parties is severed.
Mark Wilson
Articles