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Where Does The Buck Stop\?

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Where Does The Buck Stop?

Today's topic may seem a bit arcane to many of you, as it doesn't deal with any specific trading strategy. It is the outgrowth of a discussion I had with a reader a couple weeks ago, where he was basically asking who was on the other side of a given options transaction. That may seem like a really simplistic question to you, just as it did to me, but I think the process of discovery I went through is worth understanding for any serious options trader.

The genesis of my reader's question (we'll call him Phil) had to do with LEAPS (particularly LEAP Puts) on the major indices. I mistakenly assumed that he just wanted to know who was on the other side of the trade to have some sort of assurance that if he bought an index LEAP Put and rode it down to significant gains, that he would be able to harvest those gains. In other words, how do we know that a market will continue to be available for us to sell into in the future? Well, let's just say I had it partially correct.

I believe what got Phil started down this path was that he actually took the time to read the myriad disclaimers in the OCC booklet that we all got when we opened an options trading account. Granted there is a lot of legalese in those booklets, but there are a lot of statements in that booklet about the potential for a market to become (at least temporarily) unavailable. We all saw those effects last September, but I digress. Rather than rehashing my conversation with Phil, I thought it would be instructive to take you through the process of discovery, blow by blow. Below you'll find my email discussion with Phil, as it developed, with a few editorial comments thrown in for clarity.

Phil
With your giving so much advice on LEAPS, you have never explained who are writing LEAPS options? It seems an especially interesting question in the case of index options. For example, many recommend LEAPS puts/calls on market indexes, but no one ever says who is the counterparty or what is its investment strategy? If I were to buy a LEAPS put on QQQ or OEX, I would like to know who is (in theory, i.e., not the name, just the status, etc. of the entity) writing the put I would be buying.

Me
If you understand the way options can be written, you understand how LEAPS can be written and who can write them. It may be an institution, market maker or another individual trader. As to the reason why they would be willing to write the option, the answer varies from pure speculation to a hedge of an existing position.

While the knowledge about the intentions of the party on the other end of the transaction may be interesting, that knowledge is not available, and even if it was, I don't believe it would have a material impact on our trading decisions.

It is the same with most transactions in the equity and derivative markets. For instance, when you see a surge of buying in the S&P futures, you don't know if it is the opening of a new long position, closing a short position, or part of a hedged position.

As you are about to find out, I completely underestimated the depth of Phil's understanding of these basics, but fortunately he took the time to steer me back on course.

Phil
Now, I understand the role of the OCC, as to trading of options. However, there is still the matter of the option contract being traded. If it is unknowable just who, or what entity, is writing LEAPS puts, there should still be some trade organization or agency, like the OCC, determining the qualifications or status of the writer of LEAPS options? With mendacity running rampant in the world, as your newsletter loudly decries, would not the bona fides of the option writer have a material impact on your trading decisions?

Maybe, a simpler case would bring this out: what happens if the writer of any naked put option cannot buy the underlying asset when it is put at the end of the option term? Surely, a broker would not stand behind it. If the answer is a law suit, then should not the prospects for default by a large option writer, especially of index options, scare the bejesus out of you?

I could imagine some industry standard practice such as the requirement for an irrevocable letter of credit from a large money center bank for all options the OCC handles. Might the answer lie in that area?

As you can see, Phil is making a very good point. But I've never been the brightest bulb in the chandelier, so it took me a bit longer to really catch on. By the way, for those of you that are still wondering what OCC stands for, it is The Options Clearing Corporation. But more on that in a bit. Back to our discussion.

Me
Here is my rudimentary explanation of how it works. I don't know if you have ever written naked options, but from my experience, people like you and I can't do it without substantial cash in our account to cover the initial margin. That is the broker's initial insurance. If the position goes against us to too great a degree (and we're too stupid to close the position) we get a margin call, where we have the option to liquidate the position or add cash to the account to keep the position open.

It has always been my understanding (although I could be wrong) that anyone that is writing options (market-maker, fund or institution) that they are subject to similar rules. All of the floor traders I have ever talked with have indicated that they strive to never have directional risk, hedging long positions with short positions to control their risk. But I'm not sure that it is a requirement so much as an intelligent way of doing business.

I continue to believe that the answer to the question should be the same whether we are talking about indices or individual equities, near-term options or LEAPS. There again, I'll allow that I could be in error.

Astute readers will note that I still haven't really answered Phil's underlying question. Sure I've provided some basics as to the mechanisms by which the risks in the option market are controlled, but I still haven't peeled away that last layer of the onion. Fortunately, I managed to figure out what Phil was REALLY after without any further prompting, as you can see from the final installment (below) of our discussion.

Me
Phil, I found the answer! As it turns out, the OCC is the responsible party for all option transactions in the U.S. They effectively break the link between buyer and seller at the end of each business day and take responsibility for all the risk in all the trades. The OCC is the one responsible for maintaining all the pertinent margin rules of all the involved parties. According to the person I spoke to, the OCC makes sure that all positions for which it is responsible are fully hedged at the end of each day. WOW! Sounds like a lot of work to me, but they must be doing something right, because S&P has given them a AAA credit rating. Sounds pretty good to me!

I know I took the long way around to give you this information, but hopefully the journey has left you all with an understanding both of the merits of the question Phil raised, as well as a better understanding of who manages the non-trivial risks inherent to the options market.

By the way, if you want to do some further digging yourself, here's the phone number (1-800-678-4667) and website

http://www.optionsclearing.com/default.jsp

for the OCC. A good place to start is under the "About OCC" link at the left of the page. Put your mouse over that link and you'll get a menu expansion. Then select "Financial Guarantee". That should at least get you started in your exploration of this important organization. Then just let your imagination and curiosity take you on your own process of discovery.

Hoping this has been useful!

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