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Finance understanding options - Kolb R.

Kolb R. Finance understanding options - John Wiley & Sons, 1995. - 400 p.
ISBN 0-471-08554-5
Download (direct link): financeunderstandingoptions1995.pdf
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Other Trading Systems
The alignment of personnel described here follows the practice at the —¬őŇ and the Pacific Stock Exchange. Other exchanges, such as the American and Philadelphia Stock Exchanges, use a specialist instead of an order book official. In this system, the specialist keeps the limit order book but does not disclose the outstanding orders. Also, the specialist alone bears the responsibility of making a market, rather than relying on a group of market makers. In place of market makers, these exchanges have registered options traders who buy and sell for their own accounts or act as brokers for others.
One of the most important differences between the two systems is the role of the market makers and registered options traders. At the —¬őŇ and the Pacific Stock Exchange, a market maker cannot act as a broker and trade for his or her account on the same day. The same individual can play different roles on different days, however. Restricting individuals from simultaneously acting as market makers and brokers helps avoid a conflict of interest between the role of market maker and that of broker. The system of allowing an individual simultaneously to trade for himself (as a market maker) and to execute orders for the public (a broker) is
Understanding Options
called dual trading. Many observers believe that dual trading involves inherent conflicts of interest between the role of broker and market maker. For example, consider a dual trader who holds an order to execute as a broker. If this dual trader suddenly confronts a very attractive trading opportunity, he may well decide to take it for his own profit, rather than execute the order for his customer.
Types of Orders
Every options trade falls into one of four categories. It can be an order to (1) open a position with a purchase; (2) open a position with a sale; (3) close a position with a purchase; or (4) close a position with a sale.
For example, a trader could open a position by buying a call and later close that position by selling the call. Alternatively, one could open a position by selling a put and close the position by buying a put. An order that closes an existing position is an offsetting order.
As in the stock market, there are numerous types of orders in the options market. The simplest order is a market order. A market order instructs the floor broker to transact at whatever price is currently available in the marketplace. For example, one might place an order to buy one call contract for a stock at the market. The floor broker will fill this order immediately at the best price currently available. As in the stock market, the alternative to a market order is a limit order. In a limit order, the trader instructs the broker to fill the order only if certain conditions are met. For example, assume an option trades for $5 1/8. In this situation, one might place a limit order to buy an option only if the price is $5 or less. In a limit order, the trader tells the broker how long to try to fill the order. If the limit order is a day order, the broker is to fill the order that day if it can be filled within the specified limit. If the order cannot be filled that day, the order expires. Alternatively, a trader can specify a limit order as being good-until-canceled. In this case, the order stays on the limit order book indefinitely.
Order Routing and Execution
To get a better idea of how an order is executed, letís trace an order from an individual trader. A college professor in Miami decides that today is the day to buy an option on XYZ. He calls his local broker and places a market order to buy a call. The broker takes the order and makes sure she has recorded the order correctly. The broker then transmits the order to the brokerage firmís representatives at the exchange. Usually this is done over a computerized system operated by the brokerage firm.
The Options Market
The brokerage firmís clerical staff on the floor of the exchange receives the order and gives it to a runner. The runner quickly moves to the trading area and finds the firmís floor broker who deals in XYZ options. The floor broker executes the order by trading with another floor broker, a market maker, or an order book official. Then the floor broker records the price obtained and information about the opposite trader. The runner takes this information from the floor broker back to the clerical staff on the exchange floor. The brokerage firm clerks confirm the order to the Miami broker, who tells the professor the result of the transaction. Normally, the entire process takes about two minutes and the professor can reasonably expect to receive confirmation of his order in the same phone call used to place the order.
In executing the trade just described, the buyer of a call has the right to purchase 100 shares of XYZ at the exercise price. However, it might seem that the buyer of the call is in a somewhat dangerous position, because the seller of the call may not want to fulfill his part of the bargain if the price of XYZ rises. For example, if XYZ sells for $120, the seller of the call may be unwilling to part with the share for $100. The purchaser of the call needs a mechanism to secure his position without having to force the seller to perform.
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