Organisational structure of option markets

One way of depicting the organisational structure of option markets is as in Figure 8.

organisation of options markets

Figure 8: organisation of options markets

The market form of options is a mixture of formal in the shape of an exchange where options are listed, and OTC. There are many futures / options exchanges in the world, or futures / options divisions of exchanges. There are also substantial OTC markets.

As to whether option markets are primary markets and/or secondary markets, the answer depends on whether they are OTC or exchange-traded. In the case of the OTC markets, there are primary markets in which options are issued and secondary markets in which existing options can be sold and bought. In the case of exchange-traded options the primary and secondary markets are "merged". They are issued by the exchange (primary market) and can be "sold" ("closed out") in the sense of dealing in the opposite direction. For example, if a client has bought a call option, she can close out the position by selling the same call option. However, the holder/ buyer of an option has other alternatives: exercise the option (if it is an American option and has value), or letting it expire worthless on expiration date.

The main advantage of exchange-traded options is that they are guaranteed by the exchange, they are standardised and they are (usually) liquid markets. The main advantage of the OTC market is that the options are customised. The differences between these two markets are as shown in Table 3.

Exchange-traded

Regulation

None

Yes

Contracts

Usually not standardised (standardised in certain respects)

Standardised

Margin

Sometimes

Yes

Delivery dates

Customised (large range)

Standardised (limited range)

Delivery of underlying instrument

Almost always

Few settled by delivery

Instruments

Virtually all

Virtually all

Secondary market tradability

Limited

Liquid secondary markets

Large players only

Large and small players

Deal between counterparties - each faces risk

Contracts guaranteed by exchange

Screen or telephone or both

Open outcry on exchange floor, or telephone or ATS

Table 3: Comparison of otc and formalised options markets

The trading-driver process of listed options is the same as in the case of listed futures. The client telephones the broker and places an order to sell or buy a particular number of call or put options. She will of course also state the expiration date/s and strike price/s. The order placed is either a market order or a limit order. The former is an instruction to deal at the best available price, while the latter is an order to transact at a specific price.

In most listed options markets this information will be inputted into the ATS system and left there until a match is found (which in most markets is usually a few seconds or minutes because these markets are so liquid). In the case of an open outcry system of trading (as in certain overseas markets), the order is communicated to the trader in the pit. Traders form groups reflecting the various delivery dates. The order is "cried out" and another trader "cries out" if she has an opposite matching order. The trade is done with a floor broker, a market maker or a professional trader.

In OTC markets the method of trading is screen / telephone or just telephone, and the trading driver is quote. Certain broker-dealers quote option buying and selling prices (premiums). Settlement takes place on T+1 or T+2.

It will be apparent that not just anyone is able to trade in the OTC market, and this is because each party is directly exposed to the other party in terms of risks such as settlement risk, risk of tainted scrip, default risk, etc. One needs credentials and a track record to deal in the OTC options markets.

 
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