Much like other asset classes, options are traded on active exchanges that provide liquidity, matching up buyers and sellers. Option contracts are standardized, where each contract represents 100 shares of the underlying stock. Contracts may be subsequently adjusted to accommodate various types of corporate actions like stock splits or acquisitions, but at inception the deliverable is typically 100 shares.
What is an option?
Unlike most other asset classes, options are derivatives. That means that they derive their value from some other underlying security. This also means that options are inherently speculative investments. Additionally, options are contracts between two counterparties: a buyer and a seller of the underlying asset.
A call allows the option buyer (long side) to purchase the underlying stock at a specific price, known as the strike price, from the option seller (short side) at any point up until the expiration date. A put allows the option buyer (long side) to sell the underlying stock at the strike price from the option seller (short side) at any point up until expiration date.
Basic order types
There are four basic order types when it comes to trading options:
- Buy to open (BTO)
- Buy to close (BTC)
- Sell to open (STO)
- Sell to close (STC)
The buying and selling factor is self-explanatory, while the open and close factor corresponds to whether or not you're opening or closing a position. This added detail is necessary because option contracts can be created and destroyed over time, depending on buying and selling activity.
Which leads us to the next topic...
Open interest represents the total number of contracts that are currently outstanding. Open interest is an important metric for options investors and traders to consider, since open interest also determines that specific contract's liquidity. Greater liquidity helps to reduce the bid/ask spread (thereby reducing implicit transaction costs), since there are more existing contracts with counterparties seeking to trade. Open interest fluctuates over time depending on buying, selling, opening, and closing activity.
For instance, if one investor buys to open a long position while another investor sells to open a short position, a new contract is created (open interest increases by one). On the other hand, if one investor buys to close a short position while another investor sells to close a long position, that contract ceases to exist (open interest decreases by one).
If one investor buys to open a long position while another investor sells to close a long position, then the long side of that contract is simply being transferred from one investor to another. There is no change in open interest in this case. Similarly, if one investor sells to open a short position while another investor buys to close a short position, then the short side of that contract is simply being transferred from one investor to another, also with no change to open interest.
Like other exchange-traded securities, there are market makers that provide liquidity. Like all market makers, options market makers seek to profit from the bid/ask spread, standing ready to purchase contracts at the bid while also selling contracts at the offer.
There are several ways that making a market with options is very different than with stocks, though. For starters, bid/ask spreads tend to be wider in percentage terms, since many options contracts trade in $0.05 or $0.10 increments. This is compounded by the fact that options represent 100 shares, so you must multiple quoted prices by 100 as well.
Options market making is unique, though, in terms of the risk that the market maker takes on. Since an options market maker must be counterparty to contracts on demand, the market maker would potentially be exposed to asymmetric risk depending on order flow. A stock market maker simply has to manage his/her inventory of shares, but an options market maker needs to hedge this risk.
Market makers do this through a process called delta hedging, where they buy and sell shares of the underlying stock to mitigate directional risk. In fact, options market makers are the only market participants that are legally allowed to sell short naked (where they do not first borrow the stock in order to short sell). Regulators cracked down on naked short-selling during the financial crisis, but the practice is critical to the market mechanics of options market making.