The options market Over – the – Counter Market

Prior to the introduction of the Chicago Board Options Exchange, transactions in put and call options in the United States were all carried out in the over-the-counter market. About two dozen dealers and brokers were active in the market, and they were members of the Put and Call Dealers Association. These dealers and brokers usually served as middlemen between would-be buyers and sellers of options. They rarely took the position as the maker of options themselves.

Each call or put contract was individually negotiated between the buyer and the seller as to exercise price, maturity date, and amount of premium. There, was no standardization either in exercise price or on dates of maturity. One call contract could be slightly different from another, even though the underlying stock was the same. Consequently, the resale of an option was both expensive (the difference between buying and selling price was substantial) and time consuming. Many times the maker (writer) and holder of options would have to sit out the duration of the contract, even though their option contracts were in bearer form and transferable.

Chicago Board Options Exchange (cboe)

The creation of the Chicago Board Options Exchange (CBOE) in April of 1973 changed the whole picture of the options market and trading in the United States. The innovations introduced by the CBOE made trading in options as easy as trading in stocks. Investors and speculators responded with great enthusiasm. Now options are traded not only on the CBOE but also on the American Exchange, the Philadelphia Exchange, the Midwest Exchange, and the Pacific Exchange. Options traded on exchanges now account for more than 90 percent of the total volume.

The innovations introduced by the CBOE are the following:

1. Standardization of maturity dates. Under the present practice of exchanges, the expiration months are in three-month cycles. Some options expire in January, April, July, and October, while others expire in February, May, August, and November.

2. Standardization of exercise price (or striking price). The exercise price is the price per share at which the holder of the option may purchase the underlying stock upon exercise. Standardization of exercise price is accomplished in the following manner. When trading is introduced in a new expiration month, the exercise price is fixed at a dollar per share figure approximating the market price of the underlying stock. For example, if the market price of XYZ stock is 21 when trading is initiated in XYZ October options, the exercise price would ordinarily be set at 20; if the market price of the underlying stock were 48, the exercise price would ordinarily be set at 50; and if the market price were 107, the exercise price would ordinarily be set at 110. For stocks with prices below $ 200, the interval between exercise prices is usually $ 5 (for some stocks the interval can be $ 2.50). For stocks with prices over $ 200, the interval between exercise prices is $ 10.

3. Range of striking prices. New options are introduced from time to time after substantial price movements on underlying stocks. When significant price movements take place in an underlying stock, additional options with exercise prices reflecting such price movements may be opened for trading. For example, if stock option was first introduced at a striking price of $ 50, and the stock rises to $ 67, a new option will probably be offered at a striking price of $ 70.

4. Central marketplace. CBOE provides a central marketplace for continuous trading in call and put options, both new and old, issued by the Chicago Board.

5. Adjustments to exercise price. Unlike options traded in the over-the-counter market, no adjustment is made by the CBOE to reflect the declaration or payment of ordinary cash dividends as defined in the rules of the exchange. However, in the case of other distributions (stock dividend, stock split, or recapitalization), either the exercise price of options with respect to such stock is reduced by the value per share of the distributed property, or such options are equitably adjusted to include the equivalent property which a holder of the underlying stock would be entitled to receive.

6. Assignment of responsibility. The Options Clearing Corporation is the primary issuer and obliger on every option issued on the CBOE. Ordinarily, whenever a Chicago Board Option is issued to a buyer, there must exist a writer (seller) of this option. However, the holder of an option does not look to any particular writer (seller) for performance; instead, the clearing corporation bears full responsibility for honoring all the options issued on the CBOE.

7. Certificateless trading. Ordinarily no option certificates are issued by the Clearing Corporation to evidence the issuance of Chicago Board Options. Rather, the clearing corporation maintains a daily record of options issued in each account of its clearing members, and each clearing member is required to maintain a continuous record of his respective customers' position in Chicago Board Options. The ownership of Chicago Board Options is evidenced by the confirmations and periodic statements that customers receive from their brokers.