Options Are Standardized Contracts

The reason that options are inflexible as to the number of shares is because

options are standardized contracts. A standardized contract means there is a uniform

process that determines the terms, which are designed to meet the needs of most

traders and investors. By using standardized contracts, we lose some flexibility in

terms (such as the number of shares, strike prices, and expiration dates) but increase

the ease, speed, and security in which we can create the contracts.

In fact, if the exchanges find there is not sufficient demand for options on a

stock, they will not even list those options. Most of the well-known companies

have options available. If a stock has listed options, it is an

optionable stock.

Microsoft and Intel, for example, are optionable. There are currently more than

2,300 optionable stocks, so the list is quite large.

Another limitation of standardized contracts is the fixed strike price

increments. If the stock price is below $50, you will find options available in

$2.50 increments. If the stock price is between $50 and $200, options will be in

$5 increments. And if the stock price is over $200, you will find option strikes in

$10 increments. Notice that the strike price increments have nothing to do with

the current price of the stock. The increments are based on the stock’s price at the

time the options start trading. If a stock’s price has been greatly fluctuating, you

might find different increments for different months. For instance, you may find

$2.50 increments for the first two expiration months and $5 increments in later

expiration months. This just tells you that the stock’s price was above $25 when

the later months started trading.

By having standardized strikes, we can quickly bring new contracts to market

that meet the needs of the vast majority of people. Imagine how overwhelming

the task would be if the exchanges tried to meet everybody’s needs by creating

strike prices at every possible price such as $30, $30.01, $30.02, etc. and then

matched those with every possible expiration date such as June 1, June 2, June 3,

etc. It would be a near impossibility. To solve these problems, the exchanges created

standardized contracts so that we can have some flexibility while still keeping the

list manageable.

What if you really want a customized contract? Is it possible to get one?

Technically, there is nothing illegal about two people having a contract drawn up

by an attorney that specifies the terms on which they agree to buy and sell stock.

You could therefore have an attorney write a contract for you and another trader,

thus creating your own call or put option. A contract drawn in this manner is

completely flexible -- but it is also very time consuming and costly. In addition,

even though you may have a legally binding contract, it is possible that the seller

decides to not fulfill his obligation if the buyer wishes to exercise his option. If

that happens, now you’ve got your hands tied up in court trying to get the seller

to conform to the terms of the contract. In other words, customized contracts are

subject to

performance risk. That is, will the seller perform his part of the agreement

if the buyer decides to exercise?

Standardized options solve the performance risk problem too since the OCC

acts as the buyer to every seller and the seller to every buyer. If you exercise an

option, the OCC uses a random process to decide who will be assigned. When you

enter an options contract, you do not know who is on the other side of the trade.

Nobody knows. It is strictly the person who ends up with the random assignment.

Standardization increases confidence and influences the progress toward a smoothly

running, liquid market.

Besides having an attorney draw up a contract, there is another way to get

flexible contracts. You can buy FLEX contracts through the Chicago Board Options

Exchange

(CBOE) that are totally customizable, but they also require an extremely

large contract size – usually more than one million dollars. Because FLEX options

are traded through the OCC they are not exposed to performance risk despite their

large contract sizes. Because of the size requirements though, FLEX options are

mostly used by institutions such as banks, mutual funds, and pension funds. The

standardized market is the solution for the rest of us.