The Options Clearing Corporation (OCC)

Okay, this may sound good in theory but how do you know that the short

positions will actually follow through with their obligations if you decide to use

your call or put option?

The answer is that there is a clearing firm called the

Options Clearing Corporation,

or OCC. The OCC is a highly capitalized and regulated agency that acts as a

middleman to all transactions. When you buy an option, you are really buying

it from the OCC. And when you sell an option, you are really selling it to the

OCC. The OCC acts as the buyer to every seller and the seller to every buyer. It

is the OCC that guarantees the performance of all contracts. By performance we

obviously do not mean profits but rather that if you decide to use your option,

you are assured the transaction will go through. In fact, ever since the inception

of the options market and the OCC in 1973, not a single case of unfair or partial

performance has ever occurred. If you’d like to read more about the OCC, you can

find their website at www.OptionsClearing.com.

Before reading further, make sure you understand the following key concepts:

Key Concepts

1) Long call options give the buyer the right to BUY stock at a fixed price over a

given time period.

2) Short call options create the obligation to SELL stock at a fixed price over a

given time period.

3) Long put options give the buyer the right to SELL stock at a fixed price over a

given time period.

4) Short put options create the obligation to BUY stock at a fixed price over a

given time period.

5) Option sellers (calls or puts) keep the cash regardless of what happens in the

future.

6) The OCC acts as a middleman to all transactions.

More Option Terminology

We’re almost ready to talk about real call and put options but we first must

go over some other market terminology that you’ll need to understand. We just

covered the terms “long” and “short,” which are critical for understanding who has

the right and who has the obligation with any particular strategy. But we have a lot

more ground to cover before learning about strategies. Next, we must venture into

the remaining terms we will be using throughout the book.

Underlying Asset

In the pizza coupon example, we would say the

underlying asset is a pizza.

Notice that the coupon limited us to how many pizzas we can purchase; we cannot

purchase all we want. In addition, the coupon is not good for any brand of pizza

but only the one advertised on the coupon. Call and put options work in similar

ways. The underlying asset for a call or put option is generally 100 shares of stock.

There are exceptions (which we’ll explore later in Chapter Four) to this rule such

as certain stock splits or mergers. But when options are first issued, they always

represent 100 shares of the underlying stock.

The “brand” of shares we can buy is determined by the call or put option. For

example, if we have a Microsoft call option, we have the right to buy 100 shares

of Microsoft. In this case, Microsoft would be the

underlying stock. The price of an

option is tied to or

derived by the underlying stock. Because of this, options are

one of many types of

derivative instruments. A derivative instrument is one whose

value is derived by the value of another asset.