Background and Markets

When options were first traded, contracts were arranged between pairs of investors and customized to meet specific needs. These customized contracts could vary according to exercise price, expiration date, and underlying asset. Because of these infinite possibilities, it was nearly impossible for a secondary options trading market to exist. Investors would enter into customized agreements according to their investment needs; if their needs changed, it was difficult to find another investor to buy the option contract.

Secondary This lack of liquidity and standardization was one of the driving markets forces behind the creation of the Chicago Board Options Exchange (CBOE) in 1973. The CBOE enacted rules to standardize option contracts in order to restrict the number of contract types that would trade on the exchange. Soon, other option exchanges were created. This led to a broader standardization of option contracts and was the key to creating a secondary market for options and increasing the liquidity of option contracts.

Customized option contracts are still available to investors — they are traded in over-the-counter (OTC) markets. These customized options are usually considerably more expensive than the standard option contracts because of the lack of liquidity.

Standardized contracts

The first standardized contracts were for the purchase or sale of common stock. However, investors soon created demand for options on a variety of financial and physical assets, including options on:

Common stock Stock indices Debt instruments Interest rate futures Foreign currency futures Agricultural commodities Precious metals

These options are now written and traded by investors on several different exchanges.

Another important event occurring with the establishment of standardized option contracts was the creation of the Option Clearing Corporation (OCC). The OCC is the clearinghouse for options trading. It is the single guarantor of all the options listed on the options exchange. With the OCC in place, an option buyer need not be concerned with counterparty risk (lack of performance, for example).

Because options on stock are among the most common, most of our discussion and examples in this unit focus on stock options. However, the basic principles of options are the same, regardless of the underlying asset.

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