The Clearinghouse

In executing the trade just described, the buyer of a call has the right to purchase 100 shares of XYZ at the exercise price. However, it might seem that the buyer of the call is in a somewhat dangerous position, because the seller of the call may not want to fulfill his part of the bargain if the price of XYZ rises. For example, if XYZ sells for $120, the seller of the call may be unwilling to part with the share for $100. The purchaser of the call needs a mechanism to secure his position without having to force the seller to perform.

The clearinghouse, Options Clearing Corporation (OCC), performs this role. After the day's trading, the OCC first attempts to match all trades. For the college professor's transaction, there is an opposite trading party. When the broker recorded the purchase for the professor, she traded with someone else who also recorded the trade. The clearinghouse must match the paperwork from both sides of the transaction. If the two records agree, the trade is a matched trade. This process of matching trades and tracking payments is called clearing. Every options trade must be cleared. If records by the two sides of the trade disagree, the trade is an outtrade and the exchange works to resolve the disagreement.

Assuming the trade matches, the OCC guarantees both sides of the transaction. The OCC becomes the seller to every buyer and the buyer to every seller. In essence, the OCC interposes its own credibility for that of the individual traders. This has great advantages. The college professor did not even know the name of the seller of the option. Instead of being worried about the credibility of the seller, the professor need only be satisfied with the credibility of the OCC. But the OCC is well capitalized and anxious to keep a smoothly functioning market. Therefore, the college professor can be assured that the other side of his option transaction will be honored. If an options trader fails to perform as promised, the OCC absorbs the loss and proceeds against the defaulting trader. Because the OCC is a buyer to every seller and a seller to every buyer, it has a zero net position in the market. It holds the same number of short and long positions. Therefore, the OCC has very little risk exposure from fluctuating prices.

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