Options trading is in many respects similar to futures trading (see Chapter 2). An exchange has a number of members (individuals and firms) who are referred to as having seats on the exchange. Membership of an exchange entitles one to go on the floor of the exchange and trade with other members.

Market Makers

Most options exchanges (including the CBOE) use a market maker system to facilitate trading. A market maker for a certain option is an individual who will quote both a bid and an ask price on the option whenever he or she is asked to do so. The bid is the price at which the market maker is prepared to buy and the ask is the price at which the market maker is prepared to sell. At the time the bid and the ask are quoted, the market maker does not know whether the trader who asked for the quotes wants to buy or sell the option. The ask is of course higher than the bid and the amount by which the ask exceeds the bid is referred to as the bid-ask spread. The exchange sets upper limits for the bid-ask spread. It must be no more than $0.25 for options priced at less than $0.50; $0.50 for options priced between $0.50 and $10, $0.75 for options priced between $10 and $20, and $1 for options priced over $20.

The existence of the market maker ensures that buy and sell orders can always be executed at some price without any delays. Market makers therefore add liquidity to the market. The market makers themselves make their profits from the bid-ask spread. They use some of the schemes that will be discussed later in this book to hedge their risks.

The Floor Broker

Floor brokers execute trades for the general public. When an investor contacts his or her broker to buy or sell an option, the broker relays the order to the firm's floor broker in the exchange on which the option trades. If the brokerage house does not have its own floor broker, it generally has an arrangement whereby it uses either an independent floor broker or the floor broker of another firm.

The floor broker trades either with another floor broker or with the market maker. A floor broker may be on commission or may be paid a salary by the brokerage house for which he or she executes trades.

The Order Book Official

Many orders that are relayed to floor brokers are limit orders. This means that they can only be executed at the specified price or a more favorable price. Often when a limit order reaches a floor broker, it cannot be executed immediately. (For example, a limit order to buy a call at $5 cannot be executed immediately when the market maker is quoting a bid of $4| and an ask of $5 j.) In most exchanges, the floor broker will then pass the order to an individual known as the order book official (or board broker). This person enters the order into a computer along with other public limit orders. This ensures that as soon as the limit price is reached, the order is executed. The information on all outstanding limit orders is available to all traders.

The market marker/order book official system can be contrasted with the specialist system which is used in a few options exchanges (e.g., AMEX and PHLX) and is the most common system for trading stocks. Under the specialist system, an individual known as the specialist is responsible for being a market maker and keeping a record of limit orders. Unlike the order book official, the specialist does not make information on limit orders available to other traders.

Offsetting Orders

An investor who has purchased an option can close out his or her position by issuing an offsetting order to sell the same option. Similarly, an investor who has written an option can close out his or her position by issuing an offsetting order to buy the same option.

If, when an options contract is traded, neither investor is offsetting an existing position, the open interest increases by one contract. If one investor is offsetting an existing position and the other is not, the open interest stays the same. If both investors are offsetting existing positions, the open interest goes down by one contract.

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