Option mechanics

Discussion in 'Options' started by Neyo, Jun 28, 2013.

  1. Neyo


    Hi guys,

    i realise this will be a completely newbie question but for some reason i just can't wrap my head around it or seem to find it online.
    What i want to ask is how the option purchase or sale mechanics work.

    For example:
    - when i buy an option, do i buy it from the broker or do i buy it from someone(physical person) who has already posted it online as an offer he is willing to sell?
    - also, when i sell an option, do i need someone on the other side(like when selling stocks, you need a physical person on the other side of the computer accepting to buy it from you), or do i sell it to the broker?

    thanks in advance for the answers guys, i realise it's a newbie question but i just can't seem to figure it out :)
  2. 1245


    When you Buy/Sell any option contract you have entered into a transaction with another trader at that price. After the option settles and the buyer pays for the contract, your option position is then with the OCC, http://www.theocc.com/. The OCC becomes your counter party risk and makes sure when the buyer wants to exercise their option, they get what is included in the terms of the contract. The members of the OCC, your broker, have to follow the rules of the OCC for your protection.

    Before you trade any options make sure you understand the contract you are entering into. It's a simple contract but if you don't understand the terms and rules of the contract, it can cost you.

  3. Neyo


    thanks, you see i wasn't completely clear as to if the options i buy have to first be put up for sale by some other trader, or if they are put up by the broker.
    since they have to be put up by another trader on the other side of the screen that makes a lot more sense to me :)

    just one more question: if the traders place the options they are willing to sell/buy, how are the spreads between ask/bid formed?
  4. 1245


    There are many Broker Dealer Option Market Makers that make electronic markets based on what they determine they are willing to buy/sell any option at that time. In addition to that, there are customer orders left on the electronic option book at the prices they are willing to Buy/Sell. What you can view is a called the NBBO, National Best Bid and Offer. It can be made of the best markets for as many of 9 option exchanges.

  5. Neyo


    thank you for the answer again! it cleared things up quite a bit :)