How Options Are Traded

When option buyer and option seller enter into an option contract, the buyer will pay the full premium to the seller. The seller will then pay a margin to the clearing house. The calculation of the margin is based on the Theoretical Intermarket Margining System (TIMS).

Since the buyer has already paid the full option premium and the most the buyer can lose is the premium, option buyer has limited risk. On the contrary, they seller of the option has unlimited risk. Therefore to manage this risk, the clearing house requires option sellers to be margined on a daily basis.

Index Options

The concept of an option on an index entails the right or the obligation to either buy or sell an underlying basket of shares. Since the index option is based on a basket of shares, it can provide the equivalent to trading a shares portfolio that tracks the shares market as a whole.

It should be noted index options are not an exact substitute for ownership of the underlying shares because they option holder does not receive dividend income or voting rights.

Stock Options

Stock options are based on a parcel of shares in a particular company. The number of shares will generally be based on the broad lots traded on the stock exchange. The underlying stock is the stock which is bought or sold when the option is exercised.

It is important to note that stock options do not give rise to the creation of new equity for the underlying company. It is an agreement between two parties which are not necessarily connected with the company.

Stock Options are generally American style. They can be exercised at any time up to and including the day of expiration. However, it is unusual for the stock options to be exercised before expiry date because any remaining time value is lost if the option is exercised early. Only the intrinsic value can be exercised by exercising the option.