The Options Clearing Corporation (OCC) performs much the same sort of function for options markets as the clearinghouse does for futures markets (see Chapter 2). It guarantees that the option writer will fulfil his or her obligations under the terms of the option contract and keeps a record of all long and short positions. The OCC has a number of members, and all option trades must be cleared through a member. If a brokerage house is not itself a member of an exchange's OCC, it must arrange to clear its trades with a member. Members are required to have a certain minimum amount of capital and to contribute to a special fund that can be used if any member defaults on an option obligation.
When purchasing an option, the buyer must pay for it in full by the morning of the next business day. These funds are deposited with the OCC. The writer of the option maintains a margin account with his or her broker, as described earlier. The broker maintains a margin account with the OCC member that clears its trades. The OCC member, in turn, maintains a margin account with the OCC. The margin requirements described in the previous section are the margin requirements imposed by the OCC on its members. A brokerage house may require higher margins from its clients. However, it cannot require lower margins.
When an investor wishes to exercise an option, the investor notifies his or her broker. The broker in turn notifies the OCC member that clears its trades. This member then places an exercise order with the OCC. The OCC randomly selects a member with an outstanding short position in the same option. The member, using a procedure established in advance, selects a particular investor who has written the option. If the option is a call, this investor is required to sell stock at the strike price. If it is a put, the investor is required to buy stock at the strike price. The investor is said to be assigned. When an option is exercised, the open interest goes down by one.
At the expiration of the option, all in-the-money options should be exercised unless the transactions costs are so high as to wipe out the payoff from the option. Some brokerage firms will automatically exercise options for their clients at expiration when it is in their clients' interest to do so. The OCC automatically exercises stock options owned by individuals that are in the money by more than $0.75 and stock options owned by institutions that are in the money by more than $0.25.
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