Options Clearing & SettlementOptions
Exchange based trading has a long process that begins when investors deposit money into the fund. Option exchanges work to ensure every trade party acts as agreed. The exchange sets the rules for trading. Exchange clearing and settlement starts when the exchange requires you actually deposit your initial margin.
This margin stays on hand in your account to ensure you can pay the premiums. The actual level of margin is not permanent. It completely depends on the positions your account holds. Every day, the exchange updates the value of your positions, and adds or subtracts money from your margin account depending on your position’s success. This is called “Marking to Market”.
Margin, Trading, and Margin Calls
Your margin will increase or decrease with the success of your trading. If your positions perform well your margin will remain high. If you are in losing positions they subtract unrealized losses from your account, and margin will fall. If it falls below the minimum, you will have to add funds or your account’s positions will be liquidated. You will receive the notification asking for more funds known as the “margin call”. Margin can also be met by holding the underlying securities in the margin account instead of cash. It must be the underlying security. Equity option margin is not satisfied with an underlying portfolio filled with bonds.
The premium paid to the writer comes out of the margin account. Brokerages must have enough money to handle gains and losses on all transactions. This occurs after the exchange steps in as a counter party to all transactions. You purchase your put or call from the other party, and they receive the premium. After that, all of your interactions are with the exchange’s clearing house. They become the buyer of the option for the seller, and the seller of the option for the buyer. The buyers and sellers have no connection thereafter, dealing only with the exchange.
When an option is exercised, the clearing house selects a writer who sold a matching option at random. They are forced to meet their obligation. They must sell the underlying asset if they wrote a call, and they must buy the underlying asset if they wrote a put. Their obligation must be fulfilled to the exchange. Whether they do or do not is the exchange’s problem. The exchange is required to fulfill their role to the option’s exerciser, and the exerciser’s original counterparty fulfills their role to the exchange.
If options are not exercised, they expire on one of four dates set by an exchange. These days are the expiration dates, and they are always days marked with very heavy trade volumes. People are trying to get out of their bad positions and hopefully into a good one, so they can exercise options or avoid being exercised against.
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