Clearing and settlement
Each option exchange operates or authorises a clearing house, a financial institution set up to ensure that all parties live up to their commitments. Once a trade has been completed, exchange rules normally require the buyer to deposit enough money with an options broker to pay the entire premium; the writer will receive the premium payment through its broker. Each broker, in turn, has an account with the clearing house, and must have enough money on deposit at the end of each day to cover the cost of the transactions it has handled. Settlement occurs when the money from buyer and writer passes through the clearing house. Once the trade is made, there is no further connection between the buyer and the writer. Instead, the exchange itself steps in as the counter party for each trade, removing any risk that the owner of a profitable position will fail to collect from the owner of a losing position. In most cases, the exchange’s clearing house requires that each option position be marked to market each day. This means that any change in the option’s market price is reflected as an increase or decrease in the value of the customer’s position, and the customer will be asked to deposit additional funds if the position has lost value. If the customer fails to comply, its positions will be liquidated. The buyer of an exchange traded option thus has no need to worry about the reliability or creditworthiness of the writer.
Terminating options
An option can be terminated in several ways. The most common is by selling or buying an offsetting option. For example, the owner of a March 1.60 sterling put on the Philadelphia Stock Exchange would write a March 1.60 sterling put; the offsetting positions would be closed out, with the investor recording a gain or a loss depending upon whether the put it wrote had a higher premium than the one it bought. Similarly, an investor who is short a call would close out the position by buying the identical call. Another way to terminate an option is by exercising it. The owner of an American-style option may exercise it whenever it is in the money, but is not obliged to; the owner of an equity call at 55 may exercise as soon as the shares reach 55, or may hold on to the option in the hope that the stock will go even higher (and take the risk that it will fall back below 55, taking the option out of the money). Depending on the contract, the exchange will settle with the investor in cash or by exchanging the underlying. The exchange may force an investor with an opposing contract to settle. The owner of a General Motors put, for example, might wish to exercise the put, but the exchange will not want to own those shares. It will therefore select the writer of a similar General Motors put, usually at random, and require the writer to accept and pay for the shares. Alternatively, the option can be held to expiration. Some option contracts, including all index contracts, are settled at expiration for cash, with the holder of a money-losing position paying the exchange, and the exchange in turn paying the holder of a profitable position. Many equity and commodity options, however, are settled with the exchange of the underlying. Investors often wish to close out contracts before expiration to avoid other costs, such as stockbrokerage commissions and commodity storage fees, which they may incur if they hold the option until expiration.
Foreign Currency & Foreign Stocks
Investing in foreign exchange (forex or fx), currency speculation, and hedging are variations of the same basic investment strategy — you’re betting that one currency will strengthen or weaken against another. Not for the faint-hearted, these investments involve more due diligence and savvy than any of the other security types we have covered so far. Trading in FX requires a strong macroeconomics background and an understanding of interest rates.
Investing in foreign stocks is just like investing in local stocks, except you introduce another level of risk. If you try to buy a foreign stock, for example, you are really making two bets at the same time: First you must convert your currency into that used by the foreign exchange, and then you use that foreign currency to buy one or more foreign stocks. You now have all of the risk and return possibilities of stock ownership, but you are also investing in a foreign currency, which you hope will be profitable when you sell your foreign stock and convert the proceeds back into your local currency.
Currency speculation and hedging, usually through hedge funds, are similar. You invest in foreign currency believing (or hoping) that the exchange rate against the dollar becomes more favorable and therefore profitable over time. As you can imagine, you can make or lose a great deal of money in the arenas of FX, currency speculation, and hedging. You should become very knowledgeable or employ a trusted expert to help you become a smart and successful investor in these areas. Most advisors would agree that this area is consistently one of the most exciting options for investors.
Terminating options
An option can be terminated in several ways. The most common is by selling or buying an offsetting option. For example, the owner of a March 1.60 sterling put on the Philadelphia Stock Exchange would write a March 1.60 sterling put; the offsetting positions would be closed out, with the investor recording a gain or a loss depending upon whether the put it wrote had a higher premium than the one it bought. Similarly, an investor who is short a call would close out the position by buying the identical call. Another way to terminate an option is by exercising it. The owner of an American-style option may exercise it whenever it is in the money, but is not obliged to; the owner of an equity call at 55 may exercise as soon as the shares reach 55, or may hold on to the option in the hope that the stock will go even higher (and take the risk that it will fall back below 55, taking the option out of the money). Depending on the contract, the exchange will settle with the investor in cash or by exchanging the underlying. The exchange may force an investor with an opposing contract to settle. The owner of a General Motors put, for example, might wish to exercise the put, but the exchange will not want to own those shares. It will therefore select the writer of a similar General Motors put, usually at random, and require the writer to accept and pay for the shares. Alternatively, the option can be held to expiration. Some option contracts, including all index contracts, are settled at expiration for cash, with the holder of a money-losing position paying the exchange, and the exchange in turn paying the holder of a profitable position. Many equity and commodity options, however, are settled with the exchange of the underlying. Investors often wish to close out contracts before expiration to avoid other costs, such as stockbrokerage commissions and commodity storage fees, which they may incur if they hold the option until expiration.
Foreign Currency & Foreign Stocks
Investing in foreign exchange (forex or fx), currency speculation, and hedging are variations of the same basic investment strategy — you’re betting that one currency will strengthen or weaken against another. Not for the faint-hearted, these investments involve more due diligence and savvy than any of the other security types we have covered so far. Trading in FX requires a strong macroeconomics background and an understanding of interest rates.
Investing in foreign stocks is just like investing in local stocks, except you introduce another level of risk. If you try to buy a foreign stock, for example, you are really making two bets at the same time: First you must convert your currency into that used by the foreign exchange, and then you use that foreign currency to buy one or more foreign stocks. You now have all of the risk and return possibilities of stock ownership, but you are also investing in a foreign currency, which you hope will be profitable when you sell your foreign stock and convert the proceeds back into your local currency.
Currency speculation and hedging, usually through hedge funds, are similar. You invest in foreign currency believing (or hoping) that the exchange rate against the dollar becomes more favorable and therefore profitable over time. As you can imagine, you can make or lose a great deal of money in the arenas of FX, currency speculation, and hedging. You should become very knowledgeable or employ a trusted expert to help you become a smart and successful investor in these areas. Most advisors would agree that this area is consistently one of the most exciting options for investors.
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