4

Option contracts (this question also applies to futures) on exchanges are required, legally, to at least put an option margin of 50% to cover some collateral. However, if things go as expected for the contract buyer and they execute the deal of the contract, how is the seller enforced to pay the rest of the collateral?

For example, If I buy a call option for 100 shares of N at strike $20.00 where N is currently $10, and execute it when N is $30, how can I be sure that the person at the other end of the contract can actually sell me this security at the original price? From my understanding, their original margin was 50 shares of N at $10. Is it possible for the underlying stock to be used as collateral?

What actually happens if the contract holder refuses to perform his obligations?

I suppose this same concept can be applied to a futures contract, although the situation is exaggerated since magnitudes of leverage can be imposed.

Improve this question

2 Answers 2

Reset to default
8

By their agreements with the central counterparty - in the US, the exchange or the Options Clearing Corporation, which interposes itself between the counterparties of each trade and guarantees that they settle.

From the CCP article:

A clearing house stands between two clearing firms (also known as member firms or participants). Its purpose is to reduce the risk a member firm failing to honor its trade settlement obligations. A CCP reduces the settlement risks by netting offsetting transactions between multiple counterparties, by requiring collateral deposits (also called "margin deposits"), by providing independent valuation of trades and collateral, by monitoring the credit worthiness of the member firms, and in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting member's collateral on deposit.

Exercisers on most contracts are matched against random writers during the assignment process, and if the writer doesn't deliver/buy the stock, the OCC does so using its funds and goes after the defaulting party.

Improve this answer
2
  • 2
    By "goes after the defaulting party," do you mean pursue legal action?
    – Danyil Bee
    Sep 12, 2017 at 3:18
  • @DanyilBee expulsion from the market, legal action, arbitration, liquidation of all of their positions, and other things. Here's an 8 page document from the OCC on the subject - theocc.com/components/docs/risk-management/…, other clearing houses would have their own procedures.
    – dsolimano
    Sep 12, 2017 at 12:27
1

The counterparty to every exchange traded option transaction is a Central Counterparty. This is a clearing house that is formed from capital provided by each of the exchange's clearing members. Each clearing member typically posts a deposit with the clearing house to cover clearing operations. If one of the clearing members goes bankrupt and the clearing house is unable to meet its obligations, the other clearing members can be called upon to post collateral to make up the shortfall. This ensures that all transactions will clear. As a result the Central Counterparty often has an extremely high credit rating.

The clearing member will provide clearing services for non-clearing exchange members (for a fee) and will impose rules about how much collateral the non-clearing member has to post for his type of account. If that non-clearing member is a broker and has customers, he may in turn impose rules about how much collateral his customers need to post in order to open a position. At a minimum, all parties have to follow the collateral rules of the clearing house.

Usually these obligations are enforced by a customer being required by his broker to post sufficient collateral before they begin trading. That way, the broker can simply block the customer from withdrawing from his account or sell his positions to make up any capital shortfall (this process is called a 'margin call').

Improve this answer

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .