What it means
When you buy an option on an exchange, you do not deal directly with the person who sold it. The Options Clearing Corporation steps into the middle of every trade, so each side has a contract with the clearing house rather than with each other.
If a seller fails to deliver, the OCC still makes sure the buyer is paid. This role is called central clearing, and it removes the worry that the other party might default.
The OCC is regulated by the Securities and Exchange Commission and the Commodity Futures Trading Commission, and it is owned by some of the exchanges that trade options. It handles the processing that follows a trade, including matching, settlement and exercise of contracts.
To protect itself, the OCC requires members to post margin, which is a deposit of money or securities held as security. It also keeps a clearing fund contributed by member firms, which can be used if a member fails and its margin is not enough.
These layers are meant to keep the system stable during market stress. For a business, the OCC matters mainly because many companies use listed options for hedging or for share-based pay programmes.
A treasurer who buys protection on a share portfolio relies on the clearing house to make sure the contract pays out. Employees who trade options through a broker are protected in the same way.
Because the letters OCC are shared with the Office of the Comptroller of the Currency, always check the context. In a discussion of banks and charters, OCC means the regulator, while in a discussion of options, derivatives and clearing it means the clearing corporation.
Understanding the clearing house also helps when markets become stressed. If a large member defaults, the OCC can use that member's margin first, then the clearing fund and then other resources set out in its rules.
This layered design is intended to keep a single failure from spreading, which is why regulators treat clearing houses as critical parts of the financial system.
In practice
Real-world examples.
Example
An investor buys 10 call option contracts on a technology stock through her broker. The OCC becomes the seller of those contracts to her, so she is not exposed to the original seller's credit. When the stock rises, she exercises the options and the OCC arranges delivery.
Example
A manufacturer's treasurer buys put options on a commodity-linked share holding to cap potential losses. The clearing house guarantee means he can rely on payment even if the seller is in trouble. He records the hedge in the company's risk report.
Example
A broker-dealer that is a clearing member posts margin to the OCC every day against its customers' option positions. When markets swing sharply, the OCC calls for extra margin. The broker's treasury team keeps a cash buffer to meet these calls.
Case study
Seen in the real world.
Maple Ridge Capital is a fictional trading firm used to illustrate the role of a clearing house. In this illustrative story, a fund manager there sold 500 put option contracts on a share index during a calm market. When prices dropped sharply, the fund owed far more than it had expected.
The clearing house called for additional margin of $2,000,000 within a day, and the firm met the call from its cash reserves. Because margin had been collected in advance, the buyers of the options were never at risk of losing out. Maple Ridge later changed its risk limits so that it holds cash equal to at least twice its largest expected margin call. The experience persuaded management to add a daily margin forecast to its treasury dashboard, so a call from the clearing house would never again be a surprise.
Watch out
Common mistakes.
- Thinking the OCC is a bank regulator. That is the Office of the Comptroller of the Currency, while the Options Clearing Corporation is a clearing house.
- Believing the OCC removes all risk from option trading. It removes counterparty risk, but you can still lose money if the market moves against you.
- Assuming the OCC sets option prices. Prices come from trading on the exchanges, and the OCC handles clearing and settlement afterwards.
Questions
People also ask.
What does a clearing house do?
It guarantees trades by becoming the counterparty to both sides and by collecting margin to cover potential losses.
Who regulates the Options Clearing Corporation?
In the United States it is overseen by the Securities and Exchange Commission and the Commodity Futures Trading Commission.
Do ordinary investors deal with the OCC directly?
Usually not, because they trade through brokers who are clearing members or use a clearing member.
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