Comments on: Options Trading Question

Question: Options Trading Question

Anonymous — Sun, 21 Oct 2007 12:14:34 -0800

Technical options trading question.

I need to understand the mechanics of a particular options trade a little better.

Let's say A wants to temporarily transfer his shares of IBM to B, but wants to be certain of getting the shares back. Let's say that, to address this desire, the parties agree that B will write A a call for the IBM shares at a substantially in-the-money price, like $3. Let's say that B exercises the call and takes the shares back a few days later.

Does the purchase of the shares actually cross the floor of any exchange anywhere? I.e., is there a "tick" somewhere recording a sale of IBM at $3? Does the $3 purchase show up as a regular "buy" somewhere, or is it somehow routed differently than a normal buy order?

Does it depend on whether the options are over-the-counter or exchange traded?

All that is sort of background to what I really need to know: if A and B tried to swing this with regular purchases and sales, I understand there is some risk that the trade could be "broken up" on the floor of an exchange -- someone could swoop in and take the shares at the low price. Does the options contract protect against that risk?

Note, I'm not planning on doing this, this is a problem I'm analyzing.

By: TrashyRambo

TrashyRambo — Sun, 21 Oct 2007 13:03:24 -0800

They could do this privately. (In the same way as I could sell you my TV with an option to buy it back.) So no one would see anything.

If they wanted to use regular purchases: A would have to sell his shares to B. If B then "sold" A a call, then when that option is exercised, settlement would be delivery of the shares in exchange for the exercise price amount. The shares would at no time be "for sale" and able to be picked up. The exercise price would not show up as a tick on the exchange at that value.

By: crocomancer

crocomancer — Sun, 21 Oct 2007 13:06:53 -0800

I'm not sure I understand the structure here exactly: does A sell B the shares, then B writes a call which he sells to A so A can exercise it to get the shares back? Because you say both that B writes the call and that B exercises.

IANATrader, but my guess would be that if this is a private deal between A and B then it doesn't have to cross any exchange floor - you don't have to go to a broker because you're not trying to just sell to the market.

I don't think options need to come into it.

By: Mr. President Dr. Steve Elvis America

Mr. President Dr. Steve Elvis America — Sun, 21 Oct 2007 13:26:14 -0800

It's quite possible for an individual to sell shares of publicly-traded stock to another specific individual at any price the two of them please. The buyer and seller's brokers would probably have to be involved, since the seller probably doesn't actually have the stock certificates sitting in his closet, but there would be no risk of a third party disrupting the transaction.

As a practical matter, of course, stock exchanges were invented to avoid the problem of tracking someone down to buy your stock and haggling with them over the price, but they're optional. The thing is, though, most buyers won't buy for more than the exchange price and most sellers won't sell for less, so you might as well use the exchange.

In your example, Alice wants Bob to take possession of her stock for some time, then return it. What's not clear, though, is why Bob ends up (at least) $3 richer, since that's what Alice will have to pay to exercise the option, forcing Bob to sell. (I'm assuming he wrote the option for free.)

It makes more sense, from my perspective, for Alice and Bob to enter into a stock lending agreement, which could be made legally enforceable.

Under a stock lending agreement, Alice would, say, give Bob possession of the stock on January 1, and for six months thereafter, Bob would make monthly payments of $1 (or whatever) to Alice, returning the stock on June 30.

If Bob doesn't return the stock, Alice can sue him for a judgment, and none of this is susceptible to third party interference.

By: Ironmouth

Ironmouth — Sun, 21 Oct 2007 21:08:12 -0800

These transactions are done via stock lending in the real world. The method you suggest isn't used for the complications you indicated.

By: The Shiny Thing

The Shiny Thing — Sun, 21 Oct 2007 22:11:29 -0800

IANAEquityOptionsTrader, so there may be some details of the crossing mechanisms that I've got wrong, but...

While they might use the exchange's crossing mechanisms to make delivery of the shares, it wouldn't show up in the tick stream, and IBM's low for the day wouldn't be $3. (Deep-in-the-money option exercises happen all the time, so if the exercises did show up in the data stream, the prices would be all over the place.)

What the options contract does, rather than protecting against the risk of the trade being broken up on the floor, is guarantee that the shares will be returned at the end of the "loan". An option that deep in the money is effectively a forward contract, so you're definitely gonna get your shares back.

(This is a total nitpick, but it would be A exercising the call, not B.)

By: The Shiny Thing

The Shiny Thing — Sun, 21 Oct 2007 22:14:39 -0800

Mr. President Dr. Steve Elvis America: yeah, a stock loan would be a lot easier. However, the options contract is just as legally enforcible as the stock loan agreement - it'd probably be regulated by some form of the ISDA Master Agreement.

By: Mid

Mid — Mon, 22 Oct 2007 08:52:39 -0800

Sort of related: is there anything fishy if A sells the shares to B at $10, and takes a call back from B for a $5 premium and a $5 strike?

By: The Shiny Thing

The Shiny Thing — Tue, 23 Oct 2007 04:11:48 -0800

Not really. In fact, given that it's pretty much guaranteed to be exercised, the premium for the $5 call pretty much has to be $5 - maybe $4.97, to take into account the interest.

It's not especially fishy, but your market risk department (if you have one) might wonder what you were up to.