This is Part 2 of a six-part series aimed at demystifying and examining listed stock option strategies. Part 1 can be found at montrealgazette.com/business

Last week I described the problems that befell AIG, Bear Stearns and Lehman Bros., which all resulted from Over-The-Counter private transactions (OTC). With OTCs, two counterparties enter into a transaction where the price is negotiated between the parties with no registration, no orderly markets, no disclosure, no pricing transparency, no margin requirements, no requirements to maintain capital reserves, etc. To this day, overseeing organizations such as the Chicago Board of Options Exchange, Bank for International Settlements, Options Clearing Commission (OCC) and the Canadian Derivatives Clearing Corporation (CDCC) have no power over OTC transactions. The only regulation for OTC transactions comes from the International Swaps and Derivatives Association, which is a trade association interested in advancing its own agenda.

In other words, there are no checks and balances and no mechanism to oversee payments and settlements in the case of partial or total defaults.

In the case of Listed Stock Options, the OCC operates to secure the integrity of the option market it guarantees. It guarantees that for every buyer there is a seller and its job is to make certain that at the close of business each day there is a matching of all buyers and sellers. In Canada the job falls to the CDCC, owned entirely by the Montreal Exchange.

These organizations operate in such a way as to ascertain that individual investors, whether they participate in large dollar transactions or those of smaller quantum, do not have to worry about the creditworthiness of the unknown counterparty to their transaction. In fact, the option buyer or seller rarely, if ever, knows the counterparty. Additionally, the actual act of clearing and matching occurs with no implication on the part of the investor, but is done through an exchange of information between the investor’s brokerage firm and the clearing corporation.

It is worth mentioning that there are substantial checks and balances involved in each step of the process from ascertaining that the investor has the requisite funds to making sure the brokerage firm is a clearing member and is in good standing with the clearing corporation.

As a result of these safeguards, the investor can rest easy and is assured that there is no counterparty risk, thus making the benefits of purchasing and selling listed stock options fully and indisputably available. The seller of an option will receive the premium he is due and the buyer will be obligated to make payment. If either counterparty is incapable of fulfilling its obligations, the clearing corporation will see to it that the transaction is consummated properly.

Now that the option clearing process has been explained and the safeguards and guarantees identified, some of the special properties of options must be described.

The term leverage is a double-edged sword. If an investor in options is on the right side of the market, the gains from his option transactions are a multiple of what the potential earnings associated with simple stock purchases would have been. Conversely, as will be illustrated in a later instalment of this series, losses may be magnified as a result of this leverage.