Mechanics of Options Markets

You already know how to price an option — the put–call parity relation and the Black–Scholes formula give you a fair value the moment you know S_0, K, T, r, and \sigma. None of that machinery tells you how to actually buy one. Who is on the other side of the trade? What price do you really pay, versus the "theoretical" price on your screen? What happens on expiration Friday if you forget to close the position? This lesson is the trading floor's answer — the plumbing underneath every option price you've computed so far.

Exchange-listed vs. over-the-counter

Options trade in two quite different worlds.

	Exchange-listed	Over-the-counter (OTC)
Contract terms	Standardized (fixed strikes, fixed expiries)	Bespoke — any strike, any expiry, any underlying
Counterparty	The exchange's clearinghouse (via novation)	The dealer bank itself
Default risk	Effectively eliminated by daily margining	Real — managed with CSAs, collateral, CVA
Typical user	Retail, funds, anyone trading a standard name	Corporates hedging a specific exposure, large structured trades
Example venues	CBOE, Eurex, ICE	Interdealer + bank-to-client desks

The clearinghouse is the quiet hero of the exchange-listed world: once a trade is matched, the clearinghouse legally steps in as buyer to every seller and seller to every buyer (a process called novation). Neither side ever has to trust the other's balance sheet — both only have to trust the clearinghouse, which protects itself with daily margin calls. That's precisely why an exchange can quote a five-cent-wide market on a contract while OTC desks still spend real legal effort drafting an ISDA master agreement before trading a single swap.

Strike and expiry conventions

A listed equity option's ticker packs in everything: underlying, expiry, strike, and right. Exchanges list a ladder of strikes around the current spot (often every $1, $2.50, or $5, tighter near the money) and a calendar of expiries — weekly, monthly (the classic "third Friday"), quarterly, and long-dated LEAPS running out a year or more. A standard U.S. equity option contract covers 100 shares, so a quoted premium of \$3.20 costs \$320 per contract before commission.

Two numbers you'll see quoted alongside every strike are easy to conflate but measure very different things:

Volume — how many contracts changed hands today. Resets to zero every session.
Open interest — how many contracts are currently outstanding (opened but not yet closed, exercised, or expired). It only changes when a trade opens a new position or closes an existing one.

A trade between two people who are both opening new positions increases open interest by one contract. A trade where a buyer closes an existing long against a seller closing an existing short decreases it by one. A trade where one side opens and the other closes leaves open interest unchanged — only volume moves.

At the start of the day, open interest on a strike is 500 contracts. During the day, 320 contracts trade: 200 of them are a hedge fund opening a fresh long position against a market maker opening a fresh short (both new), and 120 are an existing holder closing out against another existing holder closing out. What are today's volume and closing open interest?

Volume is simply the total traded: 200 + 120 = 320 contracts. Open interest rises by the 200 newly-opened contracts and falls by the 120 newly-closed ones: 500 + 200 - 120 = 580. High volume on a strike with little change in open interest tells you traders are mostly trading in and out of existing positions; volume that tracks a rising open interest tells you fresh money is building a position.

How a market maker quotes a price

Every listed option shows two prices, not one: a bid (what a market maker will pay you to buy it from you) and an ask or offer (what they'll charge you to sell it to you), with ask always above bid. The gap — the bid-ask spread — is the market maker's compensation for standing ready to trade instantly in both directions, and for the risk of being caught on the wrong side when the underlying jumps before they can hedge.

\text{mid} = \frac{\text{bid} + \text{ask}}{2}, \qquad \text{spread} = \text{ask} - \text{bid}.

The "theoretical" Black–Scholes price you compute sits somewhere near the mid — it's a useful anchor, but you can never actually transact at it. Buy at the ask, sell at the bid, and the spread is a toll you pay on every round trip. Spreads widen for options that are far out-of-the-money, thinly traded, or close to a volatile event (earnings, a Fed announcement) — exactly when the market maker's own hedge is hardest to manage.

A one-month at-the-money call quotes bid \$2.10 / ask \$2.30. You buy at the ask and — nothing else changing — try to sell it back a minute later at the (still \$2.10) bid. On one contract (100 shares) you've paid (2.30 - 2.10)\times 100 = \$20 just for the round trip, roughly 9.5\% of the ask price, with the stock having not moved at all. This is why active options traders care about spread as much as they care about the "fair" price — a wide spread can eat a strategy's edge before it even gets started.

Physical vs. cash settlement

What actually happens at expiry if an option finishes in the money depends on how the contract is settled:

Physical settlement — the holder of an exercised call receives the actual shares (paying the strike); the holder of an exercised put delivers the shares (receiving the strike). Most U.S. equity options settle this way.
Cash settlement — instead of delivering an asset, the party in the money simply receives the intrinsic value in cash. Broad stock-index options (where "delivering the index" makes no physical sense) and most futures options settle this way.

This distinction has real consequences: a trader who forgets an in-the-money physically-settled option going into expiry can wake up unexpectedly long or short 100 shares per contract — with all the overnight risk that implies — rather than simply receiving a cash credit.

When a heavily-shorted stock's retail-driven rally sent huge call-buying volume through the options market, market makers who had sold those calls had to delta-hedge — buying the underlying stock to stay neutral, exactly as the Greeks tell you a short-call hedger must. As the stock rose, each call's delta rose too, forcing more buying, pushing the stock higher still — a feedback loop traders call a gamma squeeze. It's a vivid reminder that "the market" for an option isn't an abstract price feed: it's real desks holding real inventory who have to trade the underlying to stay hedged, and their hedging can itself move the price.

Open interest is not volume. A strike can show enormous open interest with zero volume today (nobody traded it) — open interest just answers "how many contracts are currently outstanding," not "how much activity happened."
The quoted (mid or last) price is not the price you'll get. You buy at the ask and sell at the bid; on illiquid strikes that spread can dwarf any mispricing you were hoping to exploit.
Exercising an option is not the same as trading it. Most listed-option holders simply sell their contract before expiry rather than exercising it — selling captures both intrinsic and any remaining time value, while exercising throws the time value away.