A simplistic view of equity markets is that, when you place a buy order, you’re actually being paired up with another investor who owns that stock and a middleman like your brokerage or the exchange simply matches the two of you up.
In reality, there are rarely enough buyers for all the sellers or sellers for all the buyers. Relying on buyers and sellers to be consistently present in enough numbers to make such a match-making system work is simply not realistic and, if it was attempted, would result in a very inefficient market in which trades would cost traders much more than they do in the current system.
Why?
The current market exchange system relies on market makers whose job it is to make a market in a particular stock. They act as a buyer for every seller and a seller for every buyer. In order to do this, they maintain an inventory of the stock in question and sell out of that inventory when a trader wants to buy and add to that inventory when a trader wants to sell.
In exchange to acting in this capacity and the market risk that it entails, market makers maintain a “spread” between the price at which they’re willing to buy and the price at which they’re willing to sell. Depending on how volatile and liquid the stock is (i.e. how much risk they assume by being the market maker) the spread can be very narrow where you can sell for only a few cents less than you can buy or expand to a much larger differential to compensate for the market makers costs and the market risk involved in making a market for the stock.
Because it’s even less likely to match up individual buyers and sellers of options contracts than it would be with equity trades, the options markets use market makers as well. But, with options trading, there aren’t individual market makers for the options on each particular stock. Instead, the Options Clearing Corporation (OCC) acts as the market maker for all option contracts.
So, even though the idea of buying a call implies that there’s some trader who owns the stock on the other end of the transaction actually selling a call, in reality your transaction is with the OCC and not another trader. This also guarantees that you, as the buyer of a put or a call, have the assurance that if you choose to exercise a contract that the contract terms will be honored because an independent third party is backing them up.
A slight exception to the role of the OCC as the market maker is when an option contract is exercised on a put or call option. In that case, the OCC and the brokerages it deals with assign that exercise to any seller that has an open position in a contract with the specific terms of the one that was exercised. This assignment either occurs at random or based on how long the short position has been open. Thus, the longer the position has been opened the more likely it is to receive the assignment of an exercise.
In the event that a seller is unable or unwilling to fulfill the terms of the exercise, his or her brokerage fulfills the contract then goes after the seller to recoup their costs. Like the spreads maintained by market makers in equity markets, it’s this service of guaranteeing a seller for every buyer and vice-versa that earns the OCC and the brokerages the spread that they charge when handling option contract transactions for their clients and customers.
