Privilege Dealer

A privilege dealer is any individual or firm whose regular business involves engaging in buying or selling listed equity options contracts. Privilege dealers are also known as options dealers.

Privilege dealers generally must be registered as a market maker or specialist in options with a securities exchange. The adjective “privilege” derives from the rules governing the treatment of a dealer’s gains and losses on options trades, which differ from those governing conventional securities dealers.

Options come in two varieties. Call options allow a trader to buy an equity at a set price, while put options allow traders to sell an equity at a set price. In either case, option holders must exercise their option to purchase or sell the underlying equity shares in a prescribed time period. If contract holders fail to exercise an option within that period, the contract becomes void.

Traders can enter options as either a writer or a holder of an option. Options writers accept a holder’s premium in exchange for the risk of finding a buyer or seller for the given equity at the trader’s price. To the extent the options writer can buy or sell the underlying equities at a profit, the writer has upside beyond the premium payment. To the extent the writer might lose money on trades underlying an options contract, the premium covers a portion of their risk.

Dealers operate on exchanges to help ensure liquidity through the sheer size and diversity of the portfolios they trade. Listed options on an exchange set standard elements of the contracts, including the number of equity shares in the underlying trade, the expiration date for the transaction and a range of exercise prices for the trade. To avoid forcing individual traders to locate writers or holders for options contracts, dealers maintain a portfolio of options contracts which they can then buy or sell to traders as necessary. Because they deal in high volumes, dealers generally aim to profit off the spread between the put and call prices on the underlying securities.

Like all derivatives, options contracts exist a step removed from their real asset. Their values fluctuate in part based upon the value of the underlying asset, but also based upon other contributors to risk, notably volatility in terms of the price of the underlying asset and the time until the contract’s expiration. For this reason, regulatory bodies such as the U.S. Securities and Exchange Commission impose a strict and complex set of regulations on market makers in options markets to ensure they have the ability to cover the positions in their portfolios. The SEC also maintains special rules for the tax treatment of gains and losses for options dealers.