An exchange-traded option can be defined as a uniform derivative contract traded on an exchange market. It is guaranteed and settled via a clearinghouse.
This standardized contract either sells (put option) or buys (call option) a given quantity of a financial product. The transaction should occur before or on the pre-determined date and at a strike price (pre-determined price).
These contracts are also listed on exchanges like the CBOE (Chicago Board Options Exchange). Regulators are also tasked with overseeing the exchanges. This includes:
- SEC (Securities and Exchange Commission)
- CFTC (Commodity Futures Trading Commission).
Clearinghouses like OCC (Options Clearing Corporation) also guarantee them.
Exchange-traded options benefits
Listed options/ exchange-traded options have many benefits. These benefits are what make them stand out from OTC (Over-the-counter) options. Listed options’ expiration dates, deliverables (no. of contracts/shares of an underlying asset), and standardized strike prices. As such, they accommodate and attract traders in large numbers. Over-the-counter options usually have tailored provisions.
Such volume increase is beneficial to traders as it provides them with improved liquidity and cost reduction. The more the traders demand a particular options contract, the easier it is to identify willing sellers. This automatically constricts a bid-ask spread.
Exchange-traded options standardization also makes it possible for clearinghouse guaranteeing of those options contracts. It also ensures that options contract sellers meet their end of the bargain by fulfilling their duties whenever they are trading (sell) option contracts.
Exchange-traded options drawbacks
One significant drawback, as far as exchange-traded options are concerned, is their standardization. This means investors aren’t able to customize them to fit specific requirements. When compared to un-standardized OTC, exchange-traded options can’t be tailored to fit a seller’s or buyer’s goals.
Even so, the expiration dates and strike prices provided by exchange-traded options do meet the seller’s and trader’s trading needs.
Purchase of call options means the buyer is getting rights to purchase from that option’s seller, usually 100 shares of a given stock at a strike price (pre-determined price). The call must be exercised by a set date, and failure to do so will see it expire.
To buy call options, a ‘premium’ is paid to the options seller. You will then hold the option in anticipation of an increase of that stock’s price to values exceeding the strike price. Once the strike price is exceeded, you have the option of exercising the call to buy the stock from the seller at a price that’s lower than the current market price.
After that, you can choose to keep those shares or sell them off at a profit. On the flip side, if the stock price goes down, you should let that call option expire. That way, the loss you’ll experience will only be limited to the premium cost.
Purchasing put options means buying rights to force a put seller to buy 100 shares, from you, of a given stock at a strike price. The strike price is usually higher than the current market price.
Since you have the ability to force a seller to buy shares at a strike price, the put option acts as some insurance policy for when your shares lose excess value. However, if the market price increases, the share’s value will have increased, so you can allow the option to expire. This is because the only thing you will lose is the premium cost you made for that put.
Buying options is a hedge from losses and can thus be used conventionally. Many options approaches involve significant risk and complexity. It is for this reason that not all are suitable for every investor. As a matter of fact, except for individuals with high-net-worth who can afford to incur significant losses, uncovered calls or put writing is considered unsuitable for most.
Options are contracts giving holders the ability and right to sell or buy underlying assets. This purchase is done at a set price and a specifically set time. The value of options is tied to underlying assets; these assets could be future contracts, ETFs (exchange-traded funds), market indices, interest rates, currencies, bonds, and stocks. Options are also securities, and since their value is driven by something else, they can be termed as derivatives.