Table of Contents
Chapter 1: Introduction to Options Trading
Chapter 2: Options Trading Terminology
Chapter 3: Option Trading Strategies
Chapter 4: Types of Options Trading
Chapter 5: Common Applications of Options Trading
Chapter 6: How to Trade Options
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Chapter 4: Types of Options Trading
- Classification Based on Where Options are Traded
- Classifications Based on When to Trade
- Classifications Based on Validity Term of the Option
- Classifications Based on Complexity of Option
Options can be divided into several categories depending on where, how and when they can be traded. This makes a big difference to the investor because it determines the liquidity of his investment. Whatever your investment strategy is, it is important to understand the types of options available so that you can invest in the right kind to match your investment goals.
Options Listed on an Exchange: Some options are listed on exchanges like the Chicago Board Options Exchange (CBOE). The CBOE is the largest options market in the world. Such options can be traded through these exchanges just like you would trade in stocks. These are also called listed options.
The validity period of the option, quantity of stocks involved and strike price are standardized with these options, which makes it simple for a new investor to compare and assess the various investment possibilities. These options are highly liquid because the exchange functions as the common ground where both buyers and sellers are active in large numbers.
It is far easier to track prices of listed options and make buy and sell decisions quickly and proactively in line with changing economic conditions. The transactions are fulfilled via a clearing house which performs the role of a checking mechanism to make sure all obligations are fulfilled by both parties.
Over the Counter (OTC) Options: OTC options (or dealer options) are private transactions between two parties. The absence of a large and standardized intermediary system makes the transactions quick but also increases the risk of one of the parties defaulting on their part of the deal.
The market value of the traded option is difficult to judge because there is no centralized price monitoring system like an exchange. However, these transactions are often much more flexible and can be customized to suit the needs of the two parties. This aspect makes these options very versatile and adaptable.
American Options: These options can be exercised at any point within the validity period of the contract. In general, exchange listed options can be used in this way. This liquidity and flexibility makes these very attractive to investors who can quickly react to any volatility in the markets.
European Options: These options have fixed life times during which the holder cannot exercise his rights. Only when these reach maturity, can the investor exercise the option. The lack of flexibility is often a reason for its lower price when compared with American options. Many OTCs follow the European style.
Barrier Options: Barrier options come with limitations on price instead of time. The underlying asset must touch a certain price level before the option can be exercised. Although not as flexible as American options, barrier options are still adaptable enough for those with a clear investment goal.
Options which come with long term validity periods are called LEAPS or Long term Equity Anticipation Securities. LEAPS are options that give the same advantages and rights as a regular option but for a longer time span. LEAPS are available on the stocks of well established companies.
You can invest in simple call and put options which are called ‘vanilla’ options and also more complex ones, called ‘exotic’ options. Exotic options are those which involve some complexity in the transaction beyond the simple right to buy or sell at predetermined terms.
For instance, an exotic option could allow the holder to decide whether he wants a call or put option at a certain time during the validity period of the option. It could also be a call-on-call, which will allow him to buy a call option at a certain price before a certain date. Barrier options are also often classified as exotic options.
Many vanilla options are listed on the exchange but exotic options are almost always traded OTC. This means that there is no standardization in the pricing or structure of these. These options are customized to specific investor needs and interests.
For novice investors, it is a good idea to stick to the simpler and more straightforward options. Successful investment with exotic options needs the skill and knowledge that only experienced and expert investors would have built over many years of participating in the markets.
Next Chapter: Common Applications of Options Trading