Types of Options You Can Trade
Options are derivative contracts in finance that give the buyer, known as the owner or holder of an option, the right but not obligation to buy or sell an underlying asset. The seller has a corresponding option to complete the transaction by selling or buying.
- Call options and put options are the two main types of options. Respectively, call and put options give the contract owner the right to buy or sell an underlying asset.
- Options can also be categorized as American-style or European-style options depending on their flexibility.
- Various specific types of options exist, as well as strategies for trading options.
What Are the Different Types of Options?
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In a broad sense, options may be categorized as calls or puts. If the owner has the right to buy at a set price, the option is referred to as a call. If the owner has the right to sell at a set price, the option is referred to as a put. Options are also typically classified as American-style or European-style.
Option Trade Types Terminology
Before you start trading options, let’s cover some common terms used when defining types of option trades:
- Option: You pay for the right, known as the option, to make a transaction you want. You are not under an obligation to do the transaction.
- Derivative: An option gets its value from the value of its underlying asset. The underlying value is part of what determines the price of the option.
- Strike price: This agreed-upon price does not change over time, regardless of what happens with the stock price. Strike prices can be set by reference to the spot or market price of an underlying commodity or security on the day the option is taken out. Alternately, strike prices can be fixed at a premium or at a discount.
- Expiration date: You’ll have a certain time period until the agreed-upon date. That’s when your option expires.
Two Main Option Trade Types
A call option is a contract giving you the right to buy the underlying asset at a future time at an agreed-upon price. All types of call options have expiration dates. Depending on the terms of a contract, the underlying asset may be bought at any time before the expiration date or only on the date itself. You buy a call when you believe that the underlying asset is likely to increase in price over a period of time.
An owner of a put option has the right to sell an underlying asset in the future at a price that’s pre-determined. Put options also have expiration dates. You buy a put when you expect the underlying asset’s value to decrease.
Styles of Options
Options may be considered American-style or European-style. This has nothing to do with geographical area where a contract is bought or sold but refers to the terms of the contract.
American-style options give the contract owner the right to exercise their option at any point before the contract’s expiration date. The added flexibility gives the owner of this type of contract a big advantage.
European-style options do not give their owners the same flexibility as their American-style counterparts. Owners of European-style contracts only have the right to buy or sell the underlying asset on the contract’s expiration date, not before.
Exchange-Traded Options vs. Over-the-Counter Options
Exchange-traded options are the most common types of options and are also referred to as listed options. Exchange-traded simply describes any options contract listed on a public trading exchange.
Over-the-counter, or OTC, options are only traded in OTC markets. These options are not as accessible to the general public as exchange-traded options. OTC options are usually customized contracts that have more complicated terms than exchange-traded options.
Types of Options by Underlying Security
While the term ‘options’ usually refers to stock options, the underlying security may be something other than stocks. Here are the most common types of options by underlying security:
- Stock Options: The underlying asset is shares in a specific, publicly listed company.
- Index Options: Instead of stocks in a specific company, the underlying security is an index, for example the S&P 500.
- Futures Options: The underlying security is a specified futures contract, giving the owner the right to enter into that futures contract.
- Commodity Options: The underlying asset may be either a physical commodity or a commodity futures contract.
- Forex/Currency Options: Owners of these contracts have the right to buy or sell a specified currency at an agreed-upon exchange rate.
- Basket Options: These contracts are based on the underlying asset of a group of securities. This can be made up of commodities, currencies, stocks, or other financial instruments.
Types of Options by Expiration
You can also classify options contracts by expiration cycles, which relate to the point when the owner must exercise their right to sell or buy. Here are some different types:
- Regular options: These options use standardized expiration cycles. When purchasing a contract with a regular option, you can choose from at least four different expiration months.
- Weekly options: Introduced in 2005, ‘weeklies’ are available only for a limited number of underlying securities. Weekly options are increasing in popularity and include some major indices. Weekly options are similar to regular options, but with a shorter expiration period.
- Quarterly options: Quarterlies are listed on exchanges along with expirations for the upcoming four quarters, as well as the final quarter of the year following.
- Long-Term Expiration Anticipation Securities: Known as LEAPS, these contracts are available for wide-ranging underlying securities. LEAPS always expire in January, but you can buy them with expiration dates for the next three years.
Other Types of Options in Finance
There are a few other types of options to be aware of, including:
- Employee stock options: These stock options grant employees contracts for the stock of the company they work for, and are usually used as an incentive to join a company or as a bonus or other form of remuneration.
- Cash-settled options: These contracts don’t involve the physical transfer of an underlying asset when the contract is settled or exercised and are typically used when an underlying asset is expensive or difficult to transfer. Instead, the party to a contract that makes a profit is paid in cash by the contract’s other party.
- Exotic options/Non-standardized options: Both terms apply to a contract that involves customization with complex provisions. Many exotic contracts are only found on OTC markets, but as they become more popular with mainstream investors, exotic contracts are getting listed on public exchanges as well. Common types of exotic options include:
- Barrier options: This type of contract provides a payout to the contract holder if an underlying security does or does not reach a predetermined price, depending on the terms of the contract.
- Chooser options: The owner of this type of contract can choose whether the contract is a call or put at a specified date.
- Compound options: This type of option involves an underlying security that is another options contract.
- Look-back options: Instead of having a strike price, this type of contract allows its owner to exercise at the best price an underlying security reaches during the contract’s term.
Types of Options Trades Strategies To Know
Before jumping into trading different types of options, it’s important to know strategies that can limit risk and maximize return. Here are some strategies that take advantage of the flexibility of various options:
- Covered call: This popular strategy generates income while reducing some of the risk of being long on a stock alone. However, you must be willing to sell shares at a set short strike price. You just purchase underlying stock as usual while writing a call option on the same shares.
- Married put: This strategy involves purchasing an asset while simultaneously purchasing put options for the equivalent amount of shares.
- Bull call spread: In this vertical spread, the investor buys calls at a specific strike price while simultaneously selling the same number of calls at a higher strike price. Both options have the same underlying asset and expiration date.
- Bear put spread: This vertical spread has an investor simultaneously purchasing put options at a set strike place and selling the same number of puts at a lower price, again with the same expiration date and underlying asset.
- Protective collar: This strategy is when you purchase an out-of-the-money put option while writing an out-of-the money call option, both with the same underlying asset and expiration date.
- Long straddle: Here, an investor purchases a call and put option on one underlying asset with the same expiration date and strike price.
- Long strangle: This strategy has an investor simultaneously purchasing an out-of-the-money call and put option on one underlying asset with the same expiration.
- Long call butterfly spread: You combine both a bull and bear spread strategy here, using three different strike prices. All options will be for the same underlying asset and the same expiration date.
- Iron condor: With this strategy, you will hold both a bull put spread and bear call spread at the same time.
- Iron butterfly: An investor sells an at-the-money put while buying an out-of-the-money put, and simultaneously sells an at-the-money call while buying an out-of-the-money call.
Our guides to call and put options and our training about buying options are great resources to help you learn. Learning about different options will help you develop strategies to meet your trading goals.