If you’re getting into trading, you’ve probably heard the term “options trading” thrown around. In short, an option is a derivative contract that gives the owner the ability to buy or sell securities over a particular period of time at a predetermined price.
Let’s break that down. A derivative contract is an agreement between parties that derives its value from the performance of an underlying entity, like an index rate, asset, or index. A security is any tradable financial asset. Examples of securities include stocks and bonds. So, an option is a contract that gives you the ability to buy or sell a particular security, like a stock, at a prearranged price in a future period of time.
Here are the top seven types of options you should consider:
- Call options,
- Employee stock options,
- Put options,
- American style options,
- European style options,
- Cash settle options, and
- Exotic options.
Read on to learn more about the different types of options and what each of these terms mean.
Top Seven Types of Options
Here, we break down seven different types of options and define them.
1. Call Options
Underlying it all, there are two basic types of options. One type gives you the right to buy a security, while one gives you the right to sell a security.
Call options, or calls, are the right to buy version. If you buy a call option, you’re making a bet that the value of the security is going to go up between the time you buy the option and the time you exercise it to purchase the security. To put it another way, you might buy a call option if you’re feeling bullish on a particular security.
Think of it this way: you pay a certain amount for a call option. Then, the value of the security rises between the time you purchase the option and the exercise date. Once that happens, you exercise the option by buying the security at the strike price, and then immediately re-selling it at the market price, which is higher than what you paid for it. However, if the price of the security does not rise above the strike price, or even if the price of the security goes down, then you simply don’t exercise the option. In this case, your loss is just the premium you paid for the call option.
Additionally, instead of exercising the option, you could sell the option to another investor. You can make money this way without ever having to buy and sell the security.
Your profit from this series of transactions is the proceeds of the security, minus the strike price, the premium for the call option, and any other transactional fees that you pay along the way. Your profit is also sometimes called the option’s intrinsic value.
2. Employee Stock Options
Employee stock options are basically a specific kind of call option. Employee stock options give qualified employees at their company the ability to purchase stock in the company at some point in the future at a strike price. Many employees receive stock options as part of their benefits package. This means that if the company’s share value goes up, you can still buy the company’s shares at a fixed price, effectively making an instant profit.
Companies provide employee stock options to their employees because they’re a good motivational reward. This gives the employee even more incentive to make the company more successful. It’s also beneficial to the company because the company will only incur a cost if it’s doing well overall: if the company doesn’t do well, then employees won’t exercise their option to buy. Employee stock options can be offered as an incentive for job candidates to join a company, or as a bonus for existing employees.
Most employee stock options include a vesting period, or a period during which the holder cannot yet exercise the option to buy stock. Options become “vested options” once the vesting period has passed and they’re ready to be exercised.
Employee stock options usually come with a vesting period in order to encourage employees to stay with the company. The options likely automatically expire if the holder decides to leave the company. The vesting period can vary depending on a variety of factors from just a few days to months or even longer.
3. Put Options
You might think of put options as the opposite of call options. Put options give the holder the right to sell the asset (rather than buy) at the strike price. You would, therefore, purchase a put option when you expect the value of the underlying security to go down in value. In other words, if you purchase a put option and the value of the underlying asset then goes down, you can buy the stock and then sell it to make money. Your profit would be the difference between the purchase price and the sale price.
4. American Style Options
You may have heard the term “American style options” used before. Contrary to what it might sound like, American style options doesn’t refer to where an option is bought or sold. With an American style option, however, the owner of the contract can also exercise the right to either buy or sell prior to the expiration date. In other words, the owner can exercise the option at any time during the contract. This means that American style options have an added flexibility that other types of options don’t have. However, to compensate for this bonus, American style options tend to be more expensive.
5. European Style Options
Just like every option falls into either the category of a call or put option, every option is also an American style or European style option. Unlike American style options, holders of European style options cannot exercise the option until the expiration date has passed. This means European style options are less flexible than American style options.
On the other hand, European style options can themselves be bought and sold at any time up to the day before the expiration date. So, even if you don’t exercise the option to purchase the underlying security, you can still trade it. The reduced flexibility of European style contracts also typically means they’re slightly cheaper than American style ones.
6. Cash Settle Options
Options contracts can usually be paid out in two ways: either by physical settlement or cash settlement. So far, we’ve talked about options as though they would be paid as a physical settlement. That is, the underlying security is transferred. For example, if the holder of a put option exercises, then they would sell the relevant underlying security at the agreed price.
Cash settle options are different because no assets aside from cash are exchanged. Cash settlement options are particularly useful when it’s more difficult for the underlying asset to be transferred. For example, index options are cash settlement options because when you buy an index option, you’re making a bet on the movement of the underlying index. Commodity options also often use cash settlement options, rather than transferring the actual physical commodity.
Cash settlement options are usually European style, meaning that the holder must wait until the expiration date to decide whether to exercise the option or not. However, when it comes to trading strategies, there’s not much difference between physical settlement and cash settlement.
7. Exotic Options
Finally, the term exotic options actually refers to a set of options that are customized in more complicated ways. They may also be referred to as non-standardized options. There are a wide variety of exotic options that are available, so we’ll only mention a few.
Barrier options provide a payout to the owner if the underlying security either does (or does not, depending on the terms of the contract), reach a predetermined price. Holders of barrier options are essentially betting that the underlying security will go up or down in value by at least a certain amount.
Compound options are another example of an exotic option, that’s even more complex than a barrier option. With compound options, the underlying security is itself another options contract.
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