Among the first questions people ask when they're beginning their Option Trading journeys is "What would be the several types of Options available to trade?"
Whilst there are various of different sub-categories, Exchange Traded Options or ETO's are predominantly what retail investors will trade.
In today's article, I think I'd consider the chance to list down the various kinds of options and explain their differences:
Exchange Traded Options (ETO's) are options over existing shares which are outlined in a regulated market environment. There're traded on an exchange where you can find standardized features into the contracts.
The corporation that these options are listed on, is not associated with the creation or exercise within the option. They are created between investors on the market itself.
Referred to as "Listed Options", ETOs certainly are a class of exchange traded derivatives. Their features include:
1. Standardized Contracts
2. Settlement through a clearing house with fulfilment guaranteed through the exchange; and
3. Accurate pricing models.
Types of ETOs include:
1. Stock Options
2. Commodity Options
3. Bond Options and other Rate of interest Options
4. Index (equity) Options
5. Options on Futures Contracts.
Features like expiration date, calculation of premium value and exercise price for all these options differ slightly. But, the primary difference could be the underlying asset to each class.
Over the Counter Options
Over-the-counter (OTC) options contracts aren't traded on exchanges. These are traded between two independent parties. Ordinarily, one or more with the counterparties can be institution.
By avoiding an exchange, users of OTC options can narrowly adapt the terms of the option Contract to match their requirements. OTC Option transactions generally need not be advertised within the market and therefore face little or no regulatory requirements.
The problem with an OTC Option is that counter-parties must establish credit lines amongst eachother and conform to each others' clearing and settlement procedures.
One of the main reasons a consultant would trade OTC is because this company is small rendering it unable to meet the requirements with the governing exchange.
There is greater risk involved managing OTC options, since there are no standardization requirements for the contracts and since they're not regulated through an exchange.
Different kinds of OTCs commonly traded include:
1. Interest Rate Options
2. Currency Cross Rate Options
3. Options on Swaps or Swaptions
4. Employee Stock Options issued by a service to its employees.
Index Options
Not simply are options available for select listed stocks, but fortunately they are designed for selected Indexes.
Index options provide the investor/trader contact with a share market index. A listing will depend on prices of a few shares, weighted in line with the market capitalization in the companies.
The advantage of an index option is the fact that it increases the investor/Trader exposure to a broad range of shares, instead of one person stock. This lowers the risk exposure of the investor/trader as they could trade a approach to the entire market, rather than those of a particular stock.
Because indexes are certainly not a particular company that you can tangibly buy, sell or hold, index options are cash settled instead of deliverable.
A listing who's 100 shares, for instance, can't practically be delivered, and as a consequence a cash payment is received instead.
Index options are generally European style options. This implies they can only be exercised on expiry, and not just prior to a deadline.
The premium and exercise price of an index option might be expressed in points, with some form of multiplier used to calculate the value.
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