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Types of Options
There are many different types of options that can be traded and these can be categorized in a number of ways. In a very broad sense, there are two main types: calls and puts. Calls give the buyer the right to buy the underlying asset, while puts give the buyer the right to sell the underlying asset. Along with this clear distinction, options are also usually classified based on whether they are American style or European style. This has nothing to do with geographical location, but rather when the contracts can be exercised. You can read more about the differences below.
Options can be further categorized based on the method in which they are traded, their expiration cycle, and the underlying security they relate to. There are also other specific types and a number of exotic options that exist. On this page we have published a comprehensive list of the most common categories along with the different types that fall into these categories. We have also provided further information on each type.
Call options are contracts that give the owner the right to buy the underlying asset in the future at an agreed price. You would buy a call if you believed that the underlying asset was likely to increase in price over a given period of time. Calls have an expiration date and, depending on the terms of the contract, the underlying asset can be bought any time prior to the expiration date or on the expiration date. For more detailed information on this type and some examples, please visit the following page вЂ“ Calls.
Put options are essentially the opposite of calls. The owner of a put has the right to sell the underlying asset in the future at a pre-determined price. Therefore, you would buy a put if you were expecting the underlying asset to fall in value. As with calls, there is an expiration date in the contact. For additional information and examples of how puts options work, please read the following page вЂ“ Puts.
The term вЂњAmerican styleвЂќ in relation to options has nothing to do with where contracts are bought or sold, but rather to the terms of the contracts. Options contracts come with an expiration date, at which point the owner has the right to buy the underlying security (if a call) or sell it (if a put). With American style options, the owner of the contract also has the right to exercise at any time prior to the expiration date. This additional flexibility is an obvious advantage to the owner of an American style contract. You can find more information, and working examples, on the following page вЂ“ American Style Options.
The owners of European style options contracts are not afforded the same flexibility as with American style contracts. If you own a European style contract then you have the right to buy or sell the underlying asset on which the contract is based only on the expiration date and not before. Please read the following page for more detail on this style вЂ“ European Style Options.
Exchange Traded Options
Also known as listed options, this is the most common form of options. The term вЂњExchanged TradedвЂќ is used to describe any options contract that is listed on a public trading exchange. They can be bought and sold by anyone by using the services of a suitable broker.
Over The Counter Options
вЂњOver The CounterвЂќ (OTC) options are only traded in the OTC markets, making them less accessible to the general public. They tend to be customized contracts with more complicated terms than most Exchange Traded contracts.
Option Type by Underlying Security
When people use the term options they are generally referring to stock options, where the underlying asset is shares in a publically listed company. While these are certainly very common, there are also a number of other types where the underlying security is something else. We have listed the most common of these below with a brief description.
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Stock Options: The underlying asset for these contracts is shares in a specific publically listed company.
Index Options: These are very similar to stock options, but rather than the underlying security being stocks in a specific company it is an index вЂ“ such as the S&P 500.
Forex/Currency Options: Contracts of this type grant the owner the right to buy or sell a specific currency at an agreed exchange rate.
Futures Options: The underlying security for this type is a specified futures contract. A futures option essentially gives the owner the right to enter into that specified futures contract.
Commodity Options: The underlying asset for a contract of this type can be either a physical commodity or a commodity futures contract.
Basket Options: A basket contract is based on the underlying asset of a group of securities which could be made up stocks, currencies, commodities or other financial instruments.
Option Type By Expiration
Contracts can be classified by their expiration cycle, which relates to the point to which the owner must exercise their right to buy or sell the relevant asset under the terms of the contract. Some contracts are only available with one specific type of expiration cycle, while with some contracts you are able to choose. For most options traders, this information is far from essential, but it can help to recognize the terms. Below are some details on the different contract types based on their expiration cycle.
Regular Options: These are based on the standardized expiration cycles that options contracts are listed under. When purchasing a contract of this type, you will have the choice of at least four different expiration months to choose from. The reasons for these expiration cycles existing in the way they do is due to restrictions put in place when options were first introduced about when they could be traded. Expiration cycles can get somewhat complicated, but all you really need to understand is that you will be able to choose your preferred expiration date from a selection of at least four different months.
Weekly Options: Also known as weeklies, these were introduced in 2005. They are currently only available on a limited number of underlying securities,including some of the major indices, but their popularity is increasing. The basic principle of weeklies is the same as regular options, but they just have a much shorter expiration period.
Quarterly Options: Also referred to as quarterlies, these are listed on the exchanges with expirations for the nearest four quarters plus the final quarter of the following year. Unlike regular contracts which expire on the third Friday of the expiration month, quarterlies expire on the last day of the expiration month.
Long-Term Expiration Anticipation Securities: These longer term contracts are generally known as LEAPS and are available on a fairly wide range of underlying securities. LEAPS always expire in January but can be bought with expiration dates for the following three years.
Employee Stock Options
These are a form of stock option where employees are granted contracts based on the stock of the company they work for. They are generally used as a form of remuneration, bonus, or incentive to join a company. You can read more about these on the following page вЂ“ Employee Stock Options.
Cash Settled Options
Cash settled contracts do not involve the physical transfer of the underlying asset when they are exercised or settled. Instead, whichever party to the contract has made a profit is paid in cash by the other party. These types of contracts are typically used when the underlying asset is difficult or expensive to transfer to the other party. You can find more on the following page вЂ“ Cash Settled Options.
Exotic option is a term that is used to apply to a contract that has been customized with more complex provisions. They are also classified as Non-Standardized options. There are a plethora of different exotic contracts, many of which are only available from OTC markets. Some exotic contracts, however, are becoming more popular with mainstream investors and getting listed on the public exchanges. Below are some of the more common types.
Barrier Options: These contracts provide a pay-out to the holder if the underlying security does (or does not, depending on the terms of the contract) reach a pre-determined price. For more information please read the following page вЂ“ Barrier Options.
Binary Options: When a contract of this type expires in profit for the owner, they are awarded a fixed amount of money. Please visit the following page for further details on these contracts вЂ“ Binary Options.
Chooser Options: These were named “Chooser,” options because they allow the owner of the contract to choose whether it’s a call or a put when a specific date is reached.
Compound Options: These are options where the underlying security is another options contract.
Look Back Options: This type of contract has no strike price, but instead allows the owner to exercise at the best price the underlying security reached during the term of the contract. For examples and additional details please visit the following page вЂ“ Look Back Options.
What Is an Option?
Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
- Call options allow the holder to buy the asset at a stated price within a specific timeframe.
- Put options allow the holder to sell the asset at a stated price within a specific timeframe.
Each option contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers.
- Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.
- Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation.
- Although there are many opportunities to profit with options, investors should carefully weigh the risks.
How Options Work
Options are a versatile financial product. These contracts involve a buyer and a seller, where the buyer pays an options premium for the rights granted by the contract. Each call option has a bullish buyer and a bearish seller, while put options have a bearish buyer and a bullish seller.
Options contracts usually represent 100 shares of the underlying security, and the buyer will pay a premium fee for each contract. For example, if an option has a premium of 35 cents per contract, buying one option would cost $35 ($0.35 x 100 = $35). The premium is partially based on the strike price—the price for buying or selling the security until the expiration date. Another factor in the premium price is the expiration date. Just like with that carton of milk in the refrigerator, the expiration date indicates the day the option contract must be used. The underlying asset will determine the use-by date. For stocks, it is usually the third Friday of the contract’s month.
Traders and investors will buy and sell options for several reasons. Options speculation allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. Investors will use options to hedge or reduce the risk exposure of their portfolio. In some cases, the option holder can generate income when they buy call options or become an options writer.
American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date or the exercise date. Exercising means utilizing the right to buy or sell the underlying security.
Options Risk Metrics: The Greeks
The “Greeks” is a term used in the options market to describe the different dimensions of risk involved in taking an options position, either in a particular option or a portfolio of options. These variables are called Greeks because they are typically associated with Greek symbols. Each risk variable is a result of an imperfect assumption or relationship of the option with another underlying variable. Traders use different Greek values, such as delta, theta, and others, to assess options risk and manage option portfolios.
Delta (Δ) represents the rate of change between the option’s price and a $1 change in the underlying asset’s price. In other words, the price sensitivity of the option relative to the underlying. Delta of a call option has a range between zero and one, while the delta of a put option has a range between zero and negative one. For example, assume an investor is long a call option with a delta of 0.50. Therefore, if the underlying stock increases by $1, the option’s price would theoretically increase by 50 cents.
For options traders, delta also represents the hedge ratio for creating a delta-neutral position. For example if you purchase a standard American call option with a 0.40 delta, you will need to sell 40 shares of stock to be fully hedged. Net delta for a portfolio of options can also be used to obtain the portfolio’s hedge ration.
A less common usage of an option’s delta is it’s current probability that it will expire in-the-money. For instance, a 0.40 delta call option today has an implied 40% probability of finishing in-the-money. (For more on the delta, see our article: Going Beyond Simple Delta: Understanding Position Delta.)
Theta (Θ) represents the rate of change between the option price and time, or time sensitivity – sometimes known as an option’s time decay. Theta indicates the amount an option’s price would decrease as the time to expiration decreases, all else equal. For example, assume an investor is long an option with a theta of -0.50. The option’s price would decrease by 50 cents every day that passes, all else being equal. If three trading days pass, the option’s value would theoretically decrease by $1.50.
Theta increases when options are at-the-money, and decreases when options are in- and out-of-the money. Options closer to expiration also have accelerating time decay. Long calls and long puts will usually have negative Theta; short calls and short puts will have positive Theta. By comparison, an instrument whose value is not eroded by time, such as a stock, would have zero Theta.
Gamma (Γ) represents the rate of change between an option’s delta and the underlying asset’s price. This is called second-order (second-derivative) price sensitivity. Gamma indicates the amount the delta would change given a $1 move in the underlying security. For example, assume an investor is long one call option on hypothetical stock XYZ. The call option has a delta of 0.50 and a gamma of 0.10. Therefore, if stock XYZ increases or decreases by $1, the call option’s delta would increase or decrease by 0.10.
Gamma is used to determine how stable an option’s delta is: higher gamma values indicate that delta could change dramatically in response to even small movements in the underlying’s price.Gamma is higher for options that are at-the-money and lower for options that are in- and out-of-the-money, and accelerates in magnitude as expiration approaches. Gamma values are generally smaller the further away from the date of expiration; options with longer expirations are less sensitive to delta changes. As expiration approaches, gamma values are typically larger, as price changes have more impact on gamma.
Options traders may opt to not only hedge delta but also gamma in order to be delta-gamma neutral, meaning that as the underlying price moves, the delta will remain close to zero.
Vega (V) represents the rate of change between an option’s value and the underlying asset’s implied volatility. This is the option’s sensitivity to volatility. Vega indicates the amount an option’s price changes given a 1% change in implied volatility. For example, an option with a Vega of 0.10 indicates the option’s value is expected to change by 10 cents if the implied volatility changes by 1%.
Because increased volatility implies that the underlying instrument is more likely to experience extreme values, a rise in volatility will correspondingly increase the value of an option. Conversely, a decrease in volatility will negatively affect the value of the option. Vega is at its maximum for at-the-money options that have longer times until expiration.
Those familiar with the Greek language will point out that there is no actual Greek letter named vega. There are various theories about how this symbol, which resembles the Greek letter nu, found its way into stock-trading lingo.
Rho (p) represents the rate of change between an option’s value and a 1% change in the interest rate. This measures sensitivity to the interest rate. For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options. Rho is greatest for at-the-money options with long times until expiration.
Some other Greeks, with aren’t discussed as often, are lambda, epsilon, vomma, vera, speed, zomma, color, ultima.
These Greeks are second- or third-derivatives of the pricing model and affect things such as the change in delta with a change in volatility and so on. They are increasingly used in options trading strategies as computer software can quickly compute and account for these complex and sometimes esoteric risk factors.
Risk and Profits From Buying Call Options
As mentioned earlier, the call options let the holder buy an underlying security at the stated strike price by the expiration date called the expiry. The holder has no obligation to buy the asset if they do not want to purchase the asset. The risk to the call option buyer is limited to the premium paid. Fluctuations of the underlying stock have no impact.
Call options buyers are bullish on a stock and believe the share price will rise above the strike price before the option’s expiry. If the investor’s bullish outlook is realized and the stock price increases above the strike price, the investor can exercise the option, buy the stock at the strike price, and immediately sell the stock at the current market price for a profit.
Their profit on this trade is the market share price less the strike share price plus the expense of the option—the premium and any brokerage commission to place the orders. The result would be multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.
However, if the underlying stock price does not move above the strike price by the expiration date, the option expires worthlessly. The holder is not required to buy the shares but will lose the premium paid for the call.
Risk and Profits From Selling Call Options
Selling call options is known as writing a contract. The writer receives the premium fee. In other words, an option buyer will pay the premium to the writer—or seller—of an option. The maximum profit is the premium received when selling the option. An investor who sells a call option is bearish and believes the underlying stock’s price will fall or remain relatively close to the option’s strike price during the life of the option.
If the prevailing market share price is at or below the strike price by expiry, the option expires worthlessly for the call buyer. The option seller pockets the premium as their profit. The option is not exercised because the option buyer would not buy the stock at the strike price higher than or equal to the prevailing market price.
However, if the market share price is more than the strike price at expiry, the seller of the option must sell the shares to an option buyer at that lower strike price. In other words, the seller must either sell shares from their portfolio holdings or buy the stock at the prevailing market price to sell to the call option buyer. The contract writer incurs a loss. How large of a loss depends on the cost basis of the shares they must use to cover the option order, plus any brokerage order expenses, but less any premium they received.
As you can see, the risk to the call writers is far greater than the risk exposure of call buyers. The call buyer only loses the premium. The writer faces infinite risk because the stock price could continue to rise increasing losses significantly.
Risk and Profits From Buying Put Options
Put options are investments where the buyer believes the underlying stock’s market price will fall below the strike price on or before the expiration date of the option. Once again, the holder can sell shares without the obligation to sell at the stated strike per share price by the stated date.
Since buyers of put options want the stock price to decrease, the put option is profitable when the underlying stock’s price is below the strike price. If the prevailing market price is less than the strike price at expiry, the investor can exercise the put. They will sell shares at the option’s higher strike price. Should they wish to replace their holding of these shares they may buy them on the open market.
Their profit on this trade is the strike price less the current market price, plus expenses—the premium and any brokerage commission to place the orders. The result would be multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.
The value of holding a put option will increase as the underlying stock price decreases. Conversely, the value of the put option declines as the stock price increases. The risk of buying put options is limited to the loss of the premium if the option expires worthlessly.
Risk and Profits From Selling Put Options
Selling put options is also known as writing a contract. A put option writer believes the underlying stock’s price will stay the same or increase over the life of the option—making them bullish on the shares. Here, the option buyer has the right to make the seller, buy shares of the underlying asset at the strike price on expiry.
If the underlying stock’s price closes above the strike price by the expiration date, the put option expires worthlessly. The writer’s maximum profit is the premium. The option isn’t exercised because the option buyer would not sell the stock at the lower strike share price when the market price is more.
However, if the stock’s market value falls below the option strike price, the put option writer is obligated to buy shares of the underlying stock at the strike price. In other words, the put option will be exercised by the option buyer. The buyer will sell their shares at the strike price since it is higher than the stock’s market value.
The risk for the put option writer happens when the market’s price falls below the strike price. Now, at expiration, the seller is forced to purchase shares at the strike price. Depending on how much the shares have appreciated, the put writer’s loss can be significant.
The put writer—the seller—can either hold on to the shares and hope the stock price rises back above the purchase price or sell the shares and take the loss. However, any loss is offset somewhat by the premium received.
Sometimes an investor will write put options at a strike price that is where they see the shares being a good value and would be willing to buy at that price. When the price falls, and the option buyer exercises their option, they get the stock at the price they want, with the added benefit of receiving the option premium.
A call option buyer has the right to buy assets at a price that is lower than the market when the stock’s price is rising.
The put option buyer can profit by selling stock at the strike price when the market price is below the strike price.
Option sellers receive a premium fee from the buyer for writing an option.
In a falling market, the put option seller may be forced to buy the asset at the higher strike price than they would normally pay in the market
The call option writer faces infinite risk if the stock’s price rises significantly and they are forced to buy shares at a high price.
Option buyers must pay an upfront premium to the writers of the option.
Real World Example of an Option
Suppose that Microsoft (MFST) shares are trading at $108 per share and you believe that they are going to increase in value. You decide to buy a call option to benefit from an increase in the stock’s price.
You purchase one call option with a strike price of $115 for one month in the future for 37 cents per contact. Your total cash outlay is $37 for the position, plus fees and commissions (0.37 x 100 = $37).
If the stock rises to $116, your option will be worth $1, since you could exercise the option to acquire the stock for $115 per share and immediately resell it for $116 per share. The profit on the option position would be 170.3% since you paid 37 cents and earned $1—that’s much higher than the 7.4% increase in the underlying stock price from $108 to $116 at the time of expiry.
In other words, the profit in dollar terms would be a net of 63 cents or $63 since one option contract represents 100 shares ($1 – 0.37 x 100 = $63).
If the stock fell to $100, your option would expire worthlessly, and you would be out $37 premium. The upside is that you didn’t buy 100 shares at $108, which would have resulted in an $8 per share, or $800, total loss. As you can see, options can help limit your downside risk.
Options spreads are strategies that use various combinations of buying and selling different options for a desired risk-return profile. Spreads are constructed using vanilla options, and can take advantage of various scenarios such as high- or low-volatility environments, up- or down-moves, or anything in-between.
Spread strategies, can be characterized by their payoff or visualizations of their profit-loss profile, such as bull call spreads or iron condors. See our piece on 10 common options spread strategies to learn more about things like covered calls, straddles, and calendar spreads.
Option Types: Calls & Puts
In the special language of options, contracts fall into two categories – Calls and Puts.
I n the special language of options, contracts fall into two categories – Calls and Puts. A Call represents the right of the holder to buy stock. A Put represents the right of the holder to sell stock.
A Call option is a contract that gives the buyer the right to buy 100 shares of an underlying equity at a predetermined price (the strike price) for a preset period of time. The seller of a Call option is obligated to sell the underlying security if the Call buyer exercises his or her option to buy on or before the option expiration date. For example, an American-style WXYZ Corporation May 21, 2020 60 Call entitles the buyer to purchase 100 shares of WXYZ Corporation common stock at $60 per share at any time prior to the option’s expiration date of May 21, 2020.
A Put option is a contract that gives the buyer the right to sell 100 shares of an underlying stock at a predetermined price for a preset time period. The seller of a Put option is obligated to buy the underlying security if the Put buyer exercises his or her option to sell on or before the option expiration date. Likewise, an American-style WXYZ Corporation May 21, 2020 60 Put entitles the buyer to sell 100 shares of WXYZ Corp. common stock at $60 per share at any time prior to the option’s expiration date in May.
The Expiration Process
At any given time, an option can be bought or sold with multiple expiration dates. This is indicated by a date description. The expiration date is the last day an option exists. For listed stock options, this is traditionally the Saturday following the third Friday of the expiration month. Please note that this is the deadline by which brokerage firms must submit exercise notices. You should ask your firm to explain its exercise procedures including any deadline the firm may have for exercise instructions on the last trading day before expiration.
Certain options exist for and expire at the end of week, the end of a quarter or at other times. It is very important to understand when an option will expire, as the value of the option is directly related to its expiration.
Exercising the Option
Options investors don’t actually have to buy or sell the underlying shares that are associated with their options. They can and often do simply opt to resell their options – or “trade out of their options positions”. If they do choose to purchase or sell the underlying shares represented by their options, this is called exercising the option.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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