The Different Types of Options
An option is a contract between two parties concerning the buying or selling of an asset at a set price before a set date. Before we look at the different types of options available, let us quickly glance at the information an option contract should contain.
The first thing the option contract should specify is whether the option holder has the right to buy (call option) or right to sell (put Option). Another important piece of information is the quantity and class of the underlaying asset. By this, we mean the amount and the type of shares being bought or sold. The third important piece of information which must be specified in the contract is the strike price (i.e. price buyer would be paying for the asset when the option is exercised). The fourth item to be specified in the contract would be the expiration date of the option (i.e. the last day the option can be exercised). The fifth item to be written in the contract would be the settlement terms. This means whether the sellers will deliver the actual asset or an equivalent cash amount. And finally, the last piece of information included in the option contract is the amount paid by the holder to the seller of the option.
Now let us look at the different types of options that are available:
1 Exchange-traded options or listed options- these are a type of exchange-traded derivatives. Exchange-traded derivatives are traded through specialized derivatives exchanges. These are markets where individuals trade standardized contracts that have been devised by the exchange. These contracts are settled through a clearing house. As the contracts are standardized, it is easier to have accurate pricing models on these options. These options include:
stock – Options based on the stock of a business.
commodity – Options of commodity products. These are products for which there is a universal demand and which are equivalent, in that it does not matter who produces them. They are basic resources and agricultural products such as oil, sugar, and cotton.
bond – Bonds are a debt security, this is a contract to repay borrowed money with interest at fixed intervals. Bond option is the option to buy or sell a bond at a certain price on or before the expiry date. Bond options wording differs in Europe to the United States. In Europe, a bond option is an option to buy or sell a bond at a certain date in future for a predetermined price. In the US, a bond option is an option to buy or sell a bond on or before a certain date in future for a predetermined price.
stock market index – These options are tied to the price of indexes, either broad-based indexes such as the S&P500, or narrow-based indexes which are indexes limited to a particular industry. This options gives the right to trade a specific stock index at a specified price by a specified expiration date.
futures contracts – In futures options, the strike price (price payed when option is exercised) is the specified futures price at which the future is traded if the option is exercised.
callable bull/bear contracts – CBBC- is a derivative, usually issued by third parties, usually investment banks (never stock exchanges or asset owners) which gives investors a leveraged investment in underlying assets.
2 Over-The-Counter or Dealer options – These are traded between two private parties and are not listed on an exchange. The contract terms of an OTC are unrestricted and may be written up to suit the need of the business in question. The different types of OTCs are interest rate, currency cross rate and Swaps (Swaptions). Swaptions grant the owner the right, not the obligation, to enter into an underlying swap.
3 Other option types: employee stock, awarded to employees as compensation for hard work, real estate, often used to put together large parcels of land, and prepayment, used in mortgage loans.
