You may already know that options are a specific subset of derivatives, very similar to futures, albeit with key differences. In our last week’s post on derivatives, we mentioned the four basic types and took a closer look into options and the way they work. However, as many investors and traders can confirm, option trading is far from that simple. This week, we’re going to try and make the whole concept easy to understand without oversimplifying it.
As derivatives, the price of options is determined by their underlying asset, like a security, exchange-traded fund (ETF), cryptocurrency, or even index. In short, options give you the choice to buy an asset at a predetermined price on or before a certain time, which is very much like futures. The biggest difference is that, unlike futures, you’re not required to buy or sell the instrument at any point.
Types of Options Contracts
There are two types of options contracts: calls and puts.
- A call option gives the holder the right to buy an asset. The trader who is interested in buying the asset within a certain time frame will buy a call option, letting him exercise that right. The price of the contract is called the premium and is non-refundable, even if the buyer decides not to go forward with the purchase once the time is out.
- A put option gives the holder the right to sell an asset. The trader who is interested in selling an asset within a certain time frame will buy a put option, for example to mitigate potential losses if their asset starts losing value. Again, the price of this contract is called the premium, and if used correctly, it can be the only real loss sustained by the trader.
In either case, the price at which the option contract holder can exercise their right is called the strike price.
You can buy or sell calls, or buy or sell puts, bringing the total number of combinations up to four. People who buy options are called holders, while those who sell options are called writers. Buyers or holders of either calls or puts are not obligated to buy or sell, but they have the right to do so. Sellers or writers are obligated to buy or sell if the option expires in the money, or in the way that the holder predicted it would, as long as the holder is still willing to go through with exercising their right. Since the likelihood of them deciding not to exercise that right is extremely low (because what would be the point of them paying the premium then), it is expected that writers will have to buy/sell, opening them up to significantly more losses than there are for holders, who only risk losing the premium.
Types of Options
There are countless types of options, mainly divided into European and American ones, plus a number of so-called exotic options. American option contracts can be exercised at any point between their purchase and their expiration, while European contracts can only be exercised once they’re expired. American options tend to have higher premiums than European ones.
Exotic options are especially interesting, as they’re usually reserved for professional traders, but they don’t have to be hard to understand. Some of the most popular types are:
- Chooser options let the investor decide, at some point during the contract’s lifetime, whether it’s a call or put, often used when a lot of volatility is expected.
- Compound options are options within options: they give the trader the right (but not the obligation) to buy another option at a certain price on a certain date, often used in forex markets.
- Barrier options only come alive or become extinguished when the underlying asset reaches a certain price. There are two main types:
- Knock-in options begin to function as options if the asset reaches a predetermined price level before expiration—if this price is never reached, the option has simply never existed.
- Knock-out options expire worthless if the underlying asset reaches the predetermined price before expiration, which sets a cap on the price the asset can reach while still remaining in the holder’s favor.
Several other types of barrier options exist, like rebate, turbo warrant, or Parisian options, but they’re not as commonly used.
- Binary options only offer two possibilities: either your prediction is right once the option expires and you can exercise the rights granted to you by the contract, or it’s wrong and you only lose the premium.
- Bermuda options let traders exercise their rights at predetermined dates before the expiration date, allowing for more flexibility, but since they can’t be exercised at any point like American options, their premiums are generally cheaper.
- Quantity-adjusting options, also called quanto options, let the buyer explore foreign assets with the safety net of a fixed exchange rate into their native currency.
- Look-back options do not have a fixed strike price, which instead resets to the best price of the underlying asset, letting the holder choose the best price retrospectively, but their premiums are usually much more expensive than vanilla options.
- Asian options compare the strike price to the asset’s average price over a certain time period. If there is no profit, meaning the average is lower than the strike price, the option expires worthless.
- Basket options are based on more than one underlying asset, but are otherwise identical to vanilla options.
- Extendible options let the traders, both buyers and sellers, extend the expiration date of the option for a specific period of time.
- Spread options use the spread, or difference in price between two assets, as its own underlying asset.
- Shout options let holders lock in a certain amount in profit while letting the option expire. If there is additional profit, the holder will get it, but if the total profit falls below the amount that was locked in, the holder gets to keep the locked in amount.
- Range options base their payoff on the difference between the underlying asset’s maximum and minimum price during the contract’s lifespan.
Key Takeaways
We’ve already said that exotic options are usually the choice of professional traders, as they require a thorough understanding of the topic, which lets traders weigh the potential profits and risks and make an informed decision. This knowledge far exceeds our very high-level overview provided here, but it is far from unattainable. You can, for example, start by studying Light options and the features we offer on our platform. Good luck!