Exchange-Traded Options

Most investors would just call exchange-traded options by their less unique name, “options” never knowing that there are, in fact, two different types of options that trade on the financial markets. Exchange-traded options are the most common type bought and sold because their inherent benefits entice traders to use them.

The two types of options, exchange-traded options and over-the-counter options differ in how they are bought and sold. Exchange-traded options are traded with the understanding that the contracts do not vary from seller to seller. For example, stock options on Google stock would be an excellent example of an exchange-traded option because the stock options are standardized for each month and strike price.

Over-the-counter options, however, are traded between individuals and banks with an understanding that the contract may deviate from market norms. For example, while exchange-traded options are offered for Google’s stock with increments in the amount of $5 between each strike price, two individuals, banks, or general investors may decide that they want to write their own option that would allow them to take opposing sides on an option with a strike price of…say, $592.32. While it is practically unheardof to see exchange-traded options with such an off-the-wall strike price, over-the-counter options are written for all kinds of reasons and often include vast differences like the one above in order to fit the needs of opposing investors.

For this reason, it is more common to find exchange-traded options on the retail level stocks, options and futures exchanges whereas over-the-counter options are found primarily on the derivatives markets, where investors may need more specific options contracts.

Binary Options
By necessity, exchange-traded options are always binary in that the option buyer or seller loses everything or wins everything, and it is never the case that an option is settled halfway, or that a buyer or seller make good on only a fraction of the option.

Because of this, when exchange-traded options won’t work to build a specific trade, investors often seek to buy over-the-counter options that are more complex in their nature, or create their own market based solutions known as synthetic options. A synthetic option is usually created with several different exchange-traded options and is balanced in such a way that investors can create exposure to their own, self-created market events.

For example, if you wanted to wager that corn would be greater than $5.00 or less than $2.00 by April option expiration, you would have to buy OTC or create your own synthetic option, since no one option exists for this particular investment. To create a synthetic option, an investor would buy a put option at $2.00 and a call option at $5.00 and make money only if the price of corn were to fall below $2 or rise above $5 in an amount greater than the premium price for both options.

Comments are closed.