Option Trading - Eto's, Otc's And Indexes Options
One of the first questions people ask when they are beginning their Option Trading
journeys is "What are the different types of Options available to trade?"Whilst there are a number of different sub-categories, Exchange Traded Options or ETO's are predominantly what retail investors will trade.
In today's article, I thought I would take the opportunity to break down the different types of options and explain
their differences:
Exchange Traded Options
Exchange Traded Options (ETO's) are options over existing shares that are listed in a regulated market environment. They are traded on an exchange where there are standardized features to the contracts.
The company that these options are listed on, is not involved with the creation or exercise of the option. They are created between investors in the market itself.
Also called "Listed Options", ETOs are a class of exchange traded derivatives. Their features include:
1. Standardized Contracts;
2. Settlement through a clearing house with fulfilment guaranteed by the exchange; and
3. Accurate pricing models.
Types of ETOs include:
1. Stock Options
2. Commodity Options
3. Bond Options and other Interest Rate Options
4. Index (equity) Options
5. Options on Futures Contracts.
Features such as expiration date, calculation of premium value and exercise price for each of these options differ slightly. But, the main difference is the underlying asset to each class.
Over the Counter Options
Over-the-counter (OTC) options contracts are not traded on exchanges. They are traded between two independent parties. Ordinarily, at least one of the counterparties is an institution.
By avoiding an exchange, users of OTC options can narrowly adapt the terms of the option Contract to suit their requirements. OTC Option transactions generally do not need to be advertised to the market and therefore face little or no regulatory requirements.
The disadvantage of an OTC Option is that counter-parties must establish credit lines with each other and conform to each others' clearing and settlement procedures.
One of the main reasons a company would trade OTC is because the company is small which makes it unable to meet the requirements of the governing exchange.
There is greater risk involved dealing with OTC options, because there are no standardization requirements for the contracts and because they are not regulated through an exchange.
Types 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 company to its employees.
Index Options
Not only are options available for select listed stocks, but they are also available for selected Indexes.
Index options give the investor/trader exposure to a share market index. An index is based on prices of a series of shares, weighted according to the market capitalization of the companies.
The main benefit of an index option is that it gives the investor/Trader exposure to a broad range of shares, rather than one individual stock. This lowers the risk exposure of the investor/trader as they are able to trade a view on the entire market, rather than that of a particular stock.
Because indexes are not a specific company that you can tangibly buy, sell or hold, index options are cash settled rather than deliverable.
An index that has 100 shares, for example, could not practically be delivered, and therefore a cash payment is received instead.
Index options are typically European style options. This means they can only be exercised on expiry, and not before the due date.
The premium and exercise price of an index option will be expressed in points, with some type of multiplier used to calculate the value.
So in summary, I trust this clears up the differences in the diffent types of options available to trade in the markets with Exchange Traded Options or ETO's naturally being the most commonly traded options for the retail investor and trader.
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