A listed option, or exchange-traded option, is a type of derivative security traded on a registered exchange. Listed options give the holder the right, but not the obligation, to buy or sell a specific amount of the underlying asset at a fixed price by a particular date.
Unlike over-the-counter options (OTC), they have standardized strike prices, expiration dates, settlements, and clearing.
There are two types of listed options, namely American style and European style.
Listed options, both puts and calls, provide traders the opportunity to speculate on the direction of movement in the underlying security with a much more significant level of safety.
A listed option is a standardized contract to either buy (using a call option), or sell (using a put option) a set quantity of a specific financial product, on, or before, a pre-determined date for a pre-determined price (the strike price). These are listed on exchanges such as the Chicago Board Options Exchange (CBOE). The exchanges are overseen by regulators – including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) – and are guaranteed by clearinghouses such as the Options Clearing Corporation (OCC).
Many options contracts are sold over-the-counter (OTC), with the main advantage of complete customization to the terms. However, this market is illiquid in most situations and has a higher risk that one party, either the buyer or seller, may not honor the obligations of the deal.
However, for most investors and traders, listed options provide a sufficient vehicle with a much more significant level of safety. The exchange acts as a middleman, taking the other side of the trade and providing clearing and settlement services, either directly or through a third party.
Unlike warrants, traders may write, or create, options on the underlying securities. The secondary market is active, unlike the exchange for warrants.
There are two types of listed options. These styles are the American style and the European style. The primary difference between the two is the date of execution. With American style options, they may be exercised at any time up to the expiration date. Conversely, with European style options, they may only be exercised at the expiration date. However, traders and investors may sell their long positions or buy back their short standing at any time to exit the trade before expiration. Most options found on the national exchanges are in the American style.
Several options strategies are available to limit risk, as well as to potentially profit, no matter which way the underlying security moves, if at all. For investors, writing or selling options can create an income stream from underlying stocks they already own at the expense of limiting potential profits from the underlying itself.
For both traders and investors, options also provide a vehicle for hedging. For example, a holder of a position of stock might also buy put options to protect against a significant downside move. The small amount of cost for the option contract is, in essence, an insurance policy.
While the risk for options holders is limited to the amount they paid to purchase them, called the premium, the risk for options sellers, or writers, can be infinite. This higher risk is because options sellers have the obligation, not the right, to sell or to buy, depending on the case, the underlying asset at the strike price.
For example, the holder of a $50 call option on stock ABC will exercise that option if the stock’s price rises to $70. The writer of the option sells the stock at $50, and if they do not already own it, they must go into the open market to buy the shares at $70. The net result will be a $20 loss, less the amount of premium collected initially for selling the option.
Sellers of puts take on a similar risk, with the only small comfort being that the stocks cannot fall below zero. Options buyers take the risk of time. Should the underlying stock’s price not move, then the option’s price will naturally decay as the expiration date nears. Fortunately, there are options strategies for both buyers and sellers using multiple options with similar or different strike prices and expirations to mitigate these risks.