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Investing in Options Market

Definition of Option Instruments

Option – a financial instrument that conveys the right, but not the obligation, to engage in a future transaction on some underlying security, or in a futures contract.

Traders use options to speculate, which is a relatively risky practice, while hedgers use options to reduce the risk of holding an asset.

Option styles

European option – an option that may only be exercised on expiration.
American option – an option that may be exercised on any trading day on or before expiration.
Bermudan option – an option that may be exercised only on specified dates on or before expiration.
Barrier option – any option with the general characteristic that the underlying security’s price must reach some trigger level before the exercise can occur.

Option Trading

Exchange traded options (also called “listed options”). Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange traded options include:
1. stock options,
2. commodity options,
3. bond options and other interest rate options
4. index (equity) options, and
5. options on futures contracts
Over-the-counter options (OTC options, also called “dealer options”). The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include:
1. interest rate options
2. currency cross rate options, and
3. options on swaps or swaptions.
Employee stock options are issued by a company to its employees as compensation.

Option Trading Exchanges

In the US, stock options are traded in 5 main Stock Options Exchanges, namely:

American Stock Exchange (AMEX)
Chicago Board Of Options Exchange (CBOE)
International Securities Exchange (ISE)
Pacific Exchange (PCX)
Philadelphia Stock Exchange (PHLX)

Option Trading Benefits

see benefits for derivatives
exchange traded = standardized + more or less liquid; long position represents a right, so the downside is limited to the price of the option