Options are quickly becoming one of the most popular ways to invest. They used to lurk in the shadows, and seemed to only be traded by elderly hedge fund managers. Technology has helped lower the barrier of entry to get started trading options, and brokerages like Robinhood make trading them as easy as sending a text.
But still, there seems to be some reluctance to get into options, and this is mostly because they can seem a little intimidating at first. The good news is that options trading isn’t as complicated as it can initially appear to be. The key to understanding options is to understand the different types of options, along with some basic terminology.
Once you get that down, everything else easily follows.
We’re going to highlight the different types of options, and help explain some of the lingo used in the options world so that you have the proper tools to get started trading them.
Let’s start with the two basic types of options.
What you’ll learn
Two Basic Types of Options
Calls and puts are the essence of options. They represent the two categories of options contracts, where calls are associated with bullish strategies, and puts are associated with bearish strategies. Different types of options can be used in many different ways to mitigate the risk of other investments, profit if the market is volatile, and even profit if the market is neutral.
Every option contract is tied to an underlying security, oftentimes a stock, but some option contracts represent the right to buy or sell bonds and forex, for example. Calls and puts are the two categories of options, but there are many types within those categories. We’ll dive into many of the specific types of options later on.
For now, let’s get into the basics of calls and puts to lay a nice foundation.
Call Options
A call is a contract that is associated with a security, that gives you the right, but not the obligation, to buy 100 shares of the underlying security it’s associated with at a set price, over a set period of time. Another way to think about it is, a call gives you the right to “call” stock away from somebody else.
Put Options
A put is the inverse of a call option. Puts give you the right to sell 100 shares of the underlying security at a set price over a set period of time. Puts give you the right to “put” the shares onto someone else.
‘Put’ and ‘call’ options are the foundation of options trading.
Here’s an example of how a typical option will be listed with your brokerage. This will help you understand some of the key terms associated with options. This example specifically is an in-the-money Tesla (TSLA) call option:
TSLA Oct 28, 2023 $220 Call at $14.70
Let’s break this apart:
- Ticker Symbol: TSLA – this is the ticker symbol of the security that the options contract is associated with. In this case, the contract represents the opportunity to buy (since it’s a call option) 100 shares of TSLA stock.
- Expiration Date: Oct 28, 2023 – this is the date the contract will expire. Remember in the definitions of calls and puts that a trader has the right to buy or sell stock “over a set period of time”. Your right to buy or sell the underlying shares (TSLA in this example) is between when you buy the contract, and its expiration date.
- Strike Price: $220 – This is the price at which the contract allows you to buy or sell the underlying security. The strike price will also determine if the contract is in-the-money (ITM), out-of-the-money (OTM), or at-the-money.
Calls are ITM when the strike price is below the current share price because it is more advantageous to the investor to have the right to buy stock at a lower price than the current share price. This makes ITM contracts more expensive than OTM contracts.
Puts are ITM when the strike price is above the current price. And the same concept applies – it is more beneficial to have the right to sell stock at a higher price than the current share price.
In this example, the current share price of TSLA, as of October 11, 2022, is $223.00. And because it’s a call, the contract is ITM because the share price is below the current share price. If the contract was OTM ($225 strike price for example), the contract would cost $13.45 per share ($1,345 total) as opposed to $14.70 ($1,470 total).
- Type of Contract: Call – This annotates whether it is a call or a put contract.
- Premium: $14.70 – This is the price you pay for the contract per 100 shares. So in this example, the premium is $14.70 per share, so the total price, or premium for the contract is $1,470.00.
Here is an actual list of list of TSLA call options from stock and options trading platform Robinhood:
Image courtesy of Robinhood.com.
This list of TSLA calls are set to expire on November 11, 2022. The numbers in white are the strike prices (the price you can buy TSLA at if you were to exercise the contract), and the numbers in red represent the premium of the contract per share. So for example, the contract that costs $19.25 would cost $1,925 in total because an options contract always represents 100 shares.
The gray bar in the middle lists the current share price, $207.73. This means that the ITM, more expensive contracts are below the gray line, and the OTM, less expensive contracts are above the line. This would be reversed if these were TSLA puts.
What Happens If…
What happens if a contract expires and you did not sell it or exercise it?
If an investor longs a contract and they don’t sell it or exercise it before it expires, the contract will expire worthless, and the investor that holds the contract would be out the money they spent on the position (remember – the money they spent on the position is called the ‘premium’). This is the risk you take on with long options. A lot of investors use options alert services to avoid this situation if they’re busy, and don’t have the proper time to monitor their position(s).
This sounds a little scary, but there is a silver lining. With long calls and puts, it is impossible to lose more than what you initially spent on the contract(s), so risk is finite with long options.
Short calls and puts are a different story… This is when you sell a call or a put, and receive money in the form of the option’s premium. This is because when you sell a contract, you are selling it to another person, and however much they buy the contract for is how much you will receive since you are the seller. So long as the other party doesn’t exercise the contract, you keep the initial premium received.
If the party you sold a contract to decides to exercise it, you’d be responsible for either buying the 100 shares (if you sold a put), or providing the 100 shares (if you sold a call). When you have the shares or capital already in your brokerage account to settle the terms of a contract you sold/ shorted, you are employing a covered call and cash-secured put strategy. These strategies are considered to be one of the safest ways to trade options – and understanding them is key to avoiding the errors that many beginner options traders make.
American vs. European Style Options
The most notable difference between American-style and European-style options is when you are allowed to exercise the option. With European options, you can only exercise the contract at expiration. Whereas with American style options you can exercise at any time before expiration, thus lending more flexibility for the investor.
However, more benefits come with more costs. The flexibility American options have is nice for the buyer – but for the seller, they are exposed to more risk because it’s unknown when or if the buyer will exercise the option. For this reason, European options are sometimes preferred because the time to exercise the option is fixed, and there is no worry that it will be exercised before the expiration date.
It’s worth noting that while these two styles of options are called “American” and “European”, it doesn’t have anything to do with where they’re bought, but rather to denote differing terms in the two styles of contracts.
What the Different Types of Options Allow a Trader to Do
Options go far beyond just long calls and puts. They can be used to increase the chance for a position to profit, help reduce the risk of other investments, and magnify gains via leverage.
What you’re looking to do with options depends entirely on the arrangement of the type(s) you buy or sell. Some allow you to profit if the underlying price goes up, others capture profit from the price going down. Some setups allow you to capture profit if the price goes up or down, and some even profit from the price remaining neutral.
Here we’ll explain a couple common ways options are used. Most of the time they are used as insurance for other investments (hedging), or they’re used because you can have control over much more shares for far less money, which is how they are leveraged investments.
Hedging
A common way to use options is to protect yourself against risk, aka hedge, or mitigate risk. Options, if used properly, can essentially provide insurance for other investments.
One example of this is a strategy known as a married put. This is when an investor longs 100 shares of a security, and purchases a put associated with the same security. That way, if the share price plummets, you are protected by your put because it gives you the right to sell 100 shares of the security at a set price.
Option contracts are frequently used to hedge against losses.
You can see in the image above that the long put hardly affects the ability of the investment to profit, but at the same time it protects it against downside risk. In essence: a small cost for a large benefit.
Take a look at the “Net effect…” solid line. You’ll notice that as the stock price increases, the line takes a little bit of time to start profiting, but as soon as the stock price hits the strike price, boom! The “Stock Only” line is then parallel with the “Net effect…” line, so the put has little effect to no effect on the long shares ability to profit.
You’ll also notice that the “put only” line stops losing money after the underlying price hits the strike price. This is because the put contract locks you in at a price you have the right to sell the 100 shares at (see the “Put Only” line). So no matter how far the price of the underlying may go, your loss is capped because of the floor the strike price creates.
Speculation
Speculators are oftentimes found in the futures and options market, hoping to make relatively large gains in relatively short periods of time. Short-term, large gains are possible through futures and options because they are inherently leveraged.
They’re leveraged because while a contract represents 100 shares of an underlying security, the contract itself will not cost nearly as much as it would to long 100 shares of the underlying security.
So, depending on the direction a speculator thinks an asset’s price will go, they’ll purchase calls or puts to hopefully reap the benefits of the move. The reason they are commonly found in the futures and options markets is because of how the investments can be leveraged, and therefore increase their potential profit in the short term.
Other Variations of Options
Exchange-Traded Options
Exchange-traded options are the most common type of option. They are options listed on a public exchange (i.e. NYSE, NASDAQ, SSE). If you purchase Microsoft (MSFT) options, which are listed on the NASDAQ Exchange, you are purchasing an exchange-traded option.
Benefits and drawbacks: Exchange-traded options are well regulated, so you can be confident that there is no risk posed by the other party in a transaction, as the exchange serves as an intermediary between the two parties.
But, because they’re traded on a public exchange, you are left to the mercy of how the exchange standardizes and sets up the terms and features of the contracts listed. This means that if you want to buy an exchange-traded option, you can only purchase the options provided by the exchange. So if you want to buy a call with a specific strike price, for example, and that strike price isn’t listed, you’re out of luck.
There is, however, another type of option that provides more flexibility.
Over-the-Counter Options
Over-the-counter options (OTC Options) are traded privately between two parties, and are therefore not listed on a public exchange.
Because these options are traded over the counter, they can be fully customized, as opposed to being restricted to an exchange’s standards as we mentioned with exchange-traded options.
As an example, when you search for options on an exchange, they will have set expiration dates, strike prices, and lot sizes. With OTC options, these factors can be customized, and it is completely up to the parties involved as to how they’re built.
Benefits and drawbacks: The freedom with OTC options is perhaps the most attractive characteristic of this type of option, but that liberty can overextend itself as well. Unfortunately, because OTC options are not traded on an exchange, one party can lose out because the other party did not settle the contract, for example, and there isn’t much the losing party can do about it.
Employee Stock Options (ESOs)
Employee stock options, or ESOs, are a form of equity compensation offered by companies for their employees. They are offered as call options that allow employees to buy shares of the company’s stock at a set price over a set period of time.
Therefore, employees that have ESOs benefit as the company profits, so it is mutually beneficial for them to contribute to the success of the company.
Benefits and drawbacks: The main drawback to ESOs is that they aren’t immediate cash in hand like a Christmas bonus. But the other side of the coin is they have the potential to have sizable payoffs. Oftentimes ESOs are offered by young/ startup companies, so if the company takes off, so will the employees’ ESOs.
Cash-Settled Options
Cash-settled options are, well, options settled with cash. This is different from other derivatives, where sometimes depending on the type of derivative, a physical transfer of the underlying asset is required to settle the contract(s).
What happens with cash-settled options is, the party that did not profit from the trade of one or more contracts is now responsible for settling the contract. With cash-settled options, that party provides the profiting party with cash to settle the contract.
Benefits and drawbacks: The main benefit of cash-settled options is that they are easy to settle. Money is an easy, simple thing to send, especially nowadays. Imagine having a physical settlement and having to deliver a commodity like livestock or lumber to a buyer on the settlement date.
Option Type with Different Underlying Security
As we touched on at the beginning, options represent an underlying security or asset, and are therefore a derivative of whatever type of asset they are associated with. You can have options that are derivatives of stock (stock options), currency (forex) (currency/ forex options), and commodities (commodity options), among other types of underlying securities.
These are options with different underlying securities.
Oftentimes options are thought to just represent shares of different stocks, but there is a whole other world of options that exist, giving investors a myriad of… options!
Options Differing by Expiration
The most common type of option in this category are ‘regular’ options. These are the options you’ll most often see, and expire on the third Friday of the expiration month. If there is a holiday on the Friday a contract is set to expire, it will expire the Thursday before.
The next type of option in this category is known as weekly options. Weekly options expire every Friday, as opposed to regular options that expire on the third Friday of the month.
Next, there are quarterly options. These options are set to expire on the date marking the end of the financial quarter.
Lastly, there are LEAPS, or Long-Term Equity Anticipation Securities. LEAPs are simply options that are set to expire one year or more from the time of purchase.
Summary of Options Contract Variations
If you have a good grasp of the information laid out here, you can be confident that you have a solid foundation to build on as you continue to explore options. One of, if not the trickiest parts of trading options is just understanding all of the terms & lingo used. “Long” a “call” that is $4 in “premium” per share with a $200 “strike price”… it’s as if you’re learning a new language!
The next step after familiarizing yourself with the types of options and basic terminology used is to jump in. Check out some easy-to-grasp options trading strategies that will help you learn the ins and outs, and also reduce risk.
The Different ‘Options’ in Options Trading: FAQs
What Are the Four Types of Options Contracts?
At a basic level, there are two types of option contracts, not four. These two are calls and puts. However, there are four basic order types – those four being buying a call and selling a call, and buying a put and selling a put.
What are Exotic Options?
Exotic options are options that exist outside of traditional options (i.e. American & European). They can have a lot more moving parts than ‘regular’ options, and aren’t subject to the structures and set standards of exchange-traded options.
How Do Options Differ from Futures?
Options give you the right, but not the obligation to buy an asset at a set price before, or when the contract(s) expires – whereas with futures you as the buyer are obligated to buy the asset, and the seller is obligated to provide the asset at a future date.
Is an Options Contract an Asset?
Technically options are not considered assets, as they represent an underlying asset, and are often not considered assets themselves.
