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Beginners’ Guide to Options and Their Classification

| Updated
by Beatrice Mastropietro · 7 min read
Beginners’ Guide to Options and Their Classification
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Options are classified according to what time frame they represent, what underlying asset is being traded, and how much risk is involved with each type of option. This guide will focus describing the details behind these three categories in more depth.

Options are one of the most complicated financial instruments, but they are also extremely important ones. They have a few key characteristics that you need to understand before fully comprehending their use in investing. Options classification is based on what time frame they represent, what underlying asset is being traded, and how much risk is involved with each type of option. Understanding these three categories will help you know when it’s appropriate to purchase an options contract for any given situation.

Option Definition

An option is a contract between two parties where one party (the buyer) has the right, not an obligation, to buy or sell an asset from another party (the seller) at a specific price at a specific time. This arrangement creates a form of derivative the value of which depends on that of the underlying instrument. Options can be used as pure hedging instruments if their prices change less than those of the underlying security over the life span of each contract. They protect adverse moves by allowing traders to lock in guaranteed future selling prices when holding long positions.

There are many different reasons for using options. One of the most common reasons for this is that they do not have enough money at one time or in total, so their best option is to invest little by little over a period of time. This way it will be easier for them and they can save up more with each payment towards an investment goal. Another main benefit associated with using options is risk management. It gives you the ability to keep your losses small if there is any sort of unexpected outcome resulting from your trade. At least you know you won’t lose everything on just one bad decision.

A basic example of an option is as follows. If you have a futures contract with someone, then there is an obligation to buy or sell at the contract’s expiration date. This means that if prices move in your favor when it comes time for delivery, you can’t just let them go because you have promised to deliver into that particular futures contract. Options protect investors against this situation by limiting their risk exposure without contractual obligations between two parties. These contracts confer no rights upon either party except what is outlined.

Features of Options

Options have certain common features. Firstly, each option has a value associated with it. This means that each one could be worth different amounts of money or not even worth anything at all if no other options are given out before this one expires. These last two types are called “in the money” and “out of the money”. Some options might come with additional requirements like staying employed by that specific company until you exercise your options or wait until some time passes first.

Secondly, no money, commodity, or share is exchanged when the contract is written. Generally, this option contract terminates either at the time of exercising the option by the option holder or maturity whichever is earlier. So, settlement is made only when the option holder exercises his option.

Besides, options are highly flexible. In the case of option contracts, the investor has the option to buy or sell the underlying asset by the expiration date. But there is no obligation to purchase or sell.

Options Classification

Options can be classified according to different criteria. Let us have a look at the most common options types

  • Call and Put Options

Standard options classification includes call and put options. They are two types of options that you can purchase with the underlying asset. The call option gives the buyer a right to purchase an agreed quantity of shares at a specific price for a limited time. Meanwhile, put options give buyers similar rights but inversely. These entitle their owners to sell stocks back on expiry. When they want to buy or sell financial instruments like currency pairs, indices, commodities, etc., investors use derivatives such as vanilla (or plain) swaps and futures contracts. When they need leverage over greater amounts than what cash allows them access, they resort to buying OTC (over-the-counter) derivative contracts.

  • Exchange-traded and OTC options

Exchange-traded options are also known as listed options. They trade on a formal exchange platform that is highly regulated with strict regulatory guidelines in order to ensure safety for all investors involved, which allows these assets to have high liquidity and low spreads. Listed options can be traded anytime during the day. OTC options are only available during certain hours of pre-set times when trading operations take place, so it may not be possible to buy or sell an asset at any time. Instead, you must wait until the next operation window opens up where there will likely be another fee associated with this action. Exchange-trade option contracts do not represent actual shares of stock but rather just contracts tied specifically to that one underlying security or index.

In OTC options, option holders are not obliged to trade with a certain broker. OTC options allow users to write their terms for the deal, which means there is no standardization of contracts and minimum trading requirements.

  • American Style and European Style Options

American style options give the option holder the right to exercise it at any time until expiration. Both parties can exercise American style options before it expires. In contrast, European options are only exercisable on their expiration date. American style options have higher premiums than European options because they are riskier for traders due to choosing when or if you want to execute your order.

  • Options Based on Types of Underlying Security

Options provide the right, but not the obligation to buy or sell an asset at a specific price within a specified period. They derive value from other underlying securities, including stocks, bonds, commodities, and currencies. Options classification can be based on different types of underlying security.

Stock options give their owners the right to purchase (call) or sell (put) shares in a company at a fixed price until the expiration date. The most common example is when your employer has given you a call option for stock units in his/her company.

Index options give its owner the right to participate in movements in one or more indexes such as S&P 500. These special form of equity options is based on well-known and widely used indices.

Commodity options give their owners the right to buy or sell a commodity at a fixed price until the expiration date. Options contracts in this category include agricultural, softs, energy, and metals commodities.

Currency options allow owners to purchase (call) or sell (put) foreign currencies such as Euro.

Basket options give its owner the right to participate in performance movements in multiple underlying assets comprising an index, basket, or portfolio.

  • Options According to Expiration Cycle

Regular options have a standard expiration cycle of approximately three months. Weekly options are created around earnings announcements for companies where volatility is expected to increase significantly during these weeks. These options expire on a particular day every week if they haven’t been sold by then. LEAPS options have a longer timeframe than regular options and allow investors to take long-term positions with limited capital exposure, as these options can be held till their expiration date without having to roll them over into new contracts like they would need to do for weekly or monthly options.

  • Other Types

Cash-settled options are contracts in which the value of each stock options contract is equal to a set amount of cash. The recipient receives this payment when they sell their shares and it can be used just like any other form of currency. These types of derivatives allow companies to attract talented employees without having to pay them with company stock or allow them to exercise their options.

Exotic derivatives are not as widely available contracts and may include other assets besides stock such as commodities, currencies, or bonds. These types of derivatives can be advantageous because they give companies more flexibility with structure pay packages for employees who own these kinds of stocks. For example, a company could offer an employee a potential bonus of stocks in the form of exotic options rather than cash.

Conclusion

Options are a type of derivative contracts. Depending on the specific characteristics of each contract, they can be classified into several categories. 

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FAQ

What is an option?

An option is a contract between two parties where one party (the buyer) has the right, not an obligation, to buy or sell an asset from another party (the seller) at a specific price at a specific time. This arrangement creates a form of derivative the value of which depends on that of the underlying instrument. Options can be used as pure hedging instruments if their prices change less than those of the underlying security over the life span of each contract. They protect adverse moves by allowing traders to lock in guaranteed future selling prices when holding long positions.

hat are the key features of options?

One of the main features is that they are derivative securities. The other feature is tradability, which means it can be traded in exchange for cash between two parties without affecting the underlying asset’s value.

What are the standard types of options?

Call and put options are two types of options that you can purchase with the underlying asset. The call option gives the buyer a right to purchase an agreed quantity of shares at a specific price for a limited time. Meanwhile, put options give buyers similar rights but inversely. These entitle their owners to sell stocks back on expiry.

What is a put option?

A put option is a contract that gives the holder the right to sell an underlying asset on expiry. 

What is a call option?

A call option gives the buyer a right to purchase an agreed quantity of shares at a specific price for a limited time.

What is the difference between American style and European style options?

American style options give the option holder the right to exercise it at any time until expiration. Both parties can exercise American style options before it expires. In contrast, European options are only exercisable on their expiration date. American style options have higher premiums than European options because they are riskier for traders due to choosing when or if you want to execute your order.

How is the options' price determined?

The underlying value of the underlings is what establishes the price at which an option contract is sold.

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