There are many different types of options. Options are “derivatives”, which simply means that their value is derived from another asset. Consider stock-based options, they derive their value from the stocks that they are based on. In general, derivatives can be based on a huge range of assets. This is true of options as well.
Different Types Of Options Explained
While many options are tied to stocks, options can also be based on a huge range of different assets. We’re going to go over these different types of options, and will also highlight some other types of options, such as binary options and the difference between European and American options. We’re going to highlight some of the most common assets, but don’t think of this list as exhaustive.
Equity (stock) Based Options
Equity Options are the most common and popular type of option. Equity options are based on underlying stocks. When you buy a call equity option, you gain the right but not obligation to buy stocks at a certain price. When you buy a put option, you gain the right to sell.
Equity options are sold in lots of 100, meaning you gain the right to buy or sell 100 stocks. You don’t have to actually own the stocks in question. You can simply buy the options. This is true for both put and call options. When you do own the underlying stock and also buy put options, that’s actually called a “married put”.
Besides individual stocks, you can also buy options based on a stock index. A stock index is an indicator comprised of numerous different stocks. Usually, stock indexes are created so that traders and economists may quickly and easily monitor the overall market.
For example, the S&P 500 is made up of 500 of the largest publically traded companies in the United States. These companies are spread across a wide range of industries. As such, the S&P 500 provides a good indicator of how markets are doing in general.
You can buy options that are tied to the point value assigned to each index. This way, you can “bet” on which way markets will move. Will markets rise, or will they fall? Many options traders like index-based options because they can focus on macro-trends rather than individual company performance.
Options can also be tied to commodities. What is a commodity? A commodity is a basic good that is interchangeable with other basic goods of the same time. Consider barrels of Brent Crude Oil. Each barrel of Brent Crude is equal in value to another barrel of Brent Crude. However, West Texas Intermediate Crude Oil (WTI) is a different type of oil, and so a barrel of WTI will not necessarily be of the same value as Brent. In fact, WTI is normally a bit cheaper.
Commodities are most commonly traded through “futures” contracts. Like an option, a futures contract is a derivative. Futures also feature an expiration date. Unlike options, however, when you buy a future, you are obligated to buy the asset and the seller is obligated to sell. Let’s say you purchase a future for one barrel of Brent Crude oil in May of 2018 for $50 dollars. Come May, you will be obligated to buy that barrel of oil for $50.
Options based commodities are generally based on futures, making them derivatives of derivatives. You could buy an option based on the futures contract for Brent Crude oil come May of 2018. Unlike a future, you wouldn’t be obligated to buy the barrel of crude, but you would have the option to do so.
Foreign Exchange Options
Do you know what the biggest financial market in the world is? If you’re thinking the New York Stock Exchange, or even stocks in general, you’re wrong. The biggest market is actually the Foreign Exchange, or FOREX markets. These markets run 24 hours a day, 365 days a year, and are the largest, most liquid markets in the world.
Forex markets are the global currency exchange markets that allow governments, companies, and other entities to quickly and easily convert currencies. You can buy options based on Forex markets. With these options, you will have the right but not obligation to exchange one currency at a specified rate with another currency at a future point in time.
A Quick Look At Binary Options
With so many different types of options one we can not ignore is called “binary” options. These options are gaining some popularity in Europe, but aren’t as commonly traded in the United States or by Americans in general. They offer a simple “yes” and “no” proposition. With binary options, you simply state “yes” or “no” regarding whether an asset will rise above a certain price. Binary options are often set up to expire in mere minutes or even seconds.
So let’s say you by a binary option for Acme Motors, which is currently trading at $25.50. There’s a yes or no binary option that expires in five minutes with a strike price of $25.55. In this case you can either vote “yes” or “no” that the stock price will be at or above $25.55. If you vote no, and stock prices rise to $25.54, or any price below $25.55, you’ll earn a predetermined pay, which is usually expressed as a percent. Get it wrong, and you’ll lose whatever you invested.
American Options Versus European Options
On a final note, you may sometimes hear traders talking about “American options” and “European options.” This doesn’t have anything to do with the underlying assets. European stocks can still be the underlying asset for American options, and vice versa. The difference instead comes down to the setup of the option contract itself, and it’s a very important difference.
With American options, you can exercise your option at any point before the expiration date. With European options, you can only exercise the options at the moment they expire. In other words, if you buy a call option for Apple Inc. stock, with an American option you can buy those Apple stocks at any point before the option expires. With a European option, you only have one chance to buy the Apple stock, and that’s at the exact moment the options expire. This makes American options much more flexible, and as a result, most traders prefer to trade with them.