What Are Listed Options and How Do They Work?
Learn the fundamentals of listed options, from their core mechanics to how they're traded on exchanges.
Listed options are financial contracts giving the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. These standardized contracts trade on regulated exchanges, distinguishing them from privately negotiated agreements. Options derive their value from an underlying asset, such as a stock, exchange-traded fund (ETF), or commodity. This structure provides investors with a versatile tool for various financial objectives, including speculation or hedging existing portfolio positions.
Key Elements of Listed Options
An underlying asset is the security, index, or commodity that the option holder has the right to buy or sell. For instance, a stock option’s value directly correlates with the price movements of the specific company’s shares it represents.
The strike price, also known as the exercise price, is the fixed price at which the underlying asset can be bought or sold if the option is exercised. This price is set when the option contract is created and remains constant throughout its life. It determines whether an option is “in the money,” “at the money,” or “out of the money” relative to the current market price of the underlying asset.
Every listed option contract has an expiration date, which is the final day the option holder can exercise their right to buy or sell the underlying asset. After this date, the option contract becomes worthless if it has not been exercised or closed out. These dates are standardized, often falling on the third Friday of the month for equity options, and are important for determining an option’s remaining time value.
Options are broadly categorized into two types: call options and put options. A call option grants the holder the right to buy the underlying asset, while a put option gives the holder the right to sell the underlying asset.
The option premium is the price an investor pays to purchase an option contract. This premium is determined by various factors, including the underlying asset’s price, the strike price, the time remaining until expiration, and the volatility of the underlying asset. The premium is paid upfront by the buyer to the seller (writer) of the option.
Understanding Call and Put Options
Buying a call option provides the right to purchase 100 shares of the underlying asset at the specified strike price before expiration. An investor typically buys a call option if they anticipate the price of the underlying asset will increase. For example, if an investor buys a call option on XYZ stock with a strike price of $50, and XYZ’s stock price rises to $55, the option is “in the money” as the investor can buy shares at $50 and immediately sell them in the market at the higher price.
Conversely, buying a put option gives the right to sell 100 shares of the underlying asset at the predetermined strike price before expiration. This strategy is generally employed when an investor expects the underlying asset’s price to decline. Consider an investor buying a put option on ABC stock with a strike price of $100; if ABC’s stock price falls to $95, the option becomes “in the money” because the investor can sell shares at $100 that are currently worth only $95 in the open market.
Option holders have two primary ways to realize value from their contracts: exercising the option or selling it to close the position. Exercising a call option means purchasing the underlying shares at the strike price, while exercising a put option involves selling the underlying shares at the strike price. However, most option buyers choose to sell their contracts in the open market before expiration to profit from an increase in the option’s premium or to limit losses.
Selling to close an option position means the investor sells the option contract they initially bought back into the market. This transaction cancels out the original position and allows the investor to realize any profit or loss without actually taking possession of the underlying asset. This method is often preferred due to its simplicity and the avoidance of commissions and other costs associated with buying or selling the underlying shares.
Trading Environment for Listed Options
Listed options are characterized by their standardization, meaning they have uniform contract specifications across exchanges. For instance, one equity option contract typically represents 100 shares of the underlying stock, and expiration cycles are set to specific dates, such as monthly or weekly. This standardization ensures fungibility, allowing contracts to be easily traded and offset.
These options are traded on regulated financial exchanges, such as the Chicago Board Options Exchange (CBOE) or NYSE Arca. Trading on exchanges provides several advantages, including price transparency, where current bid and ask prices are readily available to all participants. This environment also fosters liquidity, making it easier for investors to buy and sell contracts efficiently.
A central component of the listed options market is the clearinghouse, with the Options Clearing Corporation (OCC) serving as the primary clearing entity in the United States. The OCC acts as the guarantor for every option contract, standing between the buyer and seller. This role eliminates counterparty risk, ensuring that obligations are met even if one party defaults.
Trading in listed options is subject to oversight by regulatory bodies like the Securities and Exchange Commission (SEC). The SEC establishes rules and regulations designed to protect investors and maintain fair and orderly markets. This regulatory framework contributes to the integrity and reliability of the listed options environment, instilling confidence among market participants.