What Is an Exchange-Traded Option?
Let me explain what an exchange-traded option is: it's a standardized derivative contract that you trade on an exchange, and it settles through a clearinghouse with a guarantee.
Key Takeaways
- An exchange-traded option is a standardized derivative contract, traded on an exchange, that settles through a clearinghouse, and is guaranteed.
- Exchange-traded options contracts are listed on exchanges, such as the Cboe Options Exchange, and overseen by regulators, like the Securities and Exchange Commission (SEC).
- A key feature of exchange-traded options that attract investors is that they are guaranteed by clearinghouses, such as the Options Clearing Corporation (OCC).
Understanding Exchange-Traded Options
You need to understand that an exchange-traded option is a standardized contract where you can either buy—using a call option—or sell—using a put option—a set quantity of a specific financial product, on or before a predetermined date, for a predetermined price known as the strike price.
These exchange-traded options contracts are listed on exchanges like the Cboe Options Exchange. The exchanges are overseen by regulators, including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), and they are guaranteed by clearinghouses such as the Options Clearing Corporation (OCC).
Benefits of Exchange-Traded Options
Exchange-traded options, which you might also hear called 'listed options,' provide several benefits that set them apart from over-the-counter (OTC) options. Since they come with standardized strike prices, expiration dates, and deliverables—the number of shares or contracts of the underlying asset—they attract and accommodate a larger number of traders. In contrast, OTC options usually have customized provisions.
This increased volume directly benefits you as a trader by offering improved liquidity and a reduction in costs. The more traders there are for a specific options contract, the easier it is for you to find willing sellers if you're buying, or buyers if you're selling, and the narrower the bid-ask spread becomes.
The standardization of exchange-traded options also allows clearinghouses to guarantee that you, as an options contract buyer, will be able to exercise your options—and that sellers will fulfill their obligations—because the clearinghouse can match any number of buyers with any number of sellers. Clearinghouses handle this easily since all contract terms are the same, making them interchangeable. This feature significantly enhances the appeal of exchange-traded options, as it mitigates the risks involved in these transactions.
Drawbacks of Exchange-Traded Options
Exchange-traded options do come with one significant drawback: because they are standardized, you as an investor cannot tailor them to fit your requirements exactly. Unlike OTC options, which are not standardized and are negotiated directly between buyer and seller, exchange-traded options cannot be customized to your specific goals. However, in most cases, you will find that exchange-traded options provide a wide enough variety of strike prices and expiration dates to meet your trading needs.
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