What is an Exchange-Traded Option
An exchanged-traded option is a standardized contract to either buy (using a call option) or sell (using a put option) a set quantity of a specific financial product (the underlying asset), on or before a pre-determined date (the expiration date) for a pre-determined price (the strike price).
BREAKING DOWN Exchange-Traded Option
Exchange-traded options contracts are listed on exchanges such as the Chicago Board Options Exchange (CBOE). The exchanges are overseen by regulators – including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) – and are guaranteed by clearing houses such as the Options Clearing Corporation (OCC). You can learn more about ETFs that offer exchange traded options in the Investing for Beginners course.
Benefits of Exchange-Traded Options
Exchange-traded options, also known as "listed options," provide many benefits that distinguish them from over-the-counter (OTC) options. Because exchange-traded options have standardized strike prices, expiration dates and deliverables (the number of shares/contracts of the underlying asset), they attract and accommodate larger numbers of traders.
This increased volume benefits traders by providing improved liquidity and lower costs. The more traders there are for a specific options contract, the easier it is for interested buyers to identify willing sellers and the narrower the bid-ask spread becomes.
The standardization of exchange-traded options also enables clearing houses to guarantee that options contract buyers will be able to exercise their options – and that options contract sellers will fulfill the obligations they take on when selling options contracts – because the clearing house can match any of a number of options contract buyers with any of a number of options contract sellers. Clearing houses can do this more easily because the terms of the contracts are all the same, making them interchangeable.
Drawbacks of Exchange-Traded Options
Exchange-traded options do have one significant drawback: unlike OTC options – which are not standardized, but are negotiated directly between the buyer and the seller – exchange-traded options cannot be customized to fit the buyer's or seller's specific goals. However, in most cases traders will find exchange-traded options provide a wide enough variety of strike prices and expiration dates to meet their trading needs.