Difference Between Various Option Types

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Difference Between Various Option Types – Vanilla vs Binary vs Digital Options

There are different types of options and each has some unique characteristics. We have the regular ‘vanilla options’, and then there are others like binary options and digital options.

In reality, there are other exotic options too but we will focus on these three types of options as they are the most traded. Options are preferred over other trading instruments due to their simplicity in trading and ease of getting started.

We will now describe each option type in detail so you can distinguish between their features. Knowing this will help you determine which one to trade. Ultimately, choosing your preferred option type boils down to your trading preference.

Let’s start with vanilla options.

Vanilla Options

These are also referred to as classic options as they offer traders no extra features or characteristics and hence the term ‘vanilla’. These are the simplest type of option and the first option type among the rest to be traded.

They are not customizable as others and hence, different option types were developed for specific needs and they are more complex than classic options.

Vanilla options give the trader the right to buy or sell an asset at a set price at a certain date. This set price is known as the strike price. The strike price is the price at which both the buyer and the seller agree to exchange the asset.

As a trader, you can buy or sell the underlying asset depending on the market movement of the asset. If you think its price will increase, you will buy the asset and if its price will decline in the near future, you will sell the asset.

To buy an asset, you need a call option and to sell an asset, you need a put option. Keep in mind that call and put options give you the right, not the obligation to buy or sell the underlying asset.

Note that you can either buy or sell these options. To buy an option, the buyer has to pay the seller an amount. This amount is known as the premium and is the only risk that is borne by the buyer. But the seller carries unlimited risk. The premium amount increases with time and volatility.

The payout in vanilla options is variable. It depends on the underlying price of the asset.

The buyer is known as the holder and the seller is also known as the writer. Every options contract has an expiration date. The latest date on which the option can be exercised is known as the expiration date.

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Vanilla options are quite popular in the U.S. Here, the American style of options is followed. You can exercise your option on any day before the expiration date. While the European style of option trading allows you to exercise your options only on the day of expiration.

Typically, vanilla options expire once a month.

These are the basics of Vanilla options. Let’s explore binary options now.

The 4 Basic Types of Derivatives

In the previous articles we discussed about what derivative contracts are and what are the uses of such contracts? However, one important point needs to be noticed. Today, if a new person wants to buy a derivative contract, they will be bewildered at the sheer amount of choice that they will have at their disposal. There are hundreds or even thousands of types of contracts that are available in the market. This may make it seem like a difficult and confusing task to deal with derivatives. However, that is not the case. True, that there are hundreds of variations in the market. However, these variations can all be traced back to one of the four categories. These four categories are what we call the 4 basic types of derivative contracts. In this article, we will list down and explain those 4 types:

Type 1: Forward Contracts

Forward contracts are the simplest form of derivatives that are available today. Also, they are the oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a future date. The price at which this transaction will take place is decided in the present.

However, a forward contract takes place between two counterparties. This means that the exchange is not an intermediary to these transactions. Hence, there is an increase chance of counterparty credit risk. Also, before the internet age, finding an interested counterparty was a difficult proposition. Another point that needs to be noticed is that if these contracts have to be reversed before their expiration, the terms may not be favorable since each party has one and only option i.e. to deal with the other party. The details of the forward contracts are privileged information for both the parties involved and they do not have any compulsion to release this information in the public domain.

Type 2: Futures Contracts

A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of commodity at a future data but at a price which is decided in the present.

However, futures contracts are listed on the exchange. This means that the exchange is an intermediary. Hence, these contracts are of standard nature and the agreement cannot be modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and have pre-decided expirations. Also, since these contracts are traded on the exchange they have to follow a daily settlement procedure meaning that any gains or losses realized on this contract on a given day have to be settled on that very day. This is done to negate the counterparty credit risk.

An important point that needs to be mentioned is that in case of a futures contract, they buyer and seller do not enter into an agreement with one another. Rather both of them enter into an agreement with the exchange.

Type 3: Option Contracts

The third type of derivative i.e. option is markedly different from the first two types. In the first two types both the parties were bound by the contract to discharge a certain duty (buy or sell) at a certain date. The options contract, on the other hand is asymmetrical. An options contract, binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the option. So, one party has the obligation to buy or sell at a later date whereas the other party can make a choice. Obviously the party that makes a choice has to pay a premium for the privilege.

There are two types of options i.e. call option and put option. Call option allows you the right but not the obligation to buy something at a later date at a given price whereas put option gives you the right but not the obligation to sell something at a later date at a given pre decided price. Any individual therefore has 4 options when they buy an options contract. They can be on the long side or the short side of either the put or call option. Like futures, options are also traded on the exchange.

Type 4: Swaps

Swaps are probably the most complicated derivatives in the market. Swaps enable the participants to exchange their streams of cash flows. For instance, at a later date, one party may switch an uncertain cash flow for a certain one. The most common example is swapping a fixed interest rate for a floating one. Participants may decide to swap the interest rates or the underlying currency as well.

Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts are usually not traded on the exchange. These are private contracts which are negotiated between two parties. Usually investment bankers act as middlemen to these contracts. Hence, they too carry a large amount of exchange rate risks.

So, these are the 4 basic types of derivatives. Modern derivative contracts include countless combinations of these 4 basic types and result in the creation of extremely complex contracts.

Trading Order Types

Market, Limit, Stop and If Touched

All trades are made up of separate orders that are used together to make a complete trade. All trades consist of at least two orders: one to get into the trade, and another order to exit the trade. Order types are the same whether trading stocks, currencies or futures.

A single order is either a buy order or a sell order, and an order can be used either to enter a trade or to exit a trade. If a trade is entered with a buy order, then it will be exited with a sell order. If a trade is entered with a sell order, the position will be exited with a buy order.

For example, if a trader expected a stock price to go up, the simplest trade would consist of one buy order to enter the trade, and one sell order to exit the trade, hopefully at a profit after the price has actually risen.

Alternatively, if a trader expected a stock price to go down, the simplest trade would consist of one sell order to enter the trade, and one buy order to exit the trade. This last example, called shorting or shorting a stock, is when a stock is sold first and then bought back later.

Traders have access to many different types of orders that they can use in various combinations to make trades. Below, the main order types are explained, along with how these orders are used in trading.

Market Orders (MKT)

Market orders buy or sell at the current price, whatever that price may be. In an active market, market orders will always get filled, but not necessarily at the exact price that the trader intended. For example, a trader might place a market order when the best price is 1.2954, but other orders might get filled first, and the trader’s order might get filled at 1.2955 instead.

Market orders are used when you definitely want your order to be processed and are willing to risk getting a slightly different price. If you are buying, your market order will get filled at the ask price, as that is the price someone else is currently willing to sell for.

If you are selling, your market order will get filled at the bid price, as that is the price someone else is currently willing to buy at.

Limit Orders (LMT)

Limit orders are orders to buy or sell an asset at a specific price or better. Limit orders may or may not get filled depending on how the market is moving, but if they do get filled it will always be at the chosen price, or better.

For example, if a trader placed a limit order with a price of $50.50, the order would only get filled at $50.50 or better. In this case, a better price would be below $50.50, if it got filled at all. Limit orders are used when you want to make sure that you get a suitable price and are willing to risk not being filled at all. The order only gets filled if someone is willing to sell to you if you are buying at $50.50, or below.

If you wanted to sell at $50.50 or better—which would be above $50.50, in this case—you could use a sell limit order. The order will only be executed if someone else is willing to buy from you at $50.50 or above.

Stop Orders (STP)

Stop orders are similar to market orders in that they are orders to buy or sell an asset at the best available price, but these orders are only processed if the market reaches a specific price.

For example, if the current price of an asset is 1.2567, a trader might place a buy stop order with a price of 1.2572. If the market trades at 1.2572 or above, the trader’s stop order will be processed as a market order and will then get filled at the current best price.

Stop orders are processed as market orders, so if the stop or trigger price is reached, the order will always get filled, but not necessarily at the price that the trader intended. Stop orders will trigger if the market trades at or past the stop price. For a buy order, the stop price must be above the current price, and for a sell order, the stop price must be below the current price.

Stop orders can be used to enter a trade, but also used to exit a trade, typically called a stop loss. For example, if a trader buys a stock at $50.50, they may place a sell stop at $50.25. If the price reaches $50.25 or below, the sell order will be executed, getting the trader out of the position at $50.25 or below, limiting the loss on the position.

If a trader is short at $50.50, they may place a buy stop at $50.75 to limit their loss. If the price reaches $50.75 or above the buy stop will execute, closing the trader’s position at $50.75 or above.

Stop Limit Orders (STPLMT)

Traders will commonly combine a stop and a limit order to fine-tune what price they get. To open a trade, a trader could place a buy stop limit at $50.75. Assume the stock currently trades at $50.50. If the price reaches $50.75 the buy stop limit order will be executed, but only if the order can be executed at $50.75 or below.

This also works to initiate a short position. If the current price is $25.25, and a trader wants to go short if the price falls to $25.10, they could place a sell stop limit at $25.10. If the price reaches $25.10 the order will be executed, but only if the order can be executed $25.10 or above.

When using a stop limit order, the stop and limit prices of the order can be different. For the buying example, our trader could place a buy stop at $50.75, but with a limit at $50.78. The buy stop kicks in and buys if $50.75 is reached, but due to the limit order, the order will only buy up to $50.78. This assures that the trader buys if $50.75 is reached, but only if the market allows them to do so below $50.78.

Stop limit orders will remain pending until someone else is willing to transact at the stop limit order price(s), or better.

Market If Touched Orders

A buy MIT (“market if touched”) order price is placed below the current price, while the sell MIT order price is placed above the current price. For example, assume a stock is trading at $16.50. A MIT buy order could be placed at $16.40. If the price moves to $16.40 or below, the trigger price, then a market buy order will be sent out.

For a sell order, assume a stock is trading $16.50. A MIT sell order could be placed at $16.60. If the price moves to $16.60, the trigger price, then a market sell order be sent out.

Limit If Touched Orders (LIT)

A LIT (“limit if touched”) order is like a MIT order, but it sends out a limit order instead of a market order. For a LIT order, there is a trigger price and a limit price.

For example, assume a stock is trading at $16.50. A LIT trigger could be placed at $16.40. In addition, a limit price of $16.35 could be set. If the price moves to $16.40 or below, the trigger price, then a limit order will be placed at $16.35. Since it is a limit order, the buy will only be executed at $16.35 or below.

For a sell order, assume a stock is trading at $16.50. A LIT trigger could be placed at $16.60. In addition, a limit price of $16.65 could be set. If the price moves to $16.60 or above, the trigger price, then a limit order will be placed at $16.65. Since it is a limit order, the sell trade will only be executed at $16.65 or above.

Summary of Trading Order Types

A market order is used to enter or exit a position quickly. It will be filled, but not necessarily at the price expected, called slippage.

A limit order is used to cap the amount that is paid on a buy order or to sell at a specific price, or above, on a sell order. A stop order is used to capture a specific price or higher, on a buy order, or to capture a specific price or lower, on a sell order.

A buy stop limit order is used to buy at a specific price or lower or within a range, while a sell stop limit is used to sell at a specific price or higher, or within a range. This combines elements of the basic stop and limit order types.

Market if touched orders trigger a market order if a certain price is touched. A limit if touched order sends out a limit order if a specific trigger price is reached.

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