Options for Beginners Part 3

Underlying Securities

The earliest options were private, customized agreements written to address specific situations, and in many ways, those arrangements are still with us today. A hotel reservation with a cancellation fee, for instance, functions much like an option. The guest has the right, but not the obligation, to use the room. If they choose not to, the hotel collects the cancellation fee, which is essentially the premium for granting that flexibility. In modern financial markets, however, the focus is on standardized, exchange-traded options, which are tied to clearly defined underlying assets. These underlyings vary widely, and each type of option behaves according to the nature of the asset it tracks.

Commodity Options. The roots of options trading are closely tied to the futures markets, which themselves developed to provide farmers, miners, and energy producers with tools to hedge against uncertain prices. Commodity options are based on the values of agricultural goods, metals, and energy products. Depending on the exchange, these contracts may be tied directly to the physical commodity or to the futures contract written on that commodity. A futures contract obligates the buyer or seller to transact at a fixed price on a future date, while an option on a futures contract provides the right, but not the obligation, to take that position. In practice, this is often the only viable way for traders to access options on certain commodities or currencies.

Equity Options. Equity, or single-stock options, are contracts based on the common shares of individual companies. Introduced by the Chicago Board Options Exchange (CBOE) in 1973, these contracts are what most investors envision when they think of options. An equity option derives its value from the price of a company’s stock, but not every listed stock has options available. Exchanges, not the issuing companies, decide whether an option will be listed, basing their decision on perceived demand and trading interest. Standard equity options typically represent 100 shares of the underlying stock, which makes them accessible to a wide range of investors while maintaining uniformity in contract size.

Index Options. Beyond single companies, options also exist on broad measures of the market. Index options allow investors to trade based on the performance of market benchmarks such as the S&P 500 or the Nasdaq, as well as on indexes representing international markets or specific industries. These contracts are settled in cash, using a multiplier—often $100—to translate index movements into contract value. For example, if an index moves by 10 points, the option’s value changes by 10 times the multiplier, or $1,000. This structure enables participants to take positions on entire market segments without needing to buy or sell every constituent stock.

Interest Rate Options. Another important category is interest rate options, sometimes referred to as yield-based options. Unlike bond options, which are tied to the price of the bond itself, interest rate options are based on the yield of specific debt instruments. A call option on interest rates gains value when rates rise, while a put increases in value when rates fall. Because interest rates are not securities that can be physically exchanged, these contracts always settle in cash. It is critical to remember the inverse relationship between bond yields and bond prices: when yields climb, bond prices fall, and when yields drop, bond prices rise. As a result, the movement of interest rate options differs from that of bond price–based derivatives.

Miscellaneous Options. The flexibility of options contracts means they can, in theory, be written on almost any measurable variable where one party seeks protection and another seeks speculative opportunity. Exchanges are constantly innovating, introducing new contracts tied to market sentiment indicators, economic data releases, or even unusual factors like weather conditions. In every case, the same fundamental vocabulary applies: an option is a contract based on an underlying value, and its price moves in response to that underlying.