Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).
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An exchange-traded option is a standardized derivative contract, traded on an exchange, that settles through a clearinghouse and is guaranteed.
An exchange-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, on, or before, a predetermined date for a predetermined price (the strike price).
Exchange-traded options contracts are listed on exchanges such as 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 are guaranteed by clearinghouses such as the Options Clearing Corporation (OCC).
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. OTC options usually tend to have customized provisions.
This increased volume benefits traders by providing improved liquidity and a reduction in 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 clearinghouses 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 clearinghouse can match any of a number of options contract buyers with any of a number of options contract sellers. Clearinghouses can do this more easily because the terms of the contracts are all the same, making them interchangeable. This feature greatly enhances the appeal of exchange-traded options, as it mitigates the risk involved in transacting in these types of securities.
Exchange-traded options do have one significant drawback in that since they are standardized, the investor cannot tailor them to fit their requirements exactly. 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.