Options trading has its own vernacular. To get started with the basics of trading options, it’s important to familiarize yourself with options trading terminology. (This will also come in handy when you are reading Cabot Options Trader, my premium options advisory service, or the brand new Cabot Options Institute advisories.)
WHAT IS AN OPTION?
An option is a contract that allows you to buy (call option) or sell (put option) a certain amount of an underlying stock (100 shares unless adjusted for a split or other corporate action) at a specific price (strike price) for a set amount of time (any time prior to its expiration).
Options Trading Terminology
A call option gives the buyer the right to buy 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a call option is obligated to sell the stock at the strike price if the option is exercised.
A put option gives the buyer the right to sell 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a put option is obligated to purchase the stock at the strike price if exercised.
STRIKE (OR EXERCISE) PRICE
The strike price is the price per share at which the holder can purchase (for call options) or sell (for put options) the underlying stock.
Exercise is the process by which an option buyer (holder) invokes the terms of the option contract. If exercising, calls will buy the underlying stock, while put owners will sell the underlying stock under the terms set by the option contract. All option contracts that are in-the-money (i.e. have at least one cent of intrinsic value) at expiration will be automatically exercised.
The expiration date is the last day on which the option may be exercised. Monthly listed stock options cease trading on the third Friday of each month and expire the next day. Weekly options cease trading on Friday of that week.
Hedging is a conservative strategy used to reduce investment risk by implementing a transaction that offsets an existing position.
A covered call is a call option that is written (sold) against an existing stock position. The call is said to be “covered” by the underlying stock, which could be delivered if the call option is exercised.
The intrinsic value of an option is the amount of profit that can be theoretically obtained if the option is exercised at that moment and the stock either purchased (for calls) or sold (for puts) at the current market price. If an option has positive intrinsic value, it is said to be “in-the-money” (ITM) and if it has negative intrinsic value it is said to be “out-of-the-money” (OTM). For instance an XYZ June 25 Call would have $1.50 of intrinsic value if the stock were trading at $26.50, regardless of its market price at the time.
Time value is the amount by which an option’s market price exceeds its intrinsic value. In the case above with the XYZ June 25 Call priced at $3.00 while XYZ stock is trading at $26.50, the intrinsic value is $1.50 and the remaining $1.50 is time value. If an option is out-of-the-money (i.e. has no intrinsic value) then the entire market price is considered time value.
The price of an option is called its premium. Prices are quoted per share, but premium is usually the entire dollar value of the contract (price per share X 100 shares = total premium).
Because options have an expiration date, all options are wasting assets whose time value erodes to zero by expiration. This erosion is known as time decay. Time value varies with the square root of time, so that as an option approaches its expiration date, the rate of time decay increases.
To be “long” an option simply means to have purchased it in an opening transaction and thus to own or hold it.
To be short an option means to have sold the option in an opening transaction. (A short position is carried as a negative on a statement and must be purchased later to close out.)
LEAPS (LONG-TERM EQUITY ANTICIPATION SECURITIES)
LEAPS are long-term options with expiration dates as far out as three years, usually expiring in January.
Is there any other options trading terminology that you’d like to understand? Let us know in the comments below.