Dipping your toes in the options pool, but aren’t sure about the terms? Learn the language right here so you can trade confidently.
Option: An option is simply a contract between a buyer and seller that derives its value from an underlying asset. For equity options, stock or an exchange-traded fund (ETF) is the underlying asset. For the purpose of this article, we’ll refer to stock as the underlying asset.
Premium: The price options buyers pay, and sellers receive. The premium is made up of the option’s intrinsic and time value.
Options buyer: The buyer (owner or holder) of the contract pays a premium and holds the right to either buy or sell the underlying stock at a predetermined price, and within a predetermined time frame. It is important to note that the owner of an options contract has a right to buy, not an obligation. Options buyers are considered long the option.
Options seller: The seller (writer) of the contract receives a premium in exchange for assuming an obligation to fulfill the requirements of the contract: to buy or sell the underlying stock at a predetermined price for a predetermined time. It is important to note here that sellers of options receive a payment and have an obligation to fulfill the terms of the contract if executed against. Options sellers are considered short the option.
Options (types): There are two types of options contracts: call options (or calls) and put options (or puts). Listed stock options contracts control the right to buy or sell 100 shares of the underlying stock.
Strike price (exercise price): The predetermined price at which the owner of an option can purchase (call) or sell (put) the underlying stock. The strike price is also called the exercise price. Stock options have multiple strike prices listed for trading to allow buyers and sellers to choose which price levels in the stock they can buy or sell an option.
Call options: These are contracts that give the call buyer the right to buy the underlying stock at a specific price. If the call buyer does not exercise his or her right to buy the stock before the predetermined time, the options contract expires and the opportunity to buy the stock at the strike price will cease to exist. The seller of a call option may be obligated to fulfill the terms of the contract and sell the underlying stock at a specific price in exchange for the premium they have received. The owner of the call option literally has the right to “call” the stock from the seller of the call option at a specified price.
Put options: These are contracts that give the put buyer the right to sell the stock at a specific stock price any time before a predetermined date. If the put buyer does not exercise his or her right to sell the stock before the predetermined time, the options contract expires and the opportunity to sell the stock at the strike price will cease to exist. The seller of a put option may be obligated to fulfill the obligations of the contract and buy stock at a specific stock price in exchange for the payment they have received. The owner of the put option literally has the right to “put” stock to a seller of the put option at a specified price.
Expiration date: The date that an option, and the right to exercise it, will cease to exist. Typically, the expiration date falls on the third Friday of each month for monthly options. Many stocks have options that are called weekly options, with expiration dates each Friday. The expiration date is also the last trading day for the option in most equity options. If the Friday is an exchange holiday, the expiration date will occur on the preceding Thursday.
In-the-money (ITM): A call option is considered in-the-money if the current price of the stock is higher than the strike price of the option. A put option is in-the-money (ITM) if the current price of the stock is below the strike price of the option.
Out-of-the-money (OTM): A call option is out-of-the-money (OTM) if the stock is below the strike price of the option. A put option is out-of-the-money (OTM) if the stock is above the strike price of the option.
Intrinsic/time value: An options premium can have two parts: an intrinsic value and an extrinsic, or time, value. Intrinsic value is the amount that the option is in-the-money. Time value, or extrinsic value, is the difference between the premium and the intrinsic value of the option (if any). Out-of-the-money options have zero intrinsic value and are 100 percent time value.
Volatility value: The time value is sometimes referred to as the volatility value of the option.
Exercise: Long holders of options hold the right to exercise the terms of the contract purchased. For a long call, the call options owner buys the underlying stock. For a long put, the put owner sells the underlying stock. In each case, the price of the stock purchased or sold is at the exercise price.
Assignment: Notification to an options seller that a long holder of an option has exercised their rights, and they have been randomly selected to fulfill their obligation of the contract they have sold. In the case of a short call option, the seller who is assigned must sell the stock at the exercise price. For a short put option, the seller must buy the stock at the exercise price.
Sell to close: If you are long an option, it is especially important to understand that you can sell the contract to close your position at any time prior to the expiration date. You are not required to retain the options position until expiration.
Buy to close: For option sellers, if you are short an option, you can buy to close the option at any time prior to the expiration date.
Bid/ask price: As with any listed security, there exists a bid and ask price for options. The bid represents the current highest price that a buyer is willing to purchase a given options contract. The ask represents the lowest price that a seller would be willing to sell the same options contract. The ask price is also known as the offer. The bid and ask prices are shown on the options chain.
Options chain: View of the options prices for a specific stock or ETF. The expiration dates listed are horizontally displayed above the column headings.
Bid/ask spread: This is the difference between the bid price and the ask price.
Bid/ask size: The bid and ask size shown on the options chain displays the current number of contracts bid or offered at the national best (highest) bid price and best (lowest) offer price. The national best bid and offer is referred to as NBBO.
Delta: This is a measurement based on the change in the price of a stock option relative to the change in the price of the underlying stock. Options traders often closely review deltas and risk measurements (known as Greeks) to pinpoint opportunities based on a particular strategy.