Important Terms Every Options Trader Should Know

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This article will help you understand some important definitions in the options market.

Call Option

Long Call Profit/Loss Chart for Call Option Buying Strategy

A call option allows the holder (not the obligation) to buy an underlying asset (usually a stock) at a certain price (strike price) within a specific period of time.

The buyer of a call option will profit when the underlying asset increases in value. Since assets virtually have no price ceiling, the seller of a call option faces unlimited risk.

Put Option

Long Put Chart Profit/Loss Chart for Put Option Buying Strategy

In contrast to a call option, a put option allows the holder (not the obligation) to sell an underlying asset (usually a stock) at a certain price (strike price) on a specific date (expiration date).

A put option gains value when the underlying asset decreases. Therefore, buying a put option is often a hedging activity in case of holding the underlying asset.

Option Premium

Similar to stocks, the option premium reflects the current market value of the option. However, unlike stocks, the option premium is quoted on a per-share basis. Because one options contract represents the right to buy 100 shares of the underlying index/stock, the actual cost of buying or selling an option at $1 will be $100. Factors such as the strike price, intrinsic value, time value, and volatility all affect determining the option premium.

Strike Price

The strike price is the predetermined price at which a put/call option can be exercised. When exercised, the seller will sell the underlying asset to the buyer at this strike price. The difference between the strike price and the current market value of the stock tells us whether the option is in the money, out of the money, or at the money.

Expiration Date

Unlike stocks, all options contracts expire on a predetermined date. On the expiration date, all options contracts expiring on that day are settled. The underlying price of the stock determines whether the options contract is profitable or not. If the strike price of the options contract generates a profit, it will be exercised. If the option is at a loss upon expiration, it will expire worthless.

Moneyness

The term “moneyness” is used to determine the intrinsic value of an option at any given time. An option can be “in the money,” “out of the money,” or “at the money.” The relationship between the stock price and the option’s strike price will determine whether the option is profitable, at a loss, or at a breakeven.

Out-of-the-money Option

A call option is out of the money if its strike price is higher than the current market price of the stock. A put option is out of the money if its strike price is lower than the current market price of the stock.

In-the-money Option

A call option is in the money if its strike price is lower than the current market price of the stock. A put option is in the money if its strike price is higher than the current market price of the stock.

At-the-money Option

Both call and put options are considered at the money if the strike price equals the current market value of the stock.

Option Exercise

The holder of a call/put option has the right to exercise their options contract at any time. When this happens, the option seller is obligated to buy or sell 100 shares at the strike price of the options contract.

There are many instances where option holders will want to exercise their right to buy/sell stocks, such as dividend payments (options don’t pay dividends). Options are typically exercised depending on the holder. However, all profitable options contracts at expiration are automatically exercised. If an option holder doesn’t want to buy or sell the underlying stock, they need to sell the option before expiration.

Option Settlement

Options contracts are settled in one of two ways: physical settlement or cash settlement.

Physical Settlement

Most options contracts are settled through physical delivery, meaning when the option is exercised, the stock or underlying asset will be transferred.

Cash Settlement

When options contracts are settled in cash, there’s no transfer of underlying assets. The cash transfer is relatively straightforward, and these types of options contracts will be automatically settled. Cash-settled options typically include European options and most binary options.

Credit & Debit Spread Strategies

These are strategies involving buying one option and selling another option. Both are of the same type (call or put), have the same expiration time but different strike prices.

Credit Spread Strategy

In this strategy, you simultaneously buy and sell the same option of an asset but with different strike prices. Suppose a stock is trading at $68.5, you sell 10 put options at $70 with a fee of 2 and buy 10 other put options at $65 with a fee of 0.5, so you have a net credit of 1.5. If the stock rises, you’ll make a maximum profit of $1,500 at $70 (selling fee minus buying fee) due to the position of selling put options, but if the stock falls, the loss will also be limited by the position of buying put options.

Debit Spread Strategy

In a debit spread strategy, you simultaneously buy and sell the same type of option but with different strike prices. However, instead of having a credit (money in), you must have a net debit (money out), meaning the fee received when selling the option is lower than when buying it.

Suppose you buy a call option with a strike price of $100 and a fee of $2 and sell a call option with a strike price of $105 and a fee of $1. Now you have a net debit of $1. The difference between the two strike prices is $5. The maximum profit that can be achieved is the difference in strike prices minus the net debit ($4), achieved when the underlying stock reaches $105.

Stock Options Contracts

The stock options market represents the majority of tradable options. The underlying asset in this options market is stocks. If an options holder executes their contract, they will buy or sell 100 shares of the underlying stock at the strike price. Stock options contracts are usually settled through physical delivery.

Index Options Contracts

Unlike stock options, you can’t buy the underlying asset of index options because they’re not directly traded on the market. Market indices like the S&P 500 will serve as the basis for the value of these contracts. Index call and put options allow investors the right to buy or sell an entire stock index within a specified period at a specific strike price. Since there are no directly traded stocks, these options are settled in cash. This minimizes the risk of the seller not having the underlying assets to deliver.

ETF Options Contracts

ETF options combine characteristics of both index options and stock options. Like stock options, these options are settled with the underlying asset; like index options, they represent a basket of stocks or a broad market index. ETF options provide market participants with liquidity and greater diversification than individual stocks.

Ex-dividend Date

The ex-dividend date is the date when a company’s stock begins trading without the value of the issued dividend. To receive this dividend, an investor must own the stock before the market closes on the ex-dividend date.

To receive this dividend, holders of profitable call options will execute their contracts. The seller will be obligated to sell shares at the strike price. To avoid this obligation, the seller may close the position.

Pin Risk

Pin risk occurs when the price of the underlying asset of an options contract closes near the strike price on the expiration date. This situation creates uncertainty about whether the option will be exercised or not. Traders must carefully manage their positions to avoid potential losses from pin risk.

Volatility Skew

Volatility skew is the difference in implied volatility between options contracts with different strike prices. Typically, options with lower strike prices have higher implied volatility than options with higher strike prices. This skew reflects market sentiment and risk perception.

Implied Volatility

Implied volatility is the market’s expectation of how much an underlying asset will move over a specific period. It’s an essential factor in determining the price of an option. Generally, higher implied volatility leads to higher option prices because there’s a higher probability of significant price movements.

Historical Volatility

Historical volatility is the measure of an underlying asset’s price movements over a specific period. It’s calculated using past market data. Traders use historical volatility to predict future price movements and assess the risk associated with an options contract.

Theta

Theta is a measure of an option’s time decay. It represents the rate at which an option loses its value as expiration approaches. Option sellers benefit from theta decay, while option buyers face the risk of time decay eroding the value of their positions.

Gamma

Gamma measures the rate of change in an option’s delta concerning changes in the price of the underlying asset. It’s highest for at-the-money options and decreases as the option moves further into or out of the money. Option buyers seek high gamma positions to benefit from rapid changes in delta.

Delta

Delta measures the sensitivity of an option’s price to changes in the price of the underlying asset. It’s expressed as a percentage between 0 and 1 for call options and between 0 and -1 for put options. Delta is highest for at-the-money options and decreases as the option moves further into or out of the money.

Vega

Vega measures an option’s sensitivity to changes in implied volatility. It represents the change in an option’s price for a one-point change in implied volatility. Option buyers seek high vega positions to benefit from increases in implied volatility.

Rho

Rho measures an option’s sensitivity to changes in interest rates. It represents the change in an option’s price for a one-point change in interest rates. Rho is generally higher for longer-dated options and options on high-interest rate instruments.

Conclusion

Understanding these terms is crucial for anyone interested in options trading. By familiarizing yourself with these concepts, you’ll be better equipped to navigate the complexities of the options market and make informed trading decisions. Whether you’re a novice trader or an experienced investor, having a solid grasp of these fundamentals will help you succeed in the dynamic world of options trading.