Table of Contents
Chapter 1: Introduction to Options Trading
Chapter 2: Options Trading Terminology
Chapter 3: Option Trading Strategies
Chapter 4: Types of Options Trading
Chapter 5: Common Applications of Options Trading
Chapter 6: How to Trade Options
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Chapter 2: Options Terminology
– Strike Price
– Expiration Date
– Exercising the Option
– Listed Options
– Intrinsic Value
– Time Value
– Premium
– Closing the Position
– Options Market Players
– Option Holders
– Option Writers
Chapter 2: Options Terminology
Trading in options can be a complicated affair if you are not well versed with the terms used commonly in these transactions. Here is an overview to help you understand the options trading jargon.
- Strike Price
- This is the price of the underlying asset that the option holder gets to buy or sell the stock at. If you have a call option on Apple Stock with a strike price of $250, then you believe that within the option time period, the value of the stock will be higher than this price. If Apple’s stock price improves to $280 before the expiration of your options contract, you can buy the stock by paying the strike price of $250 per share instead of $280.
- Expiration Date
- This is date up to which your option can be used. You cannot purchase or sell the underlying asset at the terms of the option beyond this date even if you have not used it at all.
- Exercising the Option
- When you use the option to buy or sell according to its outlined terms, you are exercising the option. You can choose to exercise your option before the expiration date or allow it to expire, depending on how the price of the asset has moved.
- Listed Options
- Listed options are those which can be traded on an exchange. These options are typically equivalent to 100 shares in a company. The strike price and the life of the option are fixed.
- Intrinsic Value
- The intrinsic value of an option is the amount by which the market price of a stock differs from its strike price.
- Time Value
- The period left until the option expires is its time value. This can be viewed as the window of opportunity left to the option holder to make money on the option. The time value also translates into an actual monetary benefit as it gives some opportunity for the stock value to change over a period.
- Premium
- The price which you pay per share to buy an option is called its premium. It is the sum of the option’s intrinsic and time value.
- Closing the Position
- Deciding to pull out of the option to cash out the gains or to limit your losses is called ‘closing your position’. You can close your position much before its expiry date. For example, a call option may be sold to an interested buyer when the asset’s price has sufficiently improved.
When an option holder believes that the price of the stock has moved to the end of its range within the option’s expiration date, he chooses to ‘close out’ to get the maximum benefit instead of waiting it out until the option expires. The stock may fluctuate within the remaining time and the option holder’s gains may go down if he waits any longer.
In the options markets, several kinds of transactions take place simultaneously. Buyers and sellers of options deal with each other to open and close positions. It is important to understand the basic differences in the rights of these players before you start investing in options.
- Option Holders
- These are people who buy the options from the sellers. The option bought by them gives them the right to buy or sell the underlying asset if they choose to within the terms of the options contract.
- Option Writers
- These people sell options to buyers. They collect the premium (or price) of the option from the holder. These writers are obligated to sell or buy the underlying stocks if the holder decides to exercise his option.
Let’s say, holder H has bought an option to buy 100 Apple shares from writer W at a price of $250 before August 2010. If he chooses to exercise his option, writer W will have to sell 100 Apple shares to H even if the current market price is $300. W does not have a choice in whether to fulfill his part of the contract or not.
In short, the holder of an option has a right while the writer has an obligation to buy or sell the underlying asset.
Next Chapter: Option Trading Strategies