Stock option trading, and particularly trading options online, has become very popular over the last 10 years. However, there is much in the terminology of stock options that can appear be confusing at first. This article will cover some of the basic definitions that a reader should be familiar with before considering options as an investment asset.
What are stock options?
A brief description of stock options will introduce us to many new terms that we can then move onto define in greater detail. At the most basic level an option is simply a legal contract that can be bought and sold. The contract details a set of obligations that the seller (writer) of the option must fulfil and a corresponding set of rights that sit with the buyer (holder) of the option. The simplest type of options can be split into two distinct types: 'call' options and 'put' options.
A call option gives the holder the right, but not the obligation, to buy a stock at a pre-defined price (the strike price); a put option gives the holder the right, but not the obligation, to sell stock at a pre-defined price (the strike price).
European-style call/put options give the holder the right to buy/sell the stock only on the last day of the contract (expiry). American-style call/put options give the holder the right to buy/sell the stock on any day prior to and including the expiry of the option.
Having covered the basic workings of stock option we can move to look at some of the definitions of the terms mentioned.
Option strike price
The strike price is the agreed level at which the stock will be bought or sold if the option is exercised.
For a the holder of a call option, this is the price they will pay for the stock; for the writer of the call option, this is the price they will receive in return for delivering the stock, when the holder exercises the option. For the holder of a put option, the strike price is the price they will receive for selling stock by when they exercise their option; for the writer of the put it is the price which they are obligated to pay for the stock should the holder choose to exercise the option.
For listed options that trade on an exchange there will normally be a range of strike prices available for a certain expiry date.
The date at which the option contract will cease to exist. For stock options there is normally an exact time during the trading day on the expiry date at which the expiry occurs. The price of the stock at the point of expiry will usually, for european-style options, determine whether the option is exercised or not. If the stock price at expiry means the option contract is in-the-money, the option will usually be exercised.
Exercising an option
An option is 'exercised' when the holder chooses to buy the stock at the strike price (for a call), or sell the stock at the strike price (for a put). For european-style options, whether an option is exercised or not is determined by the price of the stock at the expiry time on the expiry date. Usually, an option that is in-the-money at the expiry time will be exercised automatically, although this is not always the case. American-style options differ, in that the holder has the right to exercise them at any point prior and up to the expiry time on the expiry date.
In-the-money & Out-the-money
A call option is deemed to be 'in-the-money' when the underlying stock's price is above the strike price. For a put option the option is 'in-the-money' when the stock price is below the strike price. The option is deemed to be out-the-money when these conditions are not prevailing.
The amount that an option is in-the-money determines part of the option's value, in this case it is the 'intrinsic value' of the option. The remaining value of the option - that which cannot be explained by intrinsic value - is called 'time value'.
Intrinsic value of a stock option
An option always has a non-zero value. This value can be split into two elements - the intrinsic value and the time value. The intrinsic value is the amount by which the option is in-the-money. For example, a call with a strike price of 100 will have 20 of intrinsic value when the underlying stock is trading at 120 (ignoring present value discounting). An option can never be worth less than it's intrinsic value.
Time value of an option
The second element of an option's value is the time value. Time value represents the value that is given to the potential for a stock underlying an option to move into (or further into) the money. Time value is determined by many interrelating factors but the primary drivers are the length of time until expiry and the underlying stock's implied volatility.
This concludes the introduction to the terms surrounding stock option basics.
Disclaimer: nothing in this article is legal advice, and those seeking to invest should consult an independent Financial Advisor