Option Trading Terminology Part 1
In many of my articles and in the world of option trading especially you will encounter terms that you may not see otherwise in everyday life. In this article I will address the more common terms that will have immediate relevance to new traders, for the sake of brevity. Later on I will attempt a more exhaustive list for your trading needs, but for now, here goes in no scrupulous orderâ€¦
The ask price is the price that the market will accept for an option. Basically the price you will pay to enter a position minus commissions.
The bid price is the price that you can sell your position at to exit a position.
Bid/ Ask Spread
The Bid Ask spread is the difference between the bid and ask. I consider this as an additional cost to entering a position. Generally the bid price is lower than the ask (the price you have to pay).
Derivatives are financial instruments that follow the price patterns of other financial mechanisms. Options are one type of derivative, but there are others such as futures and warrants.
The expiration date is the date upon which most option contracts are forced to conclude. This is usually the third Friday of every month.
At the Money (ATM)
An option is At the Money when the underlying is the same as the options strike price.
In the Money (ITM, probably one of the more favored terms)
An option is In the Money when the underlying's price surpasses the options strike price.
Out of the Money (OTM)
An option is Out of the Money when the underlying's price is below the options strike price.
Breaking even occurs when the cost and gain made by a position cancel each other out.
Bullish can be a mentality or a way to explain an option strategy. An option strategy is bullish when it benefits from an upward move in the underlying.
Bearish can be a mentality or a way to explain an option strategy. An option strategy is bearish when it benefits from a downward move in the underlying.
A debit is an expense to an account. No different than a debit card. A net debit transaction is one whose net position results in a charge to the account.
A credit is money received from opening an option position. A net credit transaction is one whose net position results money received in an account.
A closing order is a transaction made to exit an option position.
If you are the buyer of a call option whose options expire In the Money and you wish to take ownership of those shares then you assign the call option writer (seller). He or she must then deliver those shares to you.
The procedure in which a call option writer (seller) is required to give up the underlying to the option buyer at the price equal to the strike price.
Early exercise occurs when an option buyer uses their right to claim the shares of their In the Money option before expiration.
A call option gives the owner the right to buy shares of an underlying financial instrument at a specified date and price.
A put option gives the buyer the right to sell shares of an underlying financial instrument at a specified date and time.
Automatic exercise occurs on behalf of the option purchaser at the end of an option cycle for options that are In the Money.
The Black-Scholes Model is a pricing model used to appraise the value of options.
The option Greeks are the values used to determine an options price.
Delta is one of the five option Greeks. Delta measures the change in price of an option relative to a dollar change in the underlying. Call options have positive delta and puts have negative delta. Lets say that the price for a gold ETF (Exchange Trade Fund) increased by one dollar. If you had a call option with a delta of .50, the value of that option will increase by fifty cents. Conversely, a put option with a -.50 delta (since puts have negative delta) will decrease by fifty cents in value from the same move in the gold price. A call option delta cannot go higher than 1. At that point it is at parity (see definition below) with the underlying. Put options can reach -1 delta, which at that point has reached parity as well.
Gamma is one of the five option Greeks. Gamma measures the rate at which delta increases or falls.
Vega is one of the five option Greeks. Vega measures volatility. Vega is one of the most, if not the most, important Greeks because options are so sensitive to subtle changes in volatility. Vega benefits the option buyer, but is harmful to the option seller.
Theta is one of the five option Greeks. Theta measures the effect of time on options. Theta is a friend to the option seller, but not the buyer because assuming all other factors remain constant an option will lose value as time passes.
Rho is one of the five option Greeks. Rho measures the effect of interest rates on options. An increase in Rho's value is good for option buyers, but bad for option writers.
The exercise price is the same as the strike price. This is the price at which an option buyer can exercise their right to take delivery of stock shares.
Intrinsic Value is the value of an option that is In the Money. Out of the Money options have NO intrinsic value.
Extrinsic (Time) Value
Extrinsic value represents the value that an option that hasn't expired has. Extrinsic value equals: Intrinsic value â€“ Premium (See below). This comprises the total value of OTM options.
Historical Volatility is the volatility of past price patterns of the underlying financial instrument and is often measured against Implied Volatility to determine fair value.
Implied Volatility is the volatility used by the market to determine option prices.
Long-Term Equity Anticipation Securities. LEAPS are long term option contracts and I highly recommend them to all option traders. LEAPS can be as short term as six months, but are usually set for one year or longer.
Open interest is the amount outstanding option contracts for a given chain or series. This is an indication of liquidity. It is recommended that new option traders trade only in very liquid option chains.
See my Infobarrel.com article titled: What are Stock Market Options?
Optionable stocks are those that options can be traded on. Not all stocks have option chains because of eligibility requirements. Generally optionable stocks must trade above the three dollar per share threshold and must have a daily volume average of 500,000.
Parity is when the value of an option increases or decreases with the underlying.
The premium is the price that option buyer pays to enter a position.
Buy to Open
An option buyer buys option contracts to enter a position
Sell to Open
An option writer (seller) sells contracts to a buyer to enter a position
Buy to Close
An option writer buys back the options they sold in order to exit their position.
Sell to Close
An option buyer sells the contracts that they originally bought in order to exit their position.
Volatility is a VERY important concept for an option trader to understand. Simply put, volatility is the expected price range for a security to follow. Let's say that Google is trading at $400 per share with a volatility of 30%. Minus any other factors that play into the price (interest rates, dividends) It is expected that in one year time Google will be trading between $380 and $520 per share. There is actually a 68% chance or that occurring in this example, but that is standard deviation, which is an extensive topic all in itself.
Like I said before, this list is by no means exhaustive, but it is adequate for the green option trader just getting started and for intermediates that have been at it for a while. Till next timeâ€¦