I’ve gotten some feedback that jumping directly into options is more than some lizards can grok without a translator. So I’m going to make weekends time for education posts. Today starts with an options vocabulary lesson.

OPTION: An option is a contract representing the right to buy or sell a stock by a specified date. The contract defines 1) the underlying stock 2) the expiration (expiry) date 3) strike price. What happens with respect to the options investor depends on whether the investor was a buyer or seller and whether the contract was a “put” or a “call.” At the end of the contract (including any time up until expiry on “American” options) the contract will be “exercised” if it has value, else it will “expire” worthless.

CALL OPTION: This is an option contract that represents the right to buy a stock at a predefined price by a certain date. The behavior of call options is such that they increase in value if the underlying stock price goes up (or falls if it declines). A put option behaves exactly the opposite

PUT OPTIONS: This is an option contract that represents the right to sell a stock at a predefined price by a certain date. The behavior of put options is such that they increase in value if the underlying stock goes down (or falls if the stock goes up). A call option behaves exactly the opposite.

CONTRACTS: Each contract is a standardized agreement to make buying and selling simple. Each contract controls 100 shares of underlying stock (usually.) So if you buy two call options, you control the right to purchase 200 shares of stock at the agreed price by expiry.

STRIKE: This is the price at which the option buyer and seller agree to sell or buy shares. Sometimes the “strike” is also known as the “exercise price.” At each available expiry, there are usually dozens of different strikes available to choose from.

EXPIRATION (EXPIRY): The date on which the options contract ends. Most of the time, the expiry is set to the Saturday following the third Friday of each month. (Shortly “weekly” contracts that expire every Saturday exist for underlying stocks with a large volume of trading.)

PREMIUM: This is the price of the option contract. The price is made up of two components “intrinsic value” and “time value.”

INTRINSIC VALUE (IV): IV can by any amount zero or greater. For a call option the intrinsic value is equal to the {stock price – strike price}. For a put option the opposite is true. The value of IV on a put is equal to {strike price – stock price}

TIME VALUE (TV): This value is derived from the statistical probably that the profitability of an option will change by the expiry date. This is a little difficult for some raptors to wrap their heads around but it monetizes the fact that things could improve (or degrade) for the option holder because there is still time remaining for the underlying stock to appreciate or decline. TV is the same for calls and puts. It is a “wasting asset” that always decays towards zero as time expires. You can calculate the TV by taking {option premium – intrinsic value}.

IN THE MONEY (ITM): Any options contract that has intrinsic value and would benefit the owner if exercised. Option buyers are pleased when their contracts are In the Money.

OUT OF THE MONEY (OTM): Any options contract that has no intrinsic value. These options have time value only. Option sellers are pleased when their contracts or Out of the Money.

AT THE MONEY (ATM): The stock price and strike price are the same to the penny.

BUY TO OPEN: This is the broker command to start a position where you are the buyer of an option contract.

SELL TO CLOSE: This is the broker command to end a position when you have previously bought an option contract.

SELL TO OPEN: This is the broker command to start a position where you are the seller of an option contract.

BUY TO CLOSE: This is the broker command to end a position when you have previously sold an option contract.

OPEN INTEREST: This is the total number of contract outstanding at any given expiry/strike combination. This is an indication of how much liquidity there is in the given market. Raptors should tread lightly when the open interest is fewer than 10 contracts as bid/ask spreads will likely be very wide and there is greater chance of being taken advantage of by a market maker who has more information than you do.

A word about nomenclature: most brokers will let you place your order by choosing from drop down menus that designate between expiry, strike, call/put, and time in force. You will need to know the option’s “name” in some cases as well as if you want to look up the pricing on Yahoo! Finance. The option name is made up of the stock ticker of the underlying shares, a YYMMDD date format expiry, followed by a P for put (or C for call), some zeros, the strike, and then some more zeros. As an example, an IBM call option with the April 2015 expiry and 160 strike is known as IBM150417C00160000 and can be viewed at Yahoo! Finance at: http://finance.yahoo.com/q?s=IBM150417C00160000

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Options training – vocabulary

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