Basic Options Terminology You Need to Know
It’s important to know and understand the basic options terminology before learning how to trade options. Without this knowledge, an already complex subject can become even more difficult. You are more likely to have slow progress, and you’ll be limited in taking advantage of the opportunities options trading offers.
We’re here to get you familiar with basic options terminologies, from “what are the basics of options” to “what are calls vs puts.” By the end, you’ll be better equipped to understand the complexity of options trading and navigate its markets effectively.
The Importance of Knowing Options Terminology
Options trading involves the buying and selling of options, which are financial instruments deriving their value from an underlying asset’s market price. This financial instrument gives its holder the right to buy or sell the asset at the specified price on or before the expiration date.
SPY options derive their value from the exchange-traded fund SPY or the SPDR S&P 500 ETF. It is one of the most popular funds in the New York Stock Exchange (NYSE) and tracks the performance of the Standard & Poor’s (S&P) 500 Index. This index comprises 500 large-cap publicly traded stocks in the United States, which are selected based on market size, liquidity, and industry. The S&P 500 is one of the main indicators of the U.S. equity market and the economy’s health and stability.
Each option contract states the following
Options
Options are financial contracts that give its holder the right, but not the obligation, to buy or sell the underlying asset at the specified price within a specific timeframe. The right given by options to its holder is granted in exchange for a premium.
Underlying Asset
The underlying asset specified in an option contract is the security upon which gives the derivatives their value. This asset could be a share of stock or fund, or the value of an index fund.
Call Option
A call option gives its holder the right, but not the obligation, to buy the underlying asset at the specified strike price at a given timeframe. Call options are purchased when the buyer believes the underlying asset's market value will increase above the strike price (bullish) before the end of the contract at the expiration date.
Put Option
A put option gives its holder the right, but not the responsibility, to sell the underlying asset at a predetermined price before its specified expiration date. Generally, traders purchase a put option when they believe the underlying asset's value will decrease below (bearish) the strike price before the contract expires.
Short Position
A short position, or shorting an option, is the act of selling an option contract to a buyer. Doing so obligates you to buy or sell the underlying asset at the strike price when the buyer exercises their right before the contract expires.
Long Position
A long position is the purchase of an asset. In options trading, this makes you the buyer of a call or put option, making you its holder. It is the opposite of shorting an option or a short position.
Holder
The term "holder" refers to the trader or investor owning an options contract. Being the holder of an options contract gives you the right to buy the underlying asset if it is a call option or sell it if it is a put option at the strike price before the contract expires.
Writer
The term “writer” refers to the party selling the options contract. The writer receives the premium from the holder in exchange for the obligation to buy or sell the specified asset at the strike price, if they exercise the option.
Strike Price
The strike price is the specified price in the option contract at which its holder can buy (if it's a call option) or sell (if it's a put option) the underlying asset before the stated expiration date. It defines the price the option holder can buy or sell the underlying asset.
Expiration Date
The expiration date is the last time for the contract holder to exercise their option. Options with longer timelines between the current date and expiration are usually more expensive due to the increased time value. On the other hand, options nearing expiration lose their value quickly.
Options contracts can expire at the end of the current day's trading hours or after a week, a month, or a year. Options with expiration dates longer than one year are LEAPS or long-term equity anticipation equities.
Settlement
Settlement is how the terms of an options contract are resolved between the holder and the writer when the former exercises the right. It could be either through physical settlement or cash settlement. Physical settlement involves the delivery of the underlying asset to the option holder. On the other hand, cash settlement is the delivery of the profits from the trade to the option holder.
Premium
The premium is the price of an option contract a trader has to pay to become its holder. The price of an option contract can change depending on the underlying asset's value, moneyness, implied volatility, and the useful life of the option.
Intrinsic Value
An option's intrinsic value is the value of the options contract if the underlying asset was bought or sold at that moment. This is equivalent to the difference between the strike price and the current asset price.
Time Value
Time value refers to the time remaining until the option contract expires. The more time until expiration equates to a higher value for that option.
Implied Volatility
A call option gives its holder the right, but not the obligation, to buy the underlying asset at the specified strike price at a given timeframe. Call options are purchased when the buyer believes the underlying asset's market value will increase above the strike price (bullish) before the end of the contract at the expiration date.
Moneyness
Moneyness is the relationship between the underlying asset's current price and the option's strike price. It can dictate how you can use an option contract in your options or SPX trading strategy. The relationship between the current price and the strike can enter one of the three scenarios at any given moment:
- In the Money (ITM) A call option is "in the money" when the underlying asset's current market value is higher than the option's strike price. On the other hand, a put option is "in the money" when its current price is below its strike price.
- Out of the Money (OTM) A call option is "out of the money" when the underlying asset's current market price is lower than the option's strike price. As for put options, it is "out of the money" when the underlying asset's current market price is higher than the option's strike price.
- At the Money (ATM) An option is at the money when the current market price of the underlying asset is equal or very close to the option's strike price. This relationship between the strike price and the market value indicates that, although the option does not currently have a high intrinsic value, its time value may be high.
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By knowing what are the basics of options and understanding the basic options terminologies, you have laid the foundation for further learning about options trading and its market and mastering its fundamentals. Continuing on your learning journey will not only help you understand its complexities but also help you make better decisions once you start trading.
If you still have more questions or require in-depth guidance in delving deeper into the intricacies of options trading, look no further than All American Group. We can provide you with the support you need to start options trading with confidence. Learn more about All American Group today to take the next step towards mastering the art of options trading.
