By Matt McCallNov 20, 2017
That’s a great question, and it’s completely understandable considering some of the terms and phrases used in options trading aren’t used in regular stock trading. Here are some that every trader should be familiar with, starting with the two types of options you can buy or sell.
Call: An options contract that gives the buyer the right to buy a stock at a set price within a certain period of time. Calls are generally bought when you have a bullish outlook on either the market or a particular stock’s potential.
Put: An options contract that gives the buyer the right to sell a stock at a set price within a certain period of time. In contrast to calls, puts are a more bearish play on the market or a specific stock that aim to profit from a downside move.
When a trader wants to buy an options contract, he is considered the buyer and will be “long” the call or put. The opposite occurs when a trader sells an options contract; they are called the seller and will be “short” the call or put.
Contract Size: Each options contract will represent 100 shares of the underlying stock. For example, if you buy two call options, it give you the right to buy 200 shares of the underlying stock. This leads to pricing, which we’ll cover next.
Price: When an option costs $4, it will actually cost the investor $400 because the quoted price of the option must be multiplied by the 100 shares that the contract represents.
Intrinsic Value: This is easy to determine, as it is the difference between the current price of the underlying stock and the options strike price. Specifically, the intrinsic value for a call option is equal to the underlying stock price minus the strike price; for a put option, it is the strike price minus the underlying stock price. For example, if a stock is selling for $41 a share and the strike price on the call option is $35, the intrinsic value is $6. You could buy the option for $35, turn around and sell the stock for $41, earning you the $6.
In-the-Money Options: This applies when the option has intrinsic value. A call is in the money when the price of the underlying stock is above the strike price of the call option; a put is in the money when the price of the underlying stock is below the strike price of the put option. The majority of our trades will be in the money because they carry less risk and the element of intrinsic value means you’re paying less premium (which can impact your profit potential).
Out-of-the-Money Options: The opposite of in the money, this occurs when the price of the underlying stock is below the strike price of the call option (the opposite applies to put options). While this type of trade will be rare for us, there are situations when we’ll use them such as if we were looking to play a bigger picture theme that we felt would occur in the next few months. We could use a deep out-of-the-money call option to bet on a major change in Federal Reserve policy or an election.
Strike Price (Expiration Price): The price at which the trader has the ability to either buy or sell the stock (depends if it is a call or put) if they choose to exercise the option contract. For example, if John buys a December $40 call on XYZ stock and the stock is trading at $50, he has the option to buy the stock at the strike price of $40 and instantly have a $10 per-share gain.
Expiration Date: All options have an expiration date, and they are very important to pay attention to. This is the date that the options contract will stop trading, so an investor must make the decision before then to either close the position, let it expire or exercise the contract (we’ll talk more about these terms later on). We will typically trade options that are either front month (the next option to expire) or one month out. A big reason the expiration date is critical to pay attention to is that one strike price can carry multiple expiration dates, so you want to make sure you’re trading the correct one. Monthly options are traded the most, and they expire on the third Friday of the month.
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