Contracts. Calls. Puts. Premium. Strike price. Intrinsic value. Time value. In, out of and at the money. This is the language of options traders — a jargon-riddled dialect of traditional Wall Street-speak.
Becoming conversant first requires learning a few key terms. Here are the essentials of options trading for beginning investors.
Options contract definitions
There are four key things to know on an options contract:
1. Option type: There are two types of options you can can buy or sell:
- Call: An options contract that gives you the right to buy stock at a set price within a certain time period.
- Put: An options contract that gives you the right to sell stock at a set price within a certain time period.
2. Expiration date: The date when the options contract becomes void. It’s the due date for you to do something with the contract, and it can be days, weeks, months or years in the future.
3. Strike price, or exercise price: The price at which you can buy or sell the stock if you choose to exercise the option.
4. Premium: The per-share price you pay for an option. The premium consists of:
- Intrinsic value: The value of an option based on the difference between a stock’s current market price and the option’s strike price.
- Time value: The value of an option based on the amount of time before the contract expires. Time is valuable to investors because of the possibility that an option’s intrinsic value will increase during the contract’s time frame. As the expiration date approaches, time value decreases. This is known as time decay or “theta,” after the options pricing model used to calculate it.
» MORE: Best brokers for options trading
Stock option quotes explained
Call up a stock quote and you get the current market share price of the company — the amount you’d pay if you bought shares or the amount you’d receive if you sold them. Quotes for options contracts are a lot more complex, because multiple versions are available to trade based on type, expiration date, strike price and more.
When you call up an options quote you’ll see a table of available options contracts, called option chains:
Each row in the table contains key information about the contract:
Strike: The price you’d pay or receive if you exercised the option.
Contract name: Just like stocks have ticker symbols, options contracts have option symbols with letters and numbers that correspond to the details in a contract. In a real option chain, the company’s ticker symbol would come before the contract name.
Last: The price that was paid or received the last time the option was traded.
Bid: The price a buyer is willing to pay for the option. If you’re selling an option, this is the premium you’d receive for the contract.
Ask: The price a seller is willing to accept for the option. If you want to buy an option, this is the premium you’d pay.
Change: The price change since the previous trading day’s close, also expressed in percentage terms.
Volume: The number of contracts traded that day.
Open interest: The number of options contracts currently in play.
Volatility: A measurement of how much a stock price swings between the high and low price each day. Historic volatility, as the name implies, is calculated using past price data. It can be measured on an annual basis or during a certain time frame.
Implied volatility, or “IV” in options-quote shorthand, measures how likely it is that the market thinks a stock will experience a price swing. (You also might hear of “vega,” the option pricing model used to measure the theoretical effect that each one-point change in the stock price has on implied volatility.)
Higher implied volatility typically means higher option prices because of higher potential upside for the contract. But don’t take these calculations as certainties. Just as earnings estimates are merely an analyst’s prediction of what a company is likely to earn, volatility measures are only predictions about how much an option’s price may change.
Terms to describe what an option is worth
When it comes to describing options performance, saying “up,” “down” or “flat” doesn’t cut it. At any given moment that an options contract is in play, it is one of three things:
In the money: This refers to an option that has intrinsic value — when the relationship between stock price in the open market and the strike price favors the options contract owner. When the stock price is higher than the strike price, that’s good news for the owner of a call option. A put option is in the money if the stock price is lower than the strike price.
Out of the money: When there’s no financial benefit to exercising the option, it’s called out of the money. Practically speaking, an out-of-the-money option makes buying or selling shares at the strike price less lucrative than buying or selling on the open market. A call option is out of the money if the stock price is lower than the strike price. A put option is out of the money when the stock price is higher than the strike price.
At the money: When the stock price is roughly equal to the strike price, an option is considered at the money. Basically, it’s a wash.
Options buyer and seller terms
These last two cover types of options traders. This is another case where traditional terms like “buyer” and “seller” don’t quite capture the nuances of options trading.
Holder: Refers to the investor who owns an options contract. A call holder pays for the option to buy the stock based on the parameters of the contract. A put holder has the right to sell the stock.
Writer: Refers to the investor who is selling the options contract. The writer receives the premium from the holder in exchange for the promise to buy or sell the specified shares at the strike price, if the holder exercises the option.
Besides being on opposite sides of the transaction, the biggest difference between options holders and options writers is their exposure to risk.
Remember, holders are purchasing the right to buy or sell shares, but they aren’t obligated to do anything. Their contract grants them the freedom to decide when — or if — to exercise the option, or to sell the contract before it expires. If they end up with an out-of-the-money option, they can walk away and let the contract expire. They lose only the amount they paid for the option (the premium) plus the cost of trade commissions.
Writers don’t have that flexibility. For example, when a call holder decides to exercise an option, the writer is obligated to fulfill the order and sell the stock at the strike price. If the writer doesn’t already own enough shares of the stock, he’ll have to buy shares at the going market price — even if it’s higher than the strike price — and sell them at a loss to the call holder.
Because of the unlimited downside potential, we recommend that investors just getting started in options stick to the buying (holding) side before venturing into more sophisticated options trading strategies.