Options or options contracts are agreements to give the holder the right, but not the obligation, to buy or sell a specific amount of the underlying security at a specified price at or until a defined time in the future.
Options are derivative instruments because their value depends on the value of the underlying asset. Further, options are “decaying” assets because, all other things being equal, their value will decline over time until they expire. All assets depend on some definition of value, which is then modified by demand-supply forces established by the market players. However, options depend on many other variables, the most notable being the strike price and the time left until it expires.
In the following paragraphs, we will explain some basic options terminology.
1. Call options: A call gives the holder the right, but not the obligation, to buy a defined amount of the underlying security at a certain price at or by a certain date.
2. Put options: A put gives the holder the right, but not the obligation, to sell a defined amount of the underlying security at a certain price at or by a certain date.
3. Strike price: This is the price at which the holder of the option may buy or sell the underlying security. For example, a call option with a strike of 100 gives the right to the holder to buy the underlying stock at that price no matter what the price of the stock may be at that time.
4. Expiration: The date at which the holder no longer has any rights and the option no longer has value.
5. Premium: The price paid for the option
6. Open interest: The number of options contracts outstanding per strike/expiration combination.
7. Exercise: Using the rights acquired under the option to buy or sell the underlying security.
8. In-the-money: A call option with a strike price below the price of the underlying; a put option with a strike price above the price of the underlying.
9. Out-of-the-money: A call option with a strike price above the price of the underlying; a put option with a strike price below of the underlying.
10. At-the-money: An option with a strike price at or very close to the price of the underlying security.
11. Implied volatility: The calculated expectation of future volatility
12. American style: Options that may be exercised at any time up to and including their expiration date.
13. European style: Options that may be exercised only at expiration.
Option prices contain both an intrinsic value and a time value. The intrinsic value is the value the option would have if it were to expire now. The more in-the-money the option is, the higher the intrinsic value. Out-of-the-money options don’t have any intrinsic value.
Time value is the speculative component. The longer the option has until it expires, the greater the chance that it will move into profitability. This is why a call option with a strike price of 100 has some value even if the underlying security is trading at 50. If there is time left before expiration, there is still a chance the security could rally enough to make the option profitable.
Trade with care.
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