Key Options Trading Terms

KEY OPITONS TERMS

Don’t worry if some of these meanings aren’t crystal clear at first. That’s normal. Just keep forging ahead, and everything will become more apparent over time.

Long — This term can be pretty confusing. On this site, it usually doesn’t refer to time. As in, “Ally Invest never leaves me on hold for long.” Or distance, as in, “I went for a long jog.”

When you’re talking about options and stocks, “long” implies a position of ownership. After you have purchased an option or a stock, you are considered "long" that security in your account.

Short — Short is another one of those words you have to be careful about. It doesn’t refer to your hair after a buzz cut, or that time at camp when you short-sheeted your counselor’s bed.

If you’ve sold an option or a stock without actually owning it, you are then considered to be “short” that security in your account. That’s one of the interesting things about options. You can sell something you don’t actually own. But when you do, you may be obligated to do something at a later date. Read on to get a clearer picture of what that something might be for specific strategies.

Strike Price — The pre-agreed price per share at which stock may be bought or sold under the terms of an option contract. Some people refer to the strike price as the “exercise price”.

In-The-Money (ITM) — For call options, this means the stock price is above the strike price. So if a call has a strike price of $50 and the stock is trading at $55, that option is in-the-money.

For put options, it means the stock price is below the strike price. So if a put has a strike price of $50 and the stock is trading at $45, that option is in-the-money.

This term might also remind you of a great song from the 1930s that you can tap dance to whenever your option strategies go according to plan.

Out-of-The-Money (OTM) — For call options, this means the stock price is below the strike price. For put options, this means the stock price is above the strike price. The price of out-of-the-money options consists entirely of “time value.”

At-The-Money (ATM) — An option is “at-the-money” when the stock price is equal to the strike price. (Since the two values are rarely exactly equal, when purchasing options the strike price closest to the stock price is typically called the “ATM strike.”)

Intrinsic Value — The amount an option is in-the-money. Obviously, only in-the-money options have intrinsic value.

Time Value — The part of an option price that is based on its time to expiration. If you subtract the amount of intrinsic value from an option price, you’re left with the time value. If an option has no intrinsic value (i.e., it’s out-of-the-money) its entire worth is based on time value.

Let us also take this opportunity to say while you’re reading this site, you’re spending your time valuably.

Exercise — This occurs when the owner of an option invokes the right embedded in the option contract. In layman’s terms, it means the option owner buys or sells the underlying stock at the strike price, and requires the option seller to take the other side of the trade.

Interestingly, options are a lot like most people, in that exercise is a fairly infrequent event.

Assignment — When an option owner exercises the option, an option seller (or “writer”) is assigned and must make good on his or her obligation. That means he or she is required to buy or sell the underlying stock at the strike price.

Index Options vs. Equity Options — There are quite a few differences between options based on an index versus those based on equities, or stocks. First, index options typically can’t be exercised prior to expiration, whereas equity options typically can.

Second, the last day to trade most index options is the Thursday before the third Friday of the expiration month. (That’s not always the third Thursday of the month. It might actually be the second Thursday if the month started on a Friday.) But the last day to trade equity options is the third Friday of the expiration month.

Third, index options are cash-settled, but equity options result in stock changing hands.

NOTE: There are several exceptions to these general guidelines about index options. If you’re going to trade an index, you must take the time to understand its characteristics.

Stop-Loss Order - An order to sell a stock or option when it reaches a certain price (the stop price). The order is designed to help limit an investor’s exposure to the markets on an existing position.

Here’s how a stop-loss order works: first you select a stop price, usually below the current market price for an existing long position. By choosing a price below the current market, you’re basically saying, “This is the downside point where I would like to get out of my position.”

Past this price, you no longer want the cheese; you just want out of the trap. When your position trades at or through your stop price, your stop order will get activated as a market order, seeking the best available market price at that time the order is triggered to close out your position.

Any discussion of stop orders isn’t complete without mentioning this caveat: they do not provide much protection if the market is closed or trading is halted during the day. In those situations, stocks are likely to gap — that is, the next trade price after the trading halt might be significantly different from the prices before the halt. If the stock gaps, your downside “protective” order will most likely trigger, but it’s anybody’s guess as to what the next available price will be.

Standard Deviation — This site is about options, not statistics. But since we're be using this term a lot, let’s clarify its meaning a little.

If we assume stocks have a simple normal price distribution, we can calculate what a one-standard-deviation move for the stock will be. On an annualized basis the stock will stay within plus or minus one standard deviation roughly 68% of the time. This comes in handy when figuring out the potential range of movement for a particular stock.

For simplicity’s sake, here we assume a normal distribution. Most pricing models assume a log normal distribution. Just in case you’re a statistician or something.

In the next lesson we will get into a brief history of options.

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