Option Terminology

Boca Raton, Florida Option Trading Abuse FINRA Arbitration and Litigation Attorney:

Understanding Option Terminology:

If you are contemplating investing in options or using options as a part of your investment strategy, it is critical that you fully and completely understand what they are and the critical terms associated therewith. One of the things that I have experienced, more than once in my 30 plus years of representing investors, is that investment classes recycle themselves. For example, let's assume that the current "hot" investment class is limited partnerships, then stock trading becomes in vogue, then trading stocks on margin, then option trading and then the circle is completed with limited partnerships returning to the forefront. Obviously, there are many other types of investment classes that exist but you get the idea. Also, remember that trading in options involves substantial risks and is not appropriate for everyone.

Because option trading carries its own unique risks, brokerage firms must deliver to investors, before the first option trade, a booklet prepared by the Options Clearing Corporation called Characteristics and Risks of Standardized Options. Just to demonstrate how complicated option trading is, the current version of this booklet is 148 pages of single spaced text. The topics contained in the booklet are:

Options trading may occur in a variety of securities marketplaces and may involve a wide range of financial products, from stocks to foreign currencies. This bulletin focuses on the basics of trading listed stock options.

What are Options?

Options are contracts giving the owner the right to buy or sell an underlying asset, at a fixed price, on or before a specified future date.

Options are derivatives (they derive their value from their underlying assets). The underlying assets can include, among other things, stocks, stock indexes, exchange traded funds, fixed income products, foreign currencies, or commodities.

Option contracts trade in various securities marketplaces between a variety of market participants, including institutional investors, professional traders, and individual investors.

Options trades can be for a single contract or for several contracts.

Basic Options Terminology:

Options trading uses terminology that an investor should understand before attempting to buy or sell options. The following example of a basic stock option contract quote will help explain some of this terminology:

"ABC December 70 Call $2.20." This options quote contains five terms: "ABC," "December," "70," "Call," and "$2.20." "ABC" - This represents the stock symbol for the underlying stock of the option contract.

"December" - This is the expiration date of the option contract. This date indicates the day that the option contract expires. Generally, the expiration date for an option contract is the Saturday after the third Friday of each month. However, certain option contracts may have an expiration date that occurs after only a week, a calendar quarter, or at other some other specified time. Investors should make sure they understand when an option contract expires since an option contract's value is directly related to its expiration date. If you need help determining an option contract's expiration date, ask your account executive or brokerage firm.

"Call" and "Put" - A call is a type of option contract. Two of the most common types of option contracts are calls and puts. A call option is a contract that gives the buyer the right to buy shares of an underlying stock at the strike price (discussed below) for a specified period of time. Conversely, the seller of the call option is obligated to sell those shares to the buyer of the call option who exercises his or her option to buy on or before the expiration date.

Example: An ABC December 70 Call entitles the buyer to purchase shares of ABC common stock at $70 per share at any time prior to option's expiration date in December.

A put option is a contract that gives the buyer the right to sell shares of an underlying stock at the strike price for a specified period of time. Conversely, the seller of the put option is obligated to buy those shares from the buyer of the put option who exercises his or her option to sell on or before the expiration date.

Example: An ABC December 70 Put entitles the buyer to sell shares of ABC common stock at $70 per share at any time prior to option's expiration date in December.

"70" - The number appearing in this part of the options quote is the strike price of the option contract. This is the price at which the buyer of the option contract may buy the underlying stock, if the option contract is a call, or sell the underlying stock, if the option contract is a put. The relationship between the strike price and the actual price of a stock determines whether the option is "in-the-money," "at-the-money," or "out of the money."

"In-the-money" and "out-of-the money" have different meanings depending on whether the option is a call or a put:

A call option is in-the-money if the strike price is below the actual stock price;

A put option is in-the-money if the strike price is above the actual stock price.

Example (in-the-money call option): An investor purchases an ABC December 70 Call and ABC's current stock price is $80. The buyer's option position is in-the-money by $10, since the option gives the buyer the right to purchase ABC stock for $70.

A call option is out-of-the-money if the strike price is above the actual stock price;

A put option is out-of-the-money if the strike price is below the actual stock price.

Example (out-of-the-money call option): An investor purchases an ABC December 70 Call and ABC's current stock price is $60. The buyer's option position is out-of-the-money by $10, since the option gives the buyer the right to purchase ABC stock for $70.

"At-the-money" has the same meaning for puts and calls and indicates that the strike price and the actual price are the same.

"$2.20" - The number appearing in this part of the options quote is the premium or the price per share you pay to purchase the option contract. An option contract generally represents 100 shares of the underlying stock. In this case, a premium of $2.20 represents a payment of $220 per option contract ($2.20 x 100 shares). The premium is paid up front to the seller of the option contract and is non-refundable. The amount of the premium is determined by several factors including: (i) the underlying stock price in relation to the strike price, (ii) the length of time until the option contract expires, and (iii) the price volatility of the underlying stock.

In addition to the terms above, investors should also be familiar with the following options terminology:

Exercise - When a buyer invokes his or her right to buy or sell the underlying security it's called "exercising" the right.

Assignment - When a buyer exercises his or her right under an option contract, the seller of the option contract receives a notice called an assignment notifying the seller that he or she must fulfill the obligation to buy or sell the underlying stock at the strike price.

Holder and Writer - A buyer of an options contract can also be referred to as a "holder" of that options contract. A seller of an options contract can also be referred to as the "writer" of that options contract.

Please keep in mind that the above information is being provided for educational purposes only.  It is not designed to be complete in all material respects.  Thus, it should not be relied upon as legal or investment advice.  If you have any questions concerning the contents of this post, you should contact a qualified professional.