Everyone wants to trade options.
But options terminology can be confusing if you've never traded this complex asset class.
So we've put together a list of 51 options trading terms you need to know.
And if you'd like to learn an interesting strategy for event-driven options trade, watch Daniel Darrow's Options In Play webinar.
When a company goes through some kind of change (a merger, split, acquisition, etc.) that changes the value of its stock, the price of the options the company owns will be adjusted to reflect that change. This retains the overall equity of the options.
American Style/European Style
If an option contract is considered “American style,” then the contract can be exercised at any point up to and including the day of expiration. They make up the majority of options listed on an exchange. This is opposed to “European style” options, which are only able to be exercised on the day of expiration. Many index options are European-style. Before buying and selling any option, be aware of all contract terms.
When an option seller has been given an assignment, they are forced to sell or buy stock at the current strike price, with the quantity of shares determined by the number of contracts. Traders are most commonly assigned stock if they short a call option that expired in the money. Different brokerage firms may have different rules for assignment, so check with yours.
At the Money
An option that is at the money (ATM) has a strike price that roughly matches the price of its underlying security. For example, if TSLA is trading at $350.23, its $350 call and put options will be considered at the money. ATM options do not have intrinsic value, but they may have time value up until their expiration.
With a binary option, buyers only have two outcomes: they receive a fixed profit, or lose their whole investment. If the option surpasses a specified price by a certain time, then the trader profits. If it doesn’t surpass that price, the trader loses the money they spent on the contracts.
Black Scholes Pricing Model
The Black Scholes Pricing Model (sometimes called the Black Scholes Merton model) is a mathematical formula that determines the price of an option. However, the standard model only measures the prices of European options. It does not take into account the possibility that an American style option may be exercised before the expiration date.
An option contract reaches its break-even point when it trades at a price that does not give a profit or loss.
A call option contract gives the holder the right to buy a specified amount of an asset at a specific price up until the option expires. The holder isn’t obligated to buy the asset. If the option is exercised, the seller is obligated to sell the asset at the strike price, although they are paid a premium for taking on this risk. The premium is what the buyer paid for the option.
A trader can find any information they need to know about an underlying security through an option chain, or an option matrix. An option chain lists all available contracts for a particular asset, including both puts and calls, strike prices and pricing information within a specific maturity period.
Similarly to how all stocks have tickers, all options have contract names that identify them. The name is a combination of letters and numbers that match up to the details in that contract, including the symbol of the underlying stock, expiration date and strike price.
Here is a ticker for a JP Morgan (JPM) option from the Thinkorswim platform (these tickers will appear slightly different on other platforms):
In this case:
JPM is the underlying security
19 = the year 2019
12 = the month of December
20 = the 20th day of the month
C = call option
140 = $140 stock price
Covered Call/Covered Put
Covered calls and covered puts are two of the most popular options trading strategies. In the case of a covered call, when a trader is long on a stock, they can sell call options against the position to generate income. Let's say a trader is long 100 shares of Tesla and shorts a $400 call option. They receive a premium for the sale of the call option. And since they are now short a $400 call option, they are also agreeing to sell the 100 shares of Tesla stock at $400.
A covered put is similar, only the trader is short a stock and also shorts puts on that stock.
Delta estimates how much an option's price will change relative to changes in price of the underlying security. The delta value for a call is positive (between 0 and 1.0) because the prices for both the security and the derivative increase, while the delta value for a put is negative (between 0 and -1.0) because the price of the derivative decreases as the price of the asset increases.
If a call option has a delta value of 0.35, then as the price of the asset increases by $1, the price of the derivative also increases by about $0.35. If a put option has a delta value of 0.35, then as the price of the asset increases by $1, the price of the derivative decreases by $0.35.
Any security that relies on an underlying asset or group of assets to determine its value is considered a derivative. An option is a type of derivative because its price is derived from the value of its underlying stock. Derivatives can be traded over an exchange or over-the-counter.
When a trader decides to exercise their option contracts, they are choosing to use the right that the contract gives them to either buy or sell the underlying security at the strike price. Exercising the option before its expiration is called early exercise.
Unlike stock, options have an expiration date. Once the expiration date is reached (usually on Fridays), the option ceases to exist. It must be exercised or closed before expiration, though keep in mind that certain brokerages will automatically exercise certain options at expiration.
The extrinsic value of an options contract is comprised of everything that makes up the overall value of that contract, apart from the price of the underlying asset. It can be calculated by finding the difference between the option’s market price and the intrinsic value.
Extrinsic value is affected by two main factors: the time value of the option and the implied volatility. If the implied volatility stays the same or decreases over time (like the time value decreases over time; see time decay), then the option’s extrinsic value decreases. If the implied volatility increases at the same rate that the time value decreases, then the extrinsic value remains the same.
When an option contract has a single futures contract as the underlying asset, it is considered a futures option. The holder of a futures option has the right to take on a futures position at a specific strike price any time before the contract expires.
A futures contract is an agreement to buy or sell an asset at an agreed-upon price at some point in the future. When a futures option hits its strike price, the futures contract is taken on; the holder has not yet bought or sold the asset.
While a delta value measures the change in price of the underlying security and its derivative, gamma estimates the rate of change of the delta value. It is expressed as a percentage.
A gamma value is at its peak when the stock price is close to the option’s strike price and decreases as the option goes further into or out of the money. As the expiration date of a contract gets closer, the gamma risk grows because the change in delta becomes greater.
Traders are sometimes able to protect themselves against loss by taking another position while holding onto an investment they already own – this strategy is called hedging. Traders are not able to make much money from hedging, so it is used more to reduce or eliminate losses.
Volatility is the measurement of the price change of a stock, and historical volatility measures the volatility a stock has experienced in the past. It is typically calculated over the course of 10 to 30 days. Historical volatility is also known as statistical volatility.
The person who owns an options contract is known as the holder. This is the person who has the right to either buy or sell the underlying asset that the contract provides. They may also choose to sell the contract itself, in which case the person who buys the contract becomes the holder.
Implied volatility measures the volatility that a stock will experience over its lifespan. It can change over time along with demand and the market’s expectations of the stock’s future movement.
An index option is a type of option that allows the holder to buy or sell the value of an underlying index, like the S&P 500 or the US Aggregate Bond Index, at a specific strike price. This allows the option holder to profit off the movement of the index without putting any more than the price of the premium paid at risk.
In the Money
When an option is in the money, it has intrinsic value, or it has a strike price that is either below (if it’s a call) or above (if it’s a put) the market price of the underlying security. If an in the money option is exercised, it produces a profit. An option that gives a large profit when exercised is considered to be “deep in the money.”
An option that is in the money will have an intrinsic value, which is the calculated or perceived value of the asset. It is equal to the difference between its strike price and the market price of the underlying security. In the case that the option does not have intrinsic value (the strike price and market price are the same), it may still have extrinsic value.
Last Trading Day
The last trading day is the final day a stock is able to be traded before it expires, or the day before the expiration date. Any options contracts that are outstanding by the end of the last trading day must be resolved in some way, whether that is through a monetary settlement, delivery of the underlying security or exchange of assets. Options that do not have value are left to expire.
A long-term equity anticipation security (LEAPS) is an option contract that has an expiration date more than one year in the future. LEAPS give the same buy-or-sell rights to the holders and trade just like stocks with short-term leases. They allow holders to take advantage of stock movement over longer periods of time.
A leg is a part of a position that consists of multiple options and/or a position in the underlying asset. When a trader owns a leg position, they can execute one leg with the hope that they can later execute the other parts at a better price.
Before an investor can sell options, they must have a certain amount of money or securities in their account to act as collateral, called margin. The minimum requirements for margin are set by the Financial Industry Regulatory Authority (FINRA) and by option exchanges. Some types of options (such as covered calls or puts) use underlying stock as collateral and do not require margin.
Option contracts with 10 shares of a stock or ETF as the underlying asset (as opposed to 100 shares in a standard option contract) are considered mini options. Mini options can be identified by their contract name when listed on an exchange – a seven is added to the security symbol.
Mini options have physical settlement, so if the contract isn’t closed by its expiration date, the shares may have to be delivered. Like with other forms of options, mini options expire on the third Friday of the expiration month.
Near the Money
A near the money (or close to the money) option has a strike price close to the market price of the underlying asset. Near the money options are also in the money – i.e., the strike price is below the market price if it is a call or above the market price if it’s a put. The difference in price between the strike price and market price for near the money options is usually less than 50 cents, although there is no officially designated price difference.
Open interest is a measurement of the number of options contracts held in active positions; they have not yet been exercised or closed out and have not reached their expiration. When options holders and writers close out their positions, the open interest drops.
Options Clearing Corporation
The Options Clearing Corporation (OCC) is the entity that acts as issuer and guarantor for derivative contracts. The OCC allows options transactions to go through. It is the largest equity derivatives clearing organization in the world and operates under the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).
Out of the Money
When an option is out of the money, it only contains intrinsic value. If the contract is a call option, the strike price is above the market price of the underlying security; if it is a put option, the strike price is below the market price of the underlying security. A trader that exercises an out of the money option will lose money.
Options can be traded over-the-counter (OTC) just like stocks; trading is conducted between two parties without a central exchange or broker. This allows the two parties to trade options not listed on a formal exchange, like the NYSE. Traders must set their own strike prices and expiration dates because there is no external regulatory body to do so.
The premium is the price paid to take on an options contract. It is usually quoted per share, with most options contracts representing 100 shares. Premium is determined by intrinsic value, time value and implied volatility.
A put option contract gives the holder the right to sell a specified amount of an asset at a certain price up until the option expires. Just like with call options, the holder of a put option has the right, but not the obligation, to sell. A put option contract is the equivalent of having a short position on an asset.
A quarterly option, or a quarterly, is an options contract that expires on the last trading day of each quarter, rather than the last trading day of the month like a standard option contract. However, unlike standard contracts, quarterly options can be traded on the expiration date.
Rho measures the price change of an option relative to the price change of the risk-free interest rate, which is the minimum return expected while keeping risk at zero. As interest rates increase, the premium for a call increases while the premium for a put decreases. The rho value for a long call or short put is positive and the rho value for a short call or long put is negative.
When a trader rolls an option, they are closing a contract they already hold and simultaneously opening another contract with the same underlying security, but with a different strike price or expiration date.
Options are often classified in a series, which groups options with the same underlying security and expiration date, but different strike prices. Both calls and puts are listed in a series.
Once an option is exercised, the process through which the contract is resolved is called “settlement.” Options are settled by physical settlement, where the contract is completed by transferring the security from the seller to the buyer, or by cash settlement, where the contract is completed through cash payment rather than payment of stocks, bonds or other assets.
A straddle is a trading strategy in which the trader takes out both a call and put option with the same expiration date and strike price. The maximum loss a trader can have on a straddle is the total premium paid for both options, which only happens if the stock doesn’t move. As long as the stock moves sharply in one direction, the trader can profit off the option that has intrinsic value while the other expires worthless.
A strangle is an options strategy in which the trader sells an out of the money call and an out of the money put simultaneously. The two option contracts have different strike prices. Compared to a straddle, a strangle collects less money from the premium, but has a higher chance of profit.
All option contracts come with a set strike price, the price at which the option can be bought (if it’s a call) or sold (if it’s a put). The strike price is also called the exercise price.
Theta is the measurement of the effect of time on the option’s value. As an option gets closer to its expiration date, its value will decline. Because of this, theta is expressed as a negative number. Theta is also known as time decay.
An uncovered option, or a naked option, is a trading strategy in which the writer sells options contracts, but does not hold a corresponding position in the underlying security. This allows the writer to profit from selling the contracts without owning any additional stock. They can sell the option and keep the premium. But this strategy is risky and subjects the option writer to significant downside risk.
An underlying stock — also called an underlying asset or underlying security — is the stock upon which the price of an option is set.
Vega estimates the price change in the option is caused by the volatility of an option’s underlying security. It is he amount the option contract is expected to change in reaction to a 1% change in the underlying asset’s implied volatility. Long options have a positive vega, while short options have a negative vega.
The seller of an option contract is called the writer. A writer opens a put or call option to collect the premium from the option buyer when the trade is initiated.