Definitions

Question 1

option

Answer 1

Options are contracts giving the owner the right to buy or sell an asset at a fixed price (called the “strike price”) for a specific period of time. That period of time could be as short as a day or as long as a couple of years, depending on the option.

As with stock trades, when buying or selling options, commissions also apply. Their cost should be factored into your decision process.

Question 2

call options

Answer 2

For each call contract you buy, you have the right (but not the obligation) to purchase 100 shares of a specific security at a specific price within a specific time frame. A good way to remember this is: You have the right to “call” stock away from somebody.

Question 3

put options

Answer 3

For each put contract you buy, you have the right (but not the obligation) to sell 100 shares of a specific security at a specific price within a specific time frame. A good way to remember this is: You have the right to “put” stock to somebody.

Question 4

long

Answer 4

In the financial world, “long” doesn’t refer to things like distance or the amount of time you hang onto a security. It simply implies ownership of something. If you’ve bought a stock, or if you bought a put or call, you are long that security in your account.

Question 5

short

Answer 5

You can also be “short” in your account, meaning you’ve sold an option or a stock without actually owning it. That’s a funny-but-true fact 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. What that “something” is depends on the specific options strategy you’re using. Suffice it to say when you’re short an option, you usually don’t want to be obligated to do anything at all, but there are exceptions.

Question 6

strike price

Answer 6

That’s the pre-agreed price per share at which stock may be bought or sold under the terms of an option contract. Some traders call this the “exercise” price.

Question 7

In-the-money (ITM)

Answer 7

The definition of in-the-money refers to the relationship between the strike price and the current stock price. Its meaning is different for calls and puts.

Question 8

ITM call option

Answer 8

A call option is “in-the-money” if it is cheaper to buy the stock for the strike price than it is to buy the stock in the open market. In other words, the stock price is above the strike price. For example, if a call has a strike price of 50 and the stock is trading at $55, that option is in-the-money because the contract owner has the right to obtain the stock for less than its current market value.

Question 9

ITM put option

Answer 9

Put options are in-the-money if it is more lucrative to sell the stock at the strike price than it is to sell the stock in the open market. For puts, the stock price must be below the strike price to be in-the-money. For instance, if a put has a strike price of 50 and the stock is trading at $45, the put option is in-the-money because the contract owner has the right to sell the stock for more than its current market value.

Question 10

At-the-money (ATM)

Answer 10

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

Question 11

Out-of-the-money (OTM)

Answer 11

This term also refers to the relationship between the strike price and the current stock price. As you might have guessed, it varies for calls and puts. An option is considered to be out-of-the-money if exercising the rights associated with the option contract has no obvious benefit for the contract owner.

Question 12

OTM call option

Answer 12

For call options, it means the stock’s market price is below the strike price. For example, if a call has a strike price of 50 and the stock price is $45, the option is out-of-the-money. Think of it this way: It would be more expensive for the contract owner to buy the stock for the strike price instead of purchasing the shares in the open market. So there’s no benefit to exercising for the call option owner.

Question 13

OTM put option

Answer 13

For put options, it means the stock’s market price is above the strike price. If a put has a strike price of 50 and the stock is trading at $55, the put option is out-of-the-money. Remember, a put represents the right to sell stock. So if selling the stock at the strike price generates less money than selling the shares in the open market, the option is OTM.

Question 14

Intrinsic value

Answer 14

Intrinsic value refers to the amount an option is in-the-money. In addition to any intrinsic value, the price of nearly all option contracts includes some amount of time value. This is simply the part of an option’s price that is based on its time to expiration. The time until the option expires has value because it means the stock still has a chance to make a move.

Question 15

Time value

Answer 15

If you subtract the intrinsic value from an option’s price, you’re left with time value. Because out-of-the-money options have no intrinsic value, their price is entirely made up of time value.

Question 16

Exercise

Answer 16

When the owner of an option invokes the right embedded in the option contract, it’s called “exercising” the option. 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.

Question 17

Assignment

Answer 17

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.

Question 18

Historical volatility

Answer 18

Historical volatility refers to how much the stock price fluctuated (high price to low price each day) over a one-year period. Since it’s “historical”, this figure obviously refers to past price data. If the number of data points is not stated (for example, 30-day) then it’s assumed that historical volatility is an annualized number.

Question 19

Implied volatility (IV)

Answer 19

Implied volatility (IV) is what the marketplace is “implying” the volatility of the stock will be in the future, without regard for direction. Like historical volatility, this is an annualized number. However, implied volatility is determined using an options pricing model. So although the marketplace may use implied volatility to anticipate how volatile a stock may be in the future, there is no guarantee that this forecast will be correct.

If there’s an earnings announcement or a court decision coming up, traders will alter trading patterns on certain options. That drives the price of the options up or down, independent of the stock price movement. The implied volatility is derived from the cost of those options. Think of it this way: if there were no options traded on the stock, there would be no way to calculate the implied volatility.

Implied volatility can help you gauge how much the marketplace thinks the stock price might swing in the future. That makes it an important element in option pricing. Usually, the higher implied volatility is, the higher option prices will be because higher IV indicates the likelihood of a larger price swing.

Question 20

Greeks

Answer 20

Just like implied volatility, the options Greeks are determined by using an option pricing model. Although the Greeks collectively indicate how the marketplace expects an option’s price to change, the Greek values are theoretical in nature. There is no guarantee that these forecasts will be correct.

The most common Greeks are “delta”, “theta” and “vega.” Although you may also hear “gamma” or “rho” mentioned from time to time, we won’t get into them here. We’ll just go over the more important terms.

Question 21

Which greek tells how much will the price of an option move if the stock moves $1?

Answer 21

“Delta” provides the answer: it’s the amount an option will move based on a dollar change in the underlying stock. If the delta for an option is .50, in theory, if the stock moves $1 the option should move approximately 50 cents. If delta is .25, the option should move 25 cents for every dollar the stock moves. And if the delta is .75, how much should the option price change if the stock price changes $1?

That’s right. 75 cents.

Typically, the delta for an at-the-money option will be about .50, reflecting a roughly 50 percent chance the option will finish in-the-money. In-the-money options have a delta higher than .50. The further in-the-money an option is, the higher the delta will be.

Out-of-the-money options have a delta below .50. The further out-of-the-money an option is, the lower its delta will be. Since call options represent the ability to buy the stock, the delta of calls will be a positive number (.50). Put options, on the other hand, have deltas with negative numbers (-.50). This is because they reflect the right to sell stock.

Question 22

Theta

Answer 22

Theta is the measure of “time decay.” In other words, it’s the amount an option’s price will change (at least in theory) for a one-day change in the time to expiration. For example, if the theta for an option contract is $.07, then in theory, the time value of an option should decrease by 7 cents for each day that passes. Theta is enemy number one for the option buyer, since it measures how quickly the owner’s option is eroding in value with each passing day. On the flipside, theta is usually the option seller’s best friend, because when you sell an option, you want it to decrease in value as quickly as possible.

Question 23

Vega

Answer 23

Vega is a slightly trickier concept. It’s the amount an option’s price will change in theory for a corresponding one-point change in the implied volatility of the option contract. Remember, as implied volatility increases, it indicates a potential for wider movement in the stock price. Therefore, option prices will increase as implied volatility increases, and option prices will decrease as implied volatility decreases.

If the vega for an option contract is .10, then in theory that means if the implied volatility of the option moves one percentage point up or down the value of the option will move accordingly by 10 cents.

Keep in mind: vega doesn’t have any effect on the intrinsic value of options; it only affects the “time value” of the option’s price. Here’s an odd fact for you: Vega is not actually a Greek letter. But since it starts with a ‘V’ and measures changes in volatility, this made-up name stuck.