- What is a Stock Option?
- How Do Options Differ from Stocks?
- What is a Call Option?
- What does “In the Money” mean?
- What does At-the-Money mean?
- What is the “Premium”?
- What determines the price of an option?
- What is Delta?
- Key Options Trading Terms
What is a Stock Option?
An option is simply the right, but not the obligation, to buy or sell a specific stock at a specific price by a specific date. Options come in two varieties: a call option is the right to buy the stock, and a put option is the right to sell the stock.
How Do Options Differ from Stocks?
Stock shares represent partial ownership of a company. If the company makes a profit, then hopefully the company will be out cash dividends and you will get a little return each year from that cash, and hopefully other investors will recognize the value of the shares and the stock price will go up.
Stock options, on the other hand, are contracts that give you the option to buy or sell a specific amount of a particular stock at a certain price within a set period of time. The set price is called the strike price and the set period of time is called the expiration date. If you decide to make use of your right to buy/sell stock according to the terms of the option, you are exercising the option.
Another key difference is since options have to be exercised within a certain period of time, options have a fixed life-they expire. Stocks have no such time limit attached to them.
It is said that the value of options “derive” their value from the value of the underlying stock. That is why the term “derivatives” is often used to describe options.
What is a Call Option?
A Call option is a contract that gives the option holder the option to buy shares of stock at a specified price at a specific time.
It is definitely not an obligation for the call option to buy these shares, otherwise known as to exercise them. Call Options have an expiration month, with a specific expiry date. If the Call Option has a July 2009 expiration date, then it expires on July 17th. They always expire on the third Friday of their expiration month.
Call Options fall under 3 categories. These are: In-The-Money, At-The-Money and Out-Of-The-Money. In the money call options mean that their strike price is lower than the market price of the underlying security. At the money means the strike price is in line with the market price of that security and out of the money means the strike price is higher that the market price of that security.
So, if we were to buy a July 2009 Apple Call Option with a strike price of $100 and shares of Apple are currently trading at $120, we are considered “in the money.” By the 17th of July (expiration date), we can exercise our call option, or in other words, oblige the writer to sell us 100 shares of Apple at $100 while it’s trading at $120. This will give us an instant profit of $20. One call option contract includes 100 shares, so we would instantly make a profit of $2,000 (100 shares x $20).
It is important to learn options trading terms in order to develop a successful options strategy.
What does “In the Money” mean?
In the money refers to options and their current value.
If you are using this term in reference to a call option, then your option’s strike price is below the market price. In other words, if your option strike price is $40 when the underlying security is currently trading at $50, then you’re in the money!
This means you are $10 In-The-Money because you can buy Apple shares are $40 when they are currently trading at $50.
When using the In-The-Money in regards to put options the opposite holds true. If your strike price is higher than that of the market, then you can sell your stock for a higher price than what it is currently trading it. If your strike price is $50 and the underlying stock is trading at $40, then you are $10 in the money. You can sell your stocks for $50 and make a $10 profit.
Whenever you can sell your options or exercise them for a profit, then you are considered In-The-Money.
What does At-the-Money mean?
An option contract “at the money” describes a situation in which the market value of an underlying security equals the strike price of the option.
An at-the-money option position can be thought of as at the break-even point (not accounting for transaction fees and commissions) for an options cotract.
Suppose you bought a certain number of Coca-Cola (KO) call contracts at the strike price of 45. When the market price of KO reaches $45 you are at-the-money; you can exercise the contract for a net gain of zero (break-even).
What is the “Premium”? / What determines the price of an option?
When you buy an option, the purchase price is called the premium. The premium is not fixed, but like a stock price, is a function of supply and demand, buyers and sellers. Specifically though, an option price is mainly a function of the following features:
- IN-THE-MONEY OR INTRINSIC VALUE-The difference between the strike price and the underlying stock’s price. Obviously the right to buy IBM at $150 when IBM is at $100 is not worth much, but the right to buy IBM at $90 when IBM is at $100 is worth at least $10.
- TIME TO EXPIRATION-Options that expire in 1 month are going to be a lot cheaper than options than expire in 3 or 6 months because there is less time for price movement.
- STOCK PRICE VARIANCE-Options on stocks that moves a lot each day like Google are going to be more expensive than options on stocks like utilities that don’t move a lot each day.
What is Delta?
In stock option trading, Delta is a ratio that is used to compare the movement of the price of an option to the movement of the price of the underlying stock.
Let us consider call options. A call option with a delta of 0.5 means that for every $1.00 a stock increases in value, the call option will increase by $0.50.
For put options, it is the opposite and deltas are recorded as negative numbers. For example, a put option with a delta of -0.5 means that for every $1 the stock decreases, the put option will increase by $0.50.
In general, the higher the Delta, the more volatile the derivative option.
Call Option – the right to buy a stock (or index or ETF) at a specific price by a certain date.
Put Option – the right to sell a stock (or index or ETF) at a specific price by a certain date.
Strike Price – the specific price at which the stock can be bought or sold. Strike prices are usually integers of $5 for stocks that are price at $40 and above, and at intervals of $2.50 for stock prices below $40.
Expiration Date – the specific date at which the stock must be bought (if it is a call) or sold (if it is a put). Expiration dates are usually the 3rd Friday of each month, however, there are a few ETFs that have expiration dates at month ends.
Underlying Instrument – usually 100 shares of the specific stock or index or ETF that the option contract covers.
In the Money -The inherent or intrinsic value of an option. For a call option, if the stock price is higher than the strike price (or for a put if the stock price is less than the strike price) then the option is set to be in-the-money. Example, an “IBM April $95 Call” would be the right to buy 100 shares of IBM at $95 prior to the third Friday in April.