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"I've always been confused about options trading...
at least now I have a better understanding about it!"
Ben Masters
VIC, Australia
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> Options Guide > Options
lingo - Understanding stock options |
Options Lingo - Understanding Stock Options
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Now that we understand the basic concept of option
trading, it's time to mention the terminology used
in the option trading world.
Premium - The premium is
the amount that you pay up front for the option.
This amount is once-off and non-refundable.
Strike Price
- The strike price is the amount that you
agree to pay for the stock at a later date.
Underlying Stock
- The underlying stock is the stock for which
you are purchasing the option.
Exercising Options - No,
we are not talking about choosing to jump
up and down in front of an exercise video
featuring Anna.
By exercising an option, you are using your
right to buy, and actually purchasing the
underlying stock.
Expiration
Date - The expiration date is the
last day for you to exercise your option.
If you don't exercise it by then, your option
will expire worthless. In the United States,
the expiration date is the 3rd Friday of the
month. So if you have a June option, that
option will expire on the 3rd Friday of June.
American Options
- American options are options (not limited
by any geographic boundaries) that allow you
to exercise the options at any time
until the expiration date.
European
Options - European options are options
(not limited by any geographic boundaries)
that allow you to exercise the options at
only the expiration date. Do check
with your local Options Exchange which form
of options are used in your country.
Contract - Option trading is carried
out in numbers of contracts. One contract equates
to 100 underlying shares. If you buy one call option
contract, you are buying the right to buy 100 shares
of the underlying stock.
In-The-Money - An option
is said to be in-the-money if it is worth
something if you choose to exercise
it now.
Out-Of-The-Money
- An option is said to be out-of-the-money
if it is worthless if you
choose to exercise it now.
In our previous housing
example, you paid a Premium
of $5,000 for the Call Option, or the right
to buy the Underlying house,
at a Strike Price of $110,000.
You may exercise the right
to buy the house at the Expiration
date of 6 months' time.
Looking at our 2 possible scenarios, if the
underlying house is worth $200,000 in 6 months'
time, your option is considered In-The-Money.
If you had bought it, you would have made
a profit of $200,000 - $110,000
- $5,000 = $85,000. Your profit would be the
market value of the house, minus the amount
you paid for it, and minus the option Premium
you paid at the start for the right to buy
the house.
In the 2nd scenario, if the underlying house
is worth $80,000 in 6 months, your option
would be Out-Of-The-Money,
and you would not want to exercise it and
pay more for the house than it was actually
worth. Your loss would be
the initial $5,000 you paid for the option.
|
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| Item |
Scenario 1 |
Scenario 2 |
| Initial Premium |
$5,000 |
$5,000 |
| Strike Price |
$110,000 |
$110,000 |
| Expiration Date |
6 months |
6 months |
| House Market Value |
$200,000 |
$80,000 |
| In-The-Money? |
In |
Out |
| Profit |
$85,000 |
- $5,000 |
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Now let's
look at an option trading example in the stock market:
You are monitoring stock ABC, which is currently
priced at $19.00 on the 1st of June.
You think ABC is doing well, and should go
up in price very soon.
You decide to buy a June Call Option
for ABC, with a Strike Price
of $20.00, and an Expiration Date
of the 3rd Friday of June (options always
expire on the 3rd Friday of the month). The
Premium for the option is
$0.75. As of now on the 1st of May, the option
is Out-Of-The-Money, since
ABC's price of $19.00 is still below your
Strike Price of $20.00
On the 3rd Friday of June, you find that ABC
has increased in price by $3.00 bringing it
up to $22.00. Your option is now In-The-Money,
and you could exercise it now for a profit.
Your profit would be the market value, minus
your strike price, minus your premium, which
is $22 - $20 - $0.75 = $1.25.
|
| |
| ABC |
1st June |
3rd Friday |
| Initial Premium |
$0.75 |
$0.75 |
| Strike Price |
$20.00 |
$20.00 |
| Expiration Date |
3rd Friday |
3rd Friday |
| Current Stock Price |
$19.00 |
$22.00 |
| In-The-Money? |
Out |
In |
| Profit |
- $0.75 |
$1.25 |
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Be aware
that since each option contract covers 100 underlying
shares, all costs and profits should be multiplied
by 100 for the proper perspective.
And also be aware that option trading in general
is very risky, and should only be done after understanding
stock options intimately. Since options provide
such a large amount of leverage (you can earn a
larger percentage, as well as lose a larger percentage),
you could lose a fortune without properly understanding
stock options.
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