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The lingo of options

Lesson in Course: Derivatives and options (beginner, 4min )

What terms do we need to know before trading options?

Here's a quick list of words to familiarize ourselves with before we learn more about options contracts. Each of these words represents concepts we'll run into on our trading app.

Underlying

The underlying stock of an option is the stock that the holder of the options contracts has the right to buy or sell.

Call option

A call option gives the owner the right to buy a stock at a predetermined price. 

Owning a $9 Ford call option means we have the right to buy $F stock at $9, but we aren't obligated to buy if the market price for $F is below $9.

Put option

A put option gives the owner the right to sell a stock at a predetermined price. 

Buying a $9 Ford put option means we have the right to sell $F stock at $9, but we aren't obligated to sell if the market price for $F is above $9.

Strike Price

The strike price is the agreed price to buy or sell the underlying stock.

In the examples of the $9 Ford call and put options above, the $9 is our strike price.

Exercise

Exercising is when the option contract owner executes their right to buy or sell the underlying shares at the strike price.

Exercising a call option means we are buying the underlying at the strike. Exercising a put option means we are selling the underlying at the strike.

Assigned

An options assignment is the option contract seller's obligation to sell or buy the underlying shares at the strike price when the option is exercised. 

For a call option, assignment means the person who sold the call option has to sell the underlying to the buyer at the strike. Assignment for a put option means the seller is obligated to buy the underlying from the buyer at the strike.

 

Maturity

The maturity is the date upon when the contract expires. 

Every options contract has a maturity or expiration date, e.g. October 18, 2021. After the maturity date, our options contract will be void!

Premium

The premium is how much we have to pay to enter the contract with someone. 

The premium is also the current value of the option. If we change our mind and decide to sell an option we own, the buyer would pay us the current premium.

Intrinsic value

The intrinsic value is the difference between the strike price and the underlying stock price today and cannot be negative.

If $F is at $10 a share, then a call option at the strike price of $9 a share has $1 per share in intrinsic value. We can buy $F at $9 and turn around and sell it in the market for $10 for a gain of $1. If the difference is negative (e.g. $F is at $8 per share), the intrinsic value remains at $0 because the option holder would choose to not exercise rather than lose money on exercising.

Extrinsic value

The extrinsic value represents the value of time, volatility, and other factors of the option contract.

It represents the time value and captures the possibility that the underlying may further increase or decrease in value. At maturity, there's no value left because there's no time left. 

In-the-money

An option contract is in-the-money if there is a positive intrinsic value. 

 For call options, the underlying is higher than the strike, and for put options, the underlying is lower than the strike.

At-the-money

An option contract is at-the-money if the intrinsic value is $0. 

This happens when the underlying stock price is the same as the strike price of the option agreement.

Out-of-the-money

An option contract is out-of-the-money if the current intrinsic value is negative. 

This means that we would lose money if we exercised the option today, so we would never actually exercise at this value. For calls, the underlying is lower than the strike, and for puts, the underlying is higher than the strike.

 

Greeks

The greeks represent measurements of quantifiable risk factors that affect an option's price. 

Delta, gamma, vega, theta, and rho make up the greeks. While technical, they're essential for us to understand the risks we're taking when trading options.

Implied volatility

Implied volatility is how much the market expects a stock's price will fluctuate in the future.

This volatility captures the expected risks to the underlying price in the future.

American

An American option allows us to exercise the option at any time up to the maturity date.

These are the most common type of options available to us through most brokerages. 

Glossary

What is Call Option?

A call option gives the owner the right to buy a stock at a predetermined price.

What is Put option?

A put option gives the owner the right to sell a stock at a predetermined price.

What is Intrinsic value?

A measure of something's worth - not its price. It refers to the fundamental/objective value contained in an object, asset, or financial contract. The intrinsic value is the difference between the strike price and the underlying stock price today and cannot be negative.

What is Out-of-the-money?

An option contract is out-of-the-money if the current intrinsic value is negative. This means that we would lose money if we exercised the option today, so we would never actually exercise them. For calls, the underlying is lower than the strike, and for puts, the underlying is higher than the strike.

What is At-the-money?

An option contract is at-the-money if the intrinsic value is 0. This happens when the underlying stock price is the same as the strike price, so it doesn't matter if we exercise or not.

What is In-the-money?

An option contract is in-the-money if the current intrinsic value is positive. This means we will profit if we exercised the option today. For calls, the underlying is higher than the strike, and for puts, the underlying is lower than the strike.

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