Key Terms in Options Trading

What is an Option Contract?

An option contract is a financial derivative that gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a predetermined price, known as the strike price, within a certain time period. The buyer can choose to exercise the option or let it expire worthless. On the other hand, the seller, also known as the option writer, is obligated to sell or buy the underlying asset if the buyer exercises the option. Option contracts allow investors to speculate on the future movement of the underlying asset or hedge existing positions.

Another way to look at an option contract is to see it as an insurance contract.

You are basically buying insurance from the option writer and if an event happens, stock price goes up or down within the next 6 months for example, you have a right to use your insurance policy to benefit.  To better understand this, think of the seller of option contracts as an insurance company.  The buyer of that contract has to pay a premium to the insurance company.  That contract (insurance or option) has value only if the event occurs within a given time frame.

Thus, options trading involves several key terms that traders need to understand.  This would be similar to understanding the terms on an insurance contract for example. These include the strike price, which is the predetermined price at which the underlying asset can be bought or sold, the expiration date, which is the date when the option contract expires, the option premium, which is the amount paid for the option, and the intrinsic value, which is the difference between the current market price of the underlying asset and the strike price.

Definition of an Option Contract

An option contract is a derivative contract that gives the holder the right, but not the obligation, to buy or sell shares of a stock at the strike price before the expiration date. The option contract is an agreement between the buyer and the seller, where the buyer pays the seller a premium for the right to buy or sell the underlying security.

There are two types of option contracts: put options and call options. A put option gives the buyer the right to sell the underlying asset, while a call option gives the buyer the right to buy the underlying asset. These options can be further classified into different categories, such as index options and equity options, depending on the underlying security.

Imagine if you bought a call option at a strike price of 100 and the current stock price is 130, then what is that right worth.  At a minimum it is worth $30 (intrinsic value) since you can purchase something which is currently valued at 130 for only 100.

Say for example you had bought a put option on the same stock with a strike price of 100 and the current stock price is 70.  You use the same logic here but in reverse.   A put option gives you the right to sell something at a certain price, called the strike price.  Since in this case the strike price is 100 and the current stock price is 70, your put option is worth at a minimum $30 (intrinsic value).

What does the option term ‘moneyness’ mean?

A put option gives the buyer the right to sell the underlying asset at the strike price. If the market price of the underlying asset is lower than the strike price, the put option is considered “in-the-money” and the buyer can make a profit by exercising the option. However, if the market price is higher than the strike price, the put option is “out-of-the-money” and the buyer can choose not to exercise the option.

A call option gives the buyer the right to buy the underlying asset at the strike price. If the market price of the underlying asset is higher than the strike price, the call option is “in-the-money” and the buyer can earn a profit by exercising the option. Conversely, if the market price is lower than the strike price, the call option is “out-of-the-money” and the buyer may choose not to exercise the option.

Using our previous example, a call option with a strike price of 100 is ‘in-the-money’ when the current stock price is 130.  If the current stock price were 90 then the call option would be ‘out-of-the-money’ at that point.  Since the call option is ‘in-the-money’ is worth $30 (intrinsic value) and if it was a 6-month option, it would also have a time value provided some time was left.  Time value depends on the probability of the price increasing in the remaining time left.  Thus, the more time left before the option expiration date, the higher the time value.

Let’s say that 10 days were left on the contract before it expires.  The probability that the stock could be worth more is real since it could go up to 131 or even 135 in the time remaining.  Thus, this contract has time value and 10 days before it expires this could be worth 1.50 for example.  Therefore, the call would have a value of 31.50.

For the put option buyer with a strike price of 100 it would be ‘in-the money’ when the current stock price is 70 and ‘out-of-the money’ when the current stock price is 130 for example.  Let’s assume that the price of the stock is 130, thus the put option is ‘out-of-the-money’ and this means that the time value would be very small or almost zero.  The reason is that with 10 days left, like the previous example, the probability that the contract will be ‘in-the-money’ is small since the stock will have to loose more than 30 points to drop under 100 in 10 days.  A highly unlikely event.

Please see the table below that summarizes the key points discussed.