January 31, 2015

Options Vocabulary

Stock

A security giving you partial ownership in a company.

As a shareholder you have a claim to part of a company’s assets and earnings. Of course that claim is limited to your percentage of ownership—a company like Exxon has over four billion shares.

 

Call

An agreement that gives the purchaser the right, but not the obligation, to purchase 100 shares of stock at a specific price by a specific date.

In general, you profit on a call purchase if the stock rises in price.

 

Put

An agreement that gives the purchaser the right, but not the obligation, to sell 100 shares of stock at a specific price by a specific date.

In general, you profit on a put purchase if the stock drops in price.

 

Delta

The ratio comparing the change in stock price to the change in the option’s price.

The ratio varies from 0 to 1. If an option has a delta of .6, then a $1.00 change in the price of the stock will correspond to a $0.60 change in the price of the option. The delta increases as the option becomes more in-the-money, and decreases as the option becomes further out-of-the-money.

 

Gamma

Gamma is the rate of change of the delta as the stock price changes.

An option’s gamma will be smallest when an option is deep (furthest) in or out-of-the-money. It will be largest when an option is near at-the-money.

 

Theta

Often referred to as time decay, an options theta is a measure of its decline in value due to the passage of time.

If an option has a theta of 42.55 this means that the value of the option will decline (all other factors being equal) $42.55 per day. Theta is lowest when the option expiration date is furthest away. As the expiration date approaches the theta/time decay will increase. For the average option trader theta will not factor heavily in decisions.

 

At-the-Money

An option’s strike price is identical to the price of the underlying stock price. This is the same for both puts and calls.

In actuality, traders consider an option to be at-the-money when the strike price is very near the stock price, as it would be a very brief time period that a stock was actually trading at exactly the price (to the penny) of the strike price. How near the stock price and strike price need to be is subjective.

 

In-the-Money

A call option is in-the-money when the strike price is below the price of the stock.

A put option is in-the-money when the strike price is above the price of the stock.

For example, a $40 call option is in-the-money when the stock is trading at $45. A $40 put option is in-the-money when the stock is trading at $35.

 

Out-of-the-Money

A call option is out-of-the-money when the strike price is above the price of the stock.

A put option is out-of-the-money when the strike price is below the price of the stock.

For example, a $40 call option is out-of-the-money when the stock is trading at $35. A $40 put option is out-of-the-money when the stock is trading at $45.

 

Expiration Date

The buyer of an option (call/put) has the right, but not the obligation, to purchase/sell 100 shares of a stock at a specific price by a specific date. That specific date is called the expiration date.

All options have an expiration date. A $40 at-the-money call option with an expiration date 30 days away will cost less (have a lower premium) than the same call with an expiration date 180 days away.

 

Exercise

Again, as the buyer of a call/put option you have the right, but not the obligation, to purchase/sell 100 shares of a stock at a specific price by a specific date. You can exercise that right at any time before the expiration date.

In practice, options are rarely exercised. More often they expire worthless, or are closed out by simply selling the option.

 

Strike Price

The price at which a stock option can be exercised. This is the key determinant in the price of an option.

A call option’s strike price is the price at which the stock can be purchased. A put option’s strike price is the price at which the stock can be sold.

 

Volatility

An important determinant in the price of an option. Volatility is a measure of the rate and magnitude of a stock’s change in price.

In general, the latest high-flying internet stock will have a higher volatility than something like General Electric. In options, more importantly, a stock that is experiencing significant price swings will have more expensive options because the chance that the option will move further in or out-of-the-money is greater. Oftentimes option prices will increase as an important earnings report or court ruling approaches. Once the news from those events is out the volatility will often decrease.

 

Premium

Just another word for the price of an option.

Leave a Reply