Options trading terminology and definitions every beginner should know
Feb 22, 2023
10 min read
What we'll cover
The difference between call options and put options
What it means to exercise options
When something is at, in or out of the money
Options trading terminology can make your head spin if you’re new to this investing strategy. Calls, puts, in the money, out of the money…what does it all mean?
Decoding options might seem a little intimidating or overwhelming, but it doesn’t have to be. Mastering some of the key options trading definitions can help you build a foundation of knowledge so you can invest successfully.
Ready to learn the language of options? Here are some of the most common options trading terms to add to your vocabulary.
An American-style option allows the contract holder to exercise the option at any time up until its expiration date.
Assignment conveys an obligation to fulfill the terms of an options contract once it’s exercised. Assignment happens when an equity option seller (writer) receives an exercise notice that obligates them to buy or sell a specified number of shares of an underlying asset at its strike price.
At the money (ATM)
The relationship between an asset’s strike price and its current stock price. An option is at the money when the stock price is equal to the strike price.
A call is one type (or flavor) of an option. For each call contract you buy, you have the right (but not the obligation) to purchase 100 shares of a specific security at a specific price within a specific time frame. Here’s another way to remember this: You have the right to call stock away from somebody.
A covered call strategy involves writing call options for stocks that you are long in. Covered calls are designed to hedge against risk associated with price movements of the underlying asset.
A covered put strategy works like a covered call, except that you’re writing options for securities that you’re short on. Being short means that you’re selling securities you don’t actually own.
European-style options can only be exercised on the options contract expiration date and not before.
When the owner of an option invokes the right embedded in the option contract, it’s called exercising the option. The owner buys (if a call) or sells (if a put) the underlying stock at the strike price and requires the option seller to take the other side of the trade.
The expiration date is the latest date at which an option can be exercised. After this date, a listed option contract ceases to exist, and the option expires worthless. You can no longer trade it on any exchange or exercise the right embedded in the contract.
When an option is not exercised by its expiration date. The option has no value and is either at the money or out of the money.
A contract that gives its buyer (owner) the right, but not the obligation, to either buy or sell 100 shares of a specific underlying stock or exchange-traded fund (ETF) at a specific price (strike or exercise price) per share, at any time before the contract expires. Also known as “stock options.”
A futures option is a type of options contract in which the underlying assets are futures.
The Greeks are a set of calculations that are used to measure how different factors or events might influence an option’s price. They’re called the Greeks because of their names. For example, there’s delta, gamma, theta and vega — all of which measure options risk in different ways.
Historical volatility is a measurement of the actual observed volatility of a specific stock over a given period of time in the past, such as a month, quarter or year. In simpler terms, it’s a way to gauge how far a stock’s price has moved away from its average.
Implied volatility (IV) is derived from an option’s price and shows what the market implies about the stock’s volatility in the future. Implied volatility can be used to gauge how an option’s price might move.
It’s one of six inputs used in an options pricing model, but it’s the only one that is not directly observable in the market itself. IV can only be determined by knowing the other five variables and solving for it using a model. Implied volatility acts as a critical surrogate for option value – the higher the IV, the higher the option premium.
In the money (ITM)
In the money is another way to measure the relationship between the strike price and the current stock price and assess its intrinsic value. A call option is in the money if the stock price is above the strike price. Put options are in the money if the stock price is below the strike price.
Intrinsic value refers to the amount (if any) an option is in the money.
An option contract whose underlying security is an index that tracks the performance of a group of assets (like the S&P 500 Index – SPX), not shares of any particular stock. Index options are usually cash-settled option contracts.
In options trading, long doesn’t refer to things like distance or the amount of time you hang onto a security. It implies ownership of something. After you have purchased an option or a stock, you are considered “long” that position in your account.
Out of the money (OTM)
Out of the money refers to the relationship between the strike price and the current stock price. An option is considered to be out of the money if exercising the rights associated with the option contract has no obvious benefit for the contract owner. For call options, the market price is below the strike price. For put options, the market price is above the strike price.
A put is another type (or flavor) of an option. For each put contract you buy, you have the right (but not the obligation) to sell 100 shares of a specific security at a specific price within a specific time frame. Think of it this way: You have the right to put stock to somebody.
A premium is the price paid or received for an option in the marketplace. For example, stock option premiums are quoted on a price-per-share basis, so the total premium amount paid by the buyer to the seller in any option transaction is equal to the quoted amount times 100 (underlying shares). Option premium consists of intrinsic value (if any) plus time value.
Profit + loss graph
A representation in graph format of the possible profit and loss outcomes of a stock option strategy over a range of underlying stock prices at a given point in the future, most commonly displayed at option contract’s expiration date.
Short selling is a bearish options trading strategy in which you’re banking on shares of an asset dropping in value. You’re essentially borrowing securities from a broker and offering those securities for sale on the open market.
It’s important to note, this is about options, not statistics. But you’d probably hear standard deviation a lot in a room full of options traders, so let’s clarify its meaning.
If we assume stocks have a simple normal price distribution, we can calculate what a one-standard-deviation move for the stock will be. On an annualized basis the stock will stay within plus or minus one standard deviation roughly 68% of the time. This comes in handy when figuring out the potential range of movement for a particular stock.
For simplicity’s sake, here we assume a normal distribution. Most pricing models assume a log normal distribution. Just in case you’re a statistician or something.
The strike price is the pre-agreed price per share at which stock may be bought or sold under the terms of an option contract. Some traders call this the exercise price. Strike price is one of the five basic parts of a standard stock options quote.
The stock symbol represents the underlying security on a stock option quote. Examples include AMZN (Amazon) and GE (General Electric).
Another name for equity options (see definition above). Stock options are listed on exchanges like the NYSE in the form of a quote. It is important to understand the details of a stock option quote before you make a move — like the cost and expiration date.
Stock options quote
A stock options quote highlights the main terms and conditions in a standard stock options contract.
The price of nearly all option contracts includes time value. This part of an option’s price is based on its time to expiration. If you subtract the intrinsic value from an option’s price, you’re left with time value. Because out-of-the-money options have no intrinsic value, their price is entirely made up of time value.
Volatility crush happens when there’s a sudden and sharp drop in implied volatility of an asset. That in turn triggers a decline in a call or put option’s value. Volatility crushes can happen when events in (or outside) the market affect price expectations for a specific security.
To sell a call or put option contract that has not already been purchased (owned). The seller of an option contract is considered the “writer” of that contract. This is known as an opening sale transaction and results in a short position in that option. The seller (writer) of an equity option is subject to assignment at any time before expiration and takes on an obligation to sell (in the case of a short call) or buy (in the case of a short put) underlying stock if assignment does occur.