10.5.1 Options Terminology

Options terminology encompasses several key phrases essential to navigating the world of options trading. Below, we articulate these terms in detail and provide supplementary materials to support your learning.

Key Terms and Definitions

Strike Price

The strike price (or exercise price) is the agreed-upon price at which the underlying asset can be purchased or sold in the future, as established in the option contract.

Option Premium

The option premium is the payment an option buyer makes to the option seller. This fee grants the buyer the right to buy or sell the underlying asset without further obligation unless they decide to exercise the option. The maximum loss for an option buyer is the premium paid, whereas option writers must always be ready to fulfill their obligations.

Expiration Date

Options have specific expiration dates, usually set on the third Friday of the expiration month. Options can have different expiration periods, including weekly options which expire any of the five Fridays following their listing week.

Trading Unit

A trading unit specifies the amount of the underlying asset represented by one option contract. Standard stock options in North America usually cover 100 shares, which means one call option gives the buyer the right to purchase 100 shares of the underlying stock.

American-Style Options

American-style options allow the holder to exercise at any time up to and including the expiration date.

European-Style Options

European-style options can only be exercised on the expiration date. They are common for index options.

Long-Term Equity Anticipation Securities (LEAPS)

LEAPS are long-term options providing the same risks and rewards as regular options contracts.

Option Transactions

Opening Transactions

An opening transaction establishes a new options position. Bought options result in long positions, while sold options result in short positions. Positions close via offsets, exercise, or expiration.

Offsetting Transactions

Offsetting involves creating an opposite position of the same type and number of contracts to effectively cancel the initial position.

Exercised Options

In exercised options, the party holding the long position buys or sells the underlying asset at the strike price to the assigned counterparty.

Options Expire Worthless

Should the option not be exercised before expiration, it expires worthless, causing the option buyer to lose the paid premium and allowing the writer to keep it.

Option Value Concepts

In-the-Money

An option is said to be in-the-money if exercising it is financially advantageous.

• A call option is in-the-money when the underlying asset’s price > strike price.
• A put option is in-the-money when the underlying asset’s price < strike price.

Out-of-the-Money and At-the-Money

• A call option is out-of-the-money if the underlying asset’s price < strike price.
• A put option is out-of-the-money if the underlying asset’s price > strike price.
• Call and put options are at-the-money if the price of the underlying asset equals the strike price.

Intrinsic Value

Intrinsic value denotes the in-the-money portion of an option.

• Intrinsic Value for a Call Option: $$ \text{Intrinsic Value} = \text{Price of Underlying} - \text{Strike Price}$$
• Intrinsic Value for a Put Option: $$ \text{Intrinsic Value} = \text{Strike Price} - \text{Price of Underlying}$$

Example Calculation

Time Value

Time value signifies the premium of an option above its intrinsic value. It reflects the value of holding an option until its expiration.

$$ \text{Option Premium} - \text{Intrinsic Value} = \text{Time Value}$$

Example Calculation

For a call option on XYZ stock with a strike price of $55 and trading at $6 while the underlying asset’s price is $60:

$$ \text{Time Value} = \text{Option Premium} - ( \text{Price of Underlying} - \text{Strike Price})$$

$$ \text{Time Value} = \$6 - (\$60 - \$55) $$

$$ \text{Time Value} = \$1 $$

Key Takeaways

• The strike price determines the execution price for buying or selling the underlying asset.
• The option premium is the fee paid for the potential right in the option contract.
• Expiration date restrictions clarify the exercising timelines of options.
• Option trading units affect the contract size in the underlying asset.
• American-style options allow more flexible exercise capabilities than European-style options.
• The option’s worth is derived from both its intrinsic and time values.

Frequently Asked Questions (FAQs)

Q: What’s the difference between American-style and European-style options?

A: American-style options can be exercised any time before the expiration date, while European-style options can only be exercised on the expiration date.

Q: How is an option premium calculated?

A: The premium is the market price of the option, which includes both intrinsic value (if any) and time value.

Q: What happens if an option is out-of-the-money at expiration?

A: The option expires worthless, causing the buyer to lose the premium and the writer to gain it.

Q: What are LEAPS?

A: LEAPS are long-term equity anticipation securities, essentially providing the same benefits as regular options but with a longer time horizon.

Options Terminology

    graph TB
	    A[Options Terminology]
	    A --> B[Strike Price<br><i>Executed Price</i>]
	    A --> C[Option Premium<br><i>Fee for Potential Right</i>]
	    A --> D[Expiration Date<br><i>Specific Exercise Date</i>]
	    A --> E[Trading Unit<br><i>Size of Contract</i>]
	    A --> F[American-Style Options<br><i>Exercisable Anytime Before Expiration</i>]
	    A --> G[European-Style Options<br><i>Exercisable Only at Expiration</i>]
	    A --> H[LEAPS<br><i>Long-term Equity AnticiPation Securities</i>]

By understanding these concepts, you’ll be better equipped to analyze options and make informed trading decisions. Happy studying!