In our previous lesson, we discussed the risks involved in trading options, highlighting the potential loss of the entire investment if caution is not exercised. However, options can be less intimidating when you realize that they offer strategies for better risk control compared to equities. Before delving into options trading, it is crucial to familiarize yourself with some basic terminology:
1. Put: The right, but not the obligation, to sell the underlying asset at a specified price by a specific date.
2. Call: The right, but not the obligation, to buy the underlying asset at a specified price by a specific date.
3. Contract: The fundamental unit of an option. In stock options, it represents the right to buy or sell 100 shares of the underlying security. Purchasing one contract grants control over 100 shares of stock.
4. Long: Refers to buying or owning a contract, also known as holding.
5. Short: Refers to selling a contract, also known as writing.
6. Underlying: The asset on which the option contract is based, such as a stock, index, or ETF. For instance, if you buy an option on AAPL stock, AAPL is considered the "underlying."
7. Strike: The price at which the option contract allows the holder to buy or sell the underlying asset.
8. Exercise: This term carries two meanings. It can refer to the strike price, but it also signifies fulfilling the obligations of the option. For a call, exercise means buying the underlying asset, while for a put, it means selling the underlying asset.
9. Premium: The cost of buying an option or the amount collected from selling an option. For example, if you purchase an option for $1.00, the total cost would be ($1.00 x 100) $100.
10. Intrinsic Value: The inherent value of an option, determined by subtracting the strike price from the current price of the underlying asset. An option only has intrinsic value when it is "in-the-money."
11. Extrinsic Value: The value of an option beyond its intrinsic value, comprising mainly of time value.
12. In-the-money (ITM): An option that holds intrinsic value.
13. At-the-money (ATM): Occurs when the strike price and the market price of the underlying asset are equal. At-the-money options consist solely of time value.
14. Out-of-the-money (OTM): A call option is OTM when its strike price is higher than the current market value of the underlying asset. A put option is OTM when its strike price is lower than the current market value of the underlying asset. These options possess only time value.
15. Expiration: The date on which the option contract terminates.
16. The Greeks: Various factors that influence an option's price. We will delve into these factors as we progress through the course.
17. Holder: The buyer or owner of an option.
18. Writer: The seller of an option.
19. Hedge: A strategy implemented to protect a position, similar to an insurance policy.
20. Historical Volatility: Represents the dispersion of returns around the mean.
21. Implied Volatility: The market's estimation of future volatility based on supply and demand.
22. Synthetic: Utilizing options to create the risk/reward profile of a stock position.
23. Buy / Write: Simultaneously purchasing a stock and writing a call option against it.
24. Assignment: When an option expires at least one cent in-the-money, the holder of those options may be assigned 100 shares per option. The option buyer has the right to exercise the option at any time before expiration, potentially leading to assignment for the option seller.
25. Front Month: The nearest-term monthly option contract.
26. Calendar Spread: Also known as a time spread, this strategy involves simultaneously buying and selling two options of the same type, underlying asset, and strike price, but with different expiration months.
27. Class: Refers to the whole set of either put options or call options.
28. Long Vertical Spread: An option strategy involving simultaneous buying and selling of similar options on the same underlying asset, expiring on the same date, but with different strike prices.
29. Long Straddle: An option strategy consisting of purchasing an at-the-money put and an at-the-money call on the same underlying asset, with both options expiring in the same month.
30. Long Strangle: An option strategy involving the purchase of an out-of-the-money put and an out-of-the-money call on the same underlying asset, expiring in the same month.
31. Butterfly Spread: An option strategy combining two vertical spreads on the same underlying asset, with one spread being long and the other being short.
32. Credit: The premium received when selling an option.
33. Debit: The premium paid when buying an option.
34. Near-term: An options contract expiring within 1 to 3 months.
35. Mid-term: An options contract expiring within 4 to 6 months.
36. Far-term: An options contract expiring within 7 to 12 months.
37. LEAPS: Options contracts with an expiration date beyond one year, standing for Long-term Equity Anticipation Securities.
As you progress through the course, you will become more comfortable with these terms. Feel free to revisit them whenever necessary for a better understanding.