Options Trading Terminology

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In this final part of our introduction to options trading we explain a number of the key terms and phrases stock option trading terms and definitions are used. These are terms that aren't specifically covered in other parts of the site, but are important enough that you need to understand what they are and what they mean.

Some of these terms are relatively straightforward, and we have described stock option trading terms and definitions on this page, while others are a bit more complicated. We have linked to specific articles explaining them. For a complete list of the terminology that's used in options stock option trading terms and definitions, you can refer to our Glossary of Terms.

The following terms and phrases are all covered in detail stock option trading terms and definitions this page:. Volume in options trading is a very simple; it basically refers to the number of transactions being made that involve a particular contract. If a specific contract is being heavily traded i. If there are very few transactions involving a specific contract, then it's said to have a low volume. The trading volume of a contract is important, stock option trading terms and definitions it affects the liquidity.

It isn't the only factor that affects it, but it does play a significant part and, as with any form of investment, liquidity is definitely something that you should be considering when trading options. The liquidity of an option is a measure of how easily it can be traded at the market price; high liquid means it can be readily bought or sold.

Ideally you want to be trading contracts that have a high liquidity, for a number of reasons. First, the bid ask spread on highly liquid contracts will usually be much smaller than those with low liquidity, and a small bid ask spread will ultimately save you money. You can also be confident that any order you place for liquid contracts is likely to be filled quickly and very close to the market price.

While if you are trying to sell contracts that aren't very liquid you may struggle to find a buyer. The terms bull market and bear market are often used in most forms of investment, and relate to what's happening to the price of securities, or expected to happen.

When a financial market is experiencing rising prices, or is expected to, it's said to be a bull market. When a financial market is experiencing falling prices, or is expected, it's said to be a bear market.

Whether there is a bull market or a bear market obviously affects what kind of investment, if any, you make. It's particularly relevant in options trading as many strategies are specifically for use in certain market conditions. A strategy that might work well in a bear market, for example, wouldn't necessarily be suitable in a bull market. Fundamental analysis and technical analysis are the two most widely used forms of analysis that investors can use to decide what investments to make.

Their terms are commonly used when talking about buying stocks, but both fundamental analysis and technical analysis for trading any kind of financial instrument, including options. In very simple terms, fundamental analysis is about carrying out research securities to establish their inherent value. For example, you could use fundamental analysis to determine whether a particular stock is overvalued or undervalued by thoroughly researching the company. Its financial strength and any advantages or disadvantages they have in their industry are things to look out for.

Technical analysis is more about studying past performance and looking for trends and patterns that may exist in the price of a particular security. Technical analysts typically presents that all the factors that affect the price of a security are already factored into the market price, and it's more beneficial to look for patterns and trends that might suggest future price momentum.

Both forms of analysis have their advantages and disadvantages, and it's largely a matter of personal preference as to which might be better for you. A common misconception among beginner options traders is that one contract is based on one unit or share of the underlying asset. However, most options contracts actually cover multiple units of the underlying asset; for example, a call options contract based on stock in Company X may give you the right to purchase shares in Company X.

The amount of the underlying asset that's covered by a contract is known as the contract size, and is typically You should be aware that the contract size affects how much you pay for it. In simple terms, the moneyness of an options contract defines the relationship between the strike price of that contract and the current price of the underlying security.

The moneyness of a contract can be described as being in one of the three states: The price of a contract is closely related to its state of moneyness, and moneyness is also relevant to most trading strategies.

As such, it's a concept that you should be familiar with and you can read more on the following page: The use of leverage in options trading is one of the biggest advantages of this form of trading.

In very simple terms, leverage is basically when you multiply the power of your starting capital to increase the size of your potential profits. Because of the way options work, they can easily be used to effectively invest in a larger number of stocks, or other underlying security, than you would be able to by actually buying the underlying security.

We explain leverage in more detail on the following page — Leverage. The use of margin in investment is something of a complicated subject, not because the word has a number of different meanings and can be used differently depending on what stock option trading terms and definitions of investment you stock option trading terms and definitions making.

This often leads to confusion among investors, particularly relatively inexperienced ones, and people often misunderstand what margin means in options trading. You can read more about this particular subject on the following page: Reading options tables is an important part of trading, because this is how you get the relevant information regarding various different contracts.

There are actually a number of different ways in which this information, which includes the stock option trading terms and definitions, can be displayed but it's usually in the form of a table. Such tables are referred to commonly as either options tables or options chains. For more information on this aspect of trading please read the following page: Time decay refers to how the extrinsic value of a contract will diminish as the expiration date gets closer.

The effect of time decay can significantly impact the returns you make when trading, so it's a concept that you really need to understand. You find out more about this subject on the following page: Options premium is a term that often gets misused, even by experienced investors. It has been so widely used to mean different things that it's now basically accepted that the term has more than one meaning.

It can be used to refer to the price paid for an options contract, or the extrinsic value component of that price, of the amount received by the writer of the contract. For further clarification on this subject, please refer stock option trading terms and definitions the following page: An options symbol is essentially stock option trading terms and definitions name of an option; it's the string of characters that's used to represent specific contracts, in the same way that characters are used to represent specific stocks on the stock market.

An options symbol is usually five characters long, with the first three defining the underlying security. The fourth character defines the expiration month of the contract and the fifth relates to the strike price.

The following terms and phrases are all covered in detail on this page: Section Contents Quick Links. Contract Size A common misconception among beginner options traders is that one contract is based on one unit or share of the underlying asset.

Moneyness In stock option trading terms and definitions terms, the moneyness of an options contract defines the relationship between the strike price of that contract and the current price of the underlying security. Leverage The use of leverage in options trading is one of the biggest advantages of this form of trading. Margin The use of margin in investment is something of a complicated subject, not because the word has a number of different meanings and can be used differently depending on what form of investment you are making.

Time Decay Time decay refers to how the extrinsic value of a contract will diminish as the expiration date gets closer. Options Premium Options premium is a term that often gets stock option trading terms and definitions, even by experienced investors. Options Symbols An options symbol is essentially the name of an option; it's the string of characters that's used to represent specific contracts, in the same way that characters are used to represent specific stocks on the stock market.

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But here we present the standard textbook definitions for a whole slew of options terminology without any jokes, interjections or unnecessary asides. An equity call or put option is at-the-money when its strike price is the same as the current underlying stock price.

An underlying stock price at which an option strategy will realize neither a profit nor a loss, generally at option expiration. An equity option that gives its buyer the right to buy shares of the underlying stock at the strike price per share at any time before it expires. The call seller or writer , on the other hand, has the obligation to sell shares at the strike price if called upon to do so.

A settlement style that is generally characteristic of index options. Instead of stock changing hands after a call or put is exercised physical settlement , cash changes hands. A transaction that eliminates or reduces an open option position. A closing sell transaction eliminates or reduces a long position. A closing buy transaction eliminates or reduces a short position.

The fee charged by a brokerage firm for its services in the execution of a stock or option order on a securities exchange. Any cash received in an account from the sale of an option or stock position.

With a complex strategy involving multiple parts legs , a net credit transaction is one in which the total cash amount received is greater than the total cash amount paid. Any cash paid out of an account for the purchase of an option or stock position. With a complex strategy involving multiple parts legs , a net debit transaction is one in which the total cash amount paid is greater than the total cash amount received. The exercise or assignment of an option contract before its expiration.

This is a feature of American-style options that may be exercised or assigned at any time before they expire. A contract that gives its buyer owner the right, but not the obligation, to either buy or sell 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. With a complex strategy involving multiple parts legs , an even money transaction results when the total cash amount received is the same as the total cash amount paid.

A security that represents shares of ownership in a fund or investment trust that holds a basket collection of specific component stocks. ETF shares are listed and traded on securities exchanges just like stock, and so may be bought and sold throughout the trading day.

If you buy stock before the ex-dividend date, you will be eligible to receive the upcoming dividend payment. If you buy stock on the ex-date or afterwards, you will not receive the dividend. To employ the rights an equity option contract conveys to its buyer to either buy in the case of a call or sell in the case of a put shares of the underlying security at the strike price per share at any time before the contract expires.

A term of any equity option contract, it is the price per share at which shares of stock will change hands after an option is exercised or assigned. The day on which an option contract literally expires and ceases to exist. For equity options, this is the Saturday following the third Friday of the expiration month.

The last day on which expiring equity options trade and may be exercised is the business day prior to the expiration date, or generally the third Friday of the month.

If the option is out-of-the-money, the extrinsic value is equal to the entire premium. 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. Implied volatility for any option can only be determined via an option pricing model. An equity call contract is in-the-money when its strike price is less than the current underlying stock price. An equity put contract is in-the-money when its strike price is greater than the current underlying stock price.

Equity LEAPS calls and puts can have expirations up to three years into the future and expire in January of their expiration years. Instead of entering one order to establish all parts of a complex position simultaneously, one part is executed with the hope of establishing the other part s later at a better price.

With respect to stock prices over a period of time, a lognormal distribution of daily price changes represents not the actual dollar amount of each change, but instead the logarithms of each change. So in a sense a lognormal distribution could be considered to have a bullish bias. A position resulting from the opening purchase of a call or put contract and held owned in a brokerage account.

Shares of stock that are purchased and held in a brokerage account and which represent an equity interest in the company that issued the shares. For a data set, the mean is the sum of the observations divided by the number of observations.

The mean is often quoted along with the standard deviation: One of the most familiar mathematical distributions, it is a set of random observed numbers or closing stock prices whose distribution is symmetrical around the mean or average number. Since this a symmetrical distribution, when the numbers represent daily stock price changes, for every possible change to the upside there must be an equal price change to the downside.

The result is that a normal distribution would theoretically allow negative stock prices. Stock prices are unlimited to the upside, but in the real world a stock can only decline to zero. A transaction that creates or increases an open option position.

An opening buy transaction creates or increases a long position; an opening sell transaction creates or increases a short position also known as writing. Generated by an option pricing model are the option Greeks: An equity call option is out-of-the-money when its strike price is greater than the current underlying stock price. An equity put option is out-of-the-money when its strike price is less than the current underlying stock price. The settlement style of all equity options in which shares of underlying stock change hands when an option is exercised.

The price paid or received for an option in the marketplace. Equity 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 underlying shares. Option premium consists of intrinsic value if any plus time value. A representation in graph format of the possible profit and loss outcomes of an equity option strategy over a range of underlying stock prices at a given point in the future, most commonly at option expiration.

An equity option that gives its buyer the right to sell shares of the underlying stock at the strike price per share at any time before it expires. The put seller or writer , on the other hand, has the obligation to buy shares at the strike price if called upon to do so. Rolling a long position involves selling those options and buying others. Rolling a short position involves buying the existing position and selling writing other options to create a new short position. A position resulting from making the opening sale or writing of a call or put contract, which is then maintained in a brokerage account.

If the shares can be purchased at a price lower than their initial sale, a profit will result. If the shares are purchased at a higher price, a loss will be incurred. Unlimited losses are possible when taking a short stock position.

A complex option position established by the purchase of one option and the sale of another option with the same underlying security. A spread order is executed as a package, with both parts legs traded simultaneously, at a net debit, net credit, or for even money.

By definition, the premium of at- and out-of-the-money options consists only of time value. It is time value that is affected by time decay as well as changing volatility, interest rates and dividends. The fluctuation, up or down, in the price of a stock. To sell a call or put option contract that has not already been purchased owned. 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.

Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options.

Options investors may lose the entire amount of their investment in a relatively short period of time. Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies.

Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point.

The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.

System response and access times may vary due to market conditions, system performance, and other factors. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy.

The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.

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At-the-money An equity call or put option is at-the-money when its strike price is the same as the current underlying stock price. Back month For an option spread involving two expiration months, the month that is farther away in time.