Stock Options Basics And Definitions

Before you can begin with trading the stock and options strategies, it is necessary to learn about the basic option definitions, types, and price valuation.

This video will discuss these option trading basics, including the following:

  • What an option is
  • The components of an option contract
  • The 2 option types – call options and put options
  • The option price and its intrinsic value

What Is An Option

An option is a contract providing the right, but not the obligation, to buy or sell the option’s underlying. For equity options, the underlying is a stock or an ETF, and the option contract controls 100 shares.

The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.

Components Of The Option Contract

All option contracts include the following components:

  • Underlying:  The stock or ETF that the option contract is based on.
  • Type:  The two types of equity options are calls and puts.
  • Expiration:  The Saturday following the third Friday of the month. Therefore, the third Friday of the month is the last trading day for all expiring equity options.
  • Strike:  The price per share that the underlying may be bought or sold.  This is also referred to as the exercise price.
  • Price:  The amount that the option is bought or sold for.  This is also referred to as the option premium.

Call And Put Options

There are two types of options: Calls and Puts. You can buy or sell either type.  If you buy an option, you are the holder and long the option.  If you sell an option, you are the writer and short the option.

If you buy a call you have the right to buy the underlying at the strike price on or before expiration.  If you buy a put you have the right to sell the underlying at the strike price on or before expiration.

If you sell a call you have the obligation to sell the underlying at the strike price on or before expiration.  If you sell a put you have the obligation to buy the underlying at the strike price on or before expiration.

Calls And Puts Related Definitions

Here are some additional definitions that are related to the call and put options

  • Exercise:  When the owner of a call buys the underlying at the strike price, or the owner of a put sells the stock at the strike price.
  • Assignment:  When the seller of a call sells the underlying at the strike price, or the seller of a put buys the underlying at the strike price.
  • Expiration:  If at the time of expiration the underlying price is higher than the strike price, the option will be exercised and the seller will be assigned.
  • Closing Options:  Options do not have to be held until expiration, the buyer can sell and the seller can buy the option to close the trade at any time before the option expires.

Call And Put Option Price Value

The following terms related to the options price valuation and are especially important for option strike selection when trading.

The value of a call or put option is made up of intrinsic value and time value – these values are a function of whether the option is at the money, in the money, or out of the money.

  • Intrinsic Value:  The amount that the stock price is above the strike price for calls, or below the strike price for puts.  All options expire at intrinsic value.
  • Time Value:  The amount that the option price is greater than the intrinsic value.
  • ATM:  An at the money option is the strike price closest to the stock price
  • ITM:  An in the money call option strike price is less than the stock price, and an in the money put option strike price is less than the stock price.
  • OTM:  An out of the money call option strike price is greater than the stock price, and an out of the money put option strike price is less than the stock price.

 Underlying XYZ is $25 and the following call options are available (1) 22.5 call = 3.00 (2) 25 call = 1.25 (3) 27.5 call = .75:

  • The 22.5 call is in the money because it is lower than the stock price
    • The option price is 2.50 intrinsic value = $25 underlying – 22.5 strike price
    • The option is .50 time value = 3.00 price – 2.50 intrinsic value
    • The 25 call is at the money because it is the nearest to the underlying price
      • The option price is all time value
      • NOTE:  if xyz was 25.50 – the 25 strike would be considered the at the money strike – but it would also be in the money by .50 and be made up of .50 intrinsic value and 2.50 time value
      • The 27.5 call is out of the money because it is higher than the stock price
        • The option price is all time value

Underlying XYZ is $25 and the following put options are available (1) 22.5 put = .75 (2) 25 put = 1.25 (3) 27.5 put = 3.00:

  • The 27.5 put is in the money because it is higher than the stock price
    • The option price is 2.50 intrinsic value = 27.5 strike price – $25 underlying
    • The option is .50 time value = 3.00 price – 2.50 intrinsic value
    • The 25 put is at the money because it is the nearest to the underlying price
      • The option price is all time value
      • NOTE:  if xyz was 24.50 – the 25 strike would be considered the at the money strike – but it would also be in the money by .50 and be made up of .50 intrinsic value and 2.50 time value
      • The 22.5 put is out of the money because it is lower than the stock price
        • The option price is all time value

Call And Put Option Component Format And Symbol

Call Option

  • FB October 50 Call 2.00
  • Underlying = Facebook
  • Expiration = October – since FB has weekly options you need to know the exact expiration date –vs- the 3rd Friday in the month
  • Strike = 50
  • Type = Call
  • Price = 2.00
  • Symbol = FB131019C50
    • 13 = 2013
    • 1019 = October 19 expiration
    • C = call
    • 50 = strike

Put Option

The put options use the same format and symbol structure as the calls

  • FB October 50 Put 2.00
  • Underlying = Facebook
  • Expiration = October – since FB has weekly options you need to know the exact expiration date –vs- the 3rd Friday in the month
  • Strike = 50
  • Type = Put
  • Price = 2.00
  • Symbol = FB131019P50
    • 13 = 2013
    • 1019 = October 19 expiration
    • P = put
    • 50 = strike

In our next options trading basics video, we will discuss different call and put option trades that can be made, along with the related math and risk reward.