Options Terminology For Beginners: 13 Terms You Must Know

Options can be both thrilling and complex for beginners. With the potential for significant gains and the flexibility to manage risk, options offer an intriguing gateway into financial markets.

When starting out, it’s imperative to understand the key options terminology. While there’s traditionally been an aura of mystery and complexity around options trading, the reality is that once you become familiar with the basic terminology, it quickly becomes much more digestible.

In this article, we will demystify the most important options terminology for beginner traders, allowing them to confidently embark on their options trading journey.

Options Terminology for Beginners

1. Call and Put Options

Call option:

A call option is a contract that gives the holder the right, but not the obligation, to buy an underlying asset at a specified price within a specific time period. Buying a call option is bullish as the buyer is generally predicting the underlying asset price to increase. Selling a call option is bearish to neutral as the seller doesn’t generally expect the price to increase above the strike price.

Put option:

A put option is a contract that gives the holder the right, but not the obligation, to sell an underlying asset at a specified price within a specific time period. Buying a put option is bearish as the buyer is generally predicting the underlying asset price to decrease. Selling a put option is bullish to neutral as the seller doesn’t generally expect the price to decrease below the strike price.

2. Strike price

The strike price is the price at which the underlying asset can be bought (in the case of a call option) or sold (in the case of a put option) upon exercising the option. Strike price selection plays a critical role in determining the profitability of an option trade or strategy.

3. Expiration date

The expiration date is the date on which the option contract expires and ceases to be valid. If a trader wants to exercise their option, they must do so before, or on this date (dependent upon the type of option).

4. Premium

The premium is the price paid by the option buyer to the option seller for the right to buy or sell the underlying asset. It represents the cost of obtaining the right to potentially buy or sell the underlying asset. Premiums are influenced by the option’s intrinsic value, volatility, and time until expiration.

5. Intrinsic value and time value

Intrinsic value:

The intrinsic value of an option is the difference between the current market price of the underlying asset and the option’s strike price. In-the-money (ITM) options have intrinsic value.

Time value:

Time value reflects the potential for the option to gain intrinsic value before expiry. Market volatility, time until expiration, and interest rates are the input factors of an option’s time value. Out-of-the-money (OTM) options consist of time value.

6. In-the-money (ITM), at-the-money(ATM), and out-of-the-money(OTM)

In-the-money:

A call option is ITM when the underlying asset’s market price is above the option’s strike price. For put options, it’s when the market price is below the strike price.

At-the-money:

ATM options have a strike price approximately equal to the current market price of the underlying asset. An ATM option has basically a 50/50 chance of expiring ITM.

Out-of-the-money:

OTM options have no intrinsic value, meaning that the strike price is not favourable to the current market price of the underlying asset (for the option buyer). Generally speaking, options sellers want an options price to go or to remain OTM.

7. Option chain

An option chain is a listing of all available options for a specific underlying asset, displaying various strike prices and expiration dates.

8. Open interest

Open interest refers to the total number of outstanding option contracts for a particular strike price and expiration dates. It is an indicator of the level of market activity and can help traders gauge potential liquidity and interest in a specific option.

9. Bid and ask prices

Bid price:

The bid price represents the maximum price a buyer is willing to pay for an option contract.

Ask price:

The ask price is the minimum price a seller is willing to accept for an option contract. The difference between the bid and ask prices is known as the bid-ask spread, which represents the cost of immediate and guaranteed execution of a trade.

10. Implied volatility

Implied volatility is a measure of the market’s expectations for future price fluctuations of the underlying asset. It’s a primary factor in determining an option’s premium. Higher implied volatility normally leads to higher option premiums, as increased uncertainty makes the option more valuable.

11. Time decay

Time decay is the reduction in the value of an option as it approaches expiration. Time decay works for option sellers and against option buyers.

12. American & European style options

While there are many different option styles, the two most common and relevant to retail traders and American and European style options. There are a few key differences between these two option styles, the key differences between them are:

European style options:

These options can be exercised only at the expiration date of the option (at a single pre-defined point in time). Because of this, a slightly different pricing model is used for each, but for the average retail trader, this is of little consequence or interest. Major broad-based indices, such as the S&P 500, and foreign currency, along with most cryptocurrency options are European-style options.

American style options:

These options can be exercised at any time prior to expiration. All optionable stocks and exchange-traded funds (ETFs) have American-style options.

13. Cash-settled options:

A cash-settled option is a type of option where physical delivery of the underlying asset is not required and the settlement results in a cash payment. Almost all European-style options are cash-settled.

Options Terminology Conclusion

Having an understanding of these options terminology definitions will help you better understand the mechanics of options trading and ultimately make more informed trading decisions.