Thursday, October 23rd, 2014

Options Trading Vocabulary

 

To get a head start when you want to learn how to trade stock options you need to learn an options trading vocabulary. What are puts and calls? What is the difference between American style stock options and European style options? An options trading vocabulary contains such terms as in the money and out of the money, counterparty risk and risk management in option trading and long straddle versus short straddle. Here are a few definitions to help you grow your options trading vocabulary.

Puts and Calls in Options Trading

The basis of stock options trading is that one party pays a premium for the right to buy or sell a stock at a set price on or before a given date in the future no matter how high or low the market price of that stock might go. A call contract confers the right to buy stock at a set price called the strike price. How do puts and calls work? A put contract confers on the buyer the right to sell at the strike price. Contracts are written in 100 share lots. The seller receives the premium and incurs all risks involved. The buyer pays the premium but limits his risk while potentially leveraging his invested capital into a sizable profit. The buyer of a put or call contract can exercise the contract at any point in time up until expiration when trading American style stock options. With European style stock options the buyer can only exercise the option at expiration. However, the options contract has a constant value and when the buyer is correct in his judgment the value of his contract goes up and he can sell the contract and pocket his profit without ever touching the stock.

We’re in the Money

For the next stop on our options trading vocabulary tour, consider the old chorus line song, We’re in the Money, from the 1930’s. In the money applies to a put or call option contract that has value if sold. As opposed to in the money, out of the money refers to a contract with no value. How does this happen? Let us say that you purchase a call contract on ABC Corporation. It has a current market value of $98. The call contract is for $100. You pay a dollar a share or $100 for a contract for 100 shares. Your expectation is that the stock will go up in value so you are willing to pay a dollar a share and wait. The seller is obviously of the belief that the stock will not rise in price and is happy to receive the premium of $100 for taking on the risk of this transaction. As of the moment that you purchase the call option the contract is out of the money. Then the company announces a joint venture with XYZ Corporation and the market is happy. The stock price gaps up to $105 a share upon opening the next morning. You are now in the money. You could immediately sell your contract and make $5 per share minus the $1 per share you paid for the contract or you could wait to see if the stock goes up farther.

Strategies and Straddles

One can simply buy or sell a put or call on a stock or one can engage in more complicated options trading strategies. Include in your options trading vocabulary a basic strategy called the long straddle. In this case an options trader is confronted with a very volatile market. He believes that the stock of interest will either go up or down dramatically. However, things are so chaotic that he is not at sure which way the market will go. In this case he purchases both a put and a call on the same stock with the same strike price and same expiration date. He profits if the stock either goes up or goes down appreciably. If the stock price does not change his risk is limited to the price of two options contracts.

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