Although there are hundreds of terms that are used in
the financial language, beginners have to understand
first the most important and commonly used words.
Option – is the right of the buyer to either buy or sell
the underlying asset at a fixed price and a fixed date.
At the end of the contract, the owner can exercise to
either buy or sell the option at the strike price. The
owner has the right to pursue the contract but he or she
is not obligated to do so.
Call option – gives the owner the right to buy the
underlying asset.
Put Option – gives the owner the right to sell the
underlying asset.
Exercise – is the action where the owner can choose to
buy (if call option) or sell (if put option) the
underlying asset or, to ignore the contract. If the
owner chooses to pursue the contract, he must send an
exercise notice to the seller.
Expiration – is the date where the contract ends. After
the expiration and the owner does not exercise his or
her rights, the contract is terminated.
In-the-money – is an option with an intrinsic value. The
call option is in-the-money if the underlying asset is
higher than the strike price. The put option is
in-the-money if the underlying asset is lower than the
strike price.
Out-of-the-money – is an option with no intrinsic value.
The call option is out-of-the-money if the trading price
is lower than the strike price. The put option is
out-of-the-money if the trading price is higher than the
strike price.
Offsetting – is an act by which the owner of the option
exercises his right to buy or sell the underlying asset
before the end of the contract. This is done if the
owner feels that the profitability of the stock has
reached its peak within the date of the contract.
(Option seller) Writer – is the seller of the underlying
asset or the option.
Option buyer – is the person who acquires the rights to
convey the option.
Strike Price – is the price at which the underlying
stock must be sold or purchased if the contract is
exercised. The strike price is clearly stated in the
contract. For the buyer of the option to make a profit,
the strike price must be lower than the current trading
price of the stock. For example, if the contract states
that the strike price of a certain stock is $20 and the
current trading price at the end of the contract is $25,
the buyer can exercise his or her rights to pursue the
contract, thus earning $5 per stock.
Option Premium – is the amount of the contract which
must be paid by the buyer to the writer (the seller).
The amount of the option premium is determined by
several factors such as the type of the option (call or
put), the strike price of the current option, the
volatility of the stock, the time remaining until
expiration and the price of the underlying asset to
date. Taking into account these factors, the total
amount of the option premium is number of option
contracts, multiplied by contract multiplier. So if you
are buying 1 option contract (equivalent to 100 share
lots) at $2.5 per share, you must pay a total amount of
$250 as the option premium (1 option contract x 100
shares x $2.5 per share = $250).