As you learn about trading options, you'll find that options traders use terms that are unique to options markets. Understanding what terms like strike price, exercise price, and expiration date mean is crucial for trading options effectively. You'll see these terms appear often and understanding them can have a significant effect on your chances for profitability on an options trade.
- Options traders use terms that are unique to options markets, and understanding the terms is crucial for trading options effectively.
- Options are securities that trade on an exchange; they fall into a category called "derivative securities."
- Important options terms include "call" and "put" options, "strike price," "exercise price," "expiration date," and "naked options."
Before getting into options terminology, it's helpful to get some background on options themselves. Just like stocks and bonds, options are securities that trade on an exchange. They fall into a category called "derivative securities," because they're derived from, or linked to, another security, and their prices are dependent on the price changes of that security.
Calls and Put Options
You can buy or sell two different types of options. Put options are a type of security that gives you the right, but not the obligation, to "put" the underlying stock to someone at a pre-set price. Call options work in the reverse: They give you the right, but not the obligation, to "call" in a security at a pre-set price.
Options are often used to hedge or limit your risk on investments. For example, suppose you want to purchase a certain stock, but only if you think the price is going to jump up. You would buy a call option to lock in the price of the stock to make sure you can buy it for your portfolio before the price jumps.
You would buy a put option if you owned the stock but wanted to make sure you could sell it if the price drops below a certain level so you don't lose money. Options are often referred to as insurance policies, because they give you a certain level of protection against price fluctuations when used strategically in your investing portfolio. In addition to buying them, traders sell put and call options to enact other investing strategies.
Option Strike Price
A strike price is set for each option by the seller of the option, who is also called the "writer." When you buy a call option, the strike price is the price at which you can buy the underlying stock if you want to use the option. For example, if you buy a call option with a strike price of $10, you have a right, but no obligation, to buy that stock at $10.
It is worthwhile to do so if the underlying stock is trading above $10. In that case, you can also sell the call for a profit. The profit is approximately the difference between the underlying stock price and the strike price. Alternatively, you can use, or "exercise," your option and buy the stock at $10, even if it is trading at $15 on the stock exchange.
When you buy a put option, the strike price is the price at which you can sell the underlying asset. For example, if you buy a put option that has a strike price of $10, you have the right to sell that stock at $10. It is worthwhile to do so if the underlying stock is actually trading below $10.
In that case, you may also sell the put for a profit. The profit is approximately the difference between the strike price and the underlying stock price. Just like the call option, you may also exercise your option and sell or short the stock at $10, even if it is trading at $5 on the stock exchange.
The Exercise Price
An option buyer pays a price called a "premium," which is the cost of the option, for their right to buy or sell the underlying asset at the option's strike price. If a buyer chooses to use that right, then they are "exercising" the option. In other words, the option's strike price is synonymous with its exercise price.
Exercising an option is beneficial if the underlying asset price is above the strike price of the call option on it, or the underlying asset price is below the strike price of a put option.
Traders don't need to exercise an option, because it is not an obligation. You only exercise an option if you want to buy or sell the actual underlying asset. Most options are not exercised, even the profitable ones.
For example, a trader buys a call option for a premium of $1 on a stock, with a strike price of $10. Near the expiration date of the option, the underlying stock is trading at $16. Instead of exercising the option and taking control of the stock at $10, the options trader will typically just sell the option, closing out the trade. In doing so, they net approximately $5 per share they control.
Since one option controls 100 shares of stock, this trades nets $500. The math is as follows: A $16 share price less the strike price of $10 means the option is worth approximately $6. The trader paid $1 for the option, so the profit is $5. The option is worth approximately $6, because there are other factors that affect the worth of an option aside from the price of the underlying stock. These other factors are called "greeks."
The strike price (or exercise price) is the price at which you take control of the underlying stock should you choose to exercise the option. Regardless of what price the underlying security is trading at, the strike price (or exercise price) is known when you buy the option contract, is fixed, and doesn't change for that specific option.
The Option's Expiration Date
Options contracts specify the expiration date as part of the contract specifications. For European-style options, the expiration date is the only date that an in-the-money (in profit) options contract can be exercised. That is because European-style options can't be exercised, nor can the position be closed, before the expiration date.
For U.S.-style options, the expiration date is the last date that an in-the-money options contract can be exercised. That is because U.S.-style options can be exercised, or bought or sold, on any day up to the expiration date. Options contracts that are out of the money (not in profit) on the expiration date are not exercised and expire worthless.
For example, if you buy a call option with a strike price of $10, and the underlying stock currently trades at $9 on the stock exchange, there is no reason to exercise that option; it is worthless on the expiration date. Any premium paid for that option is forfeited.
Options traders who have bought options contracts want their options to be in the money. Traders who have sold or written wrote options contracts want the buyer's options to be out of the money and expire worthless on the expiration date. When a buyer's option expires worthless, that means the seller gets to keep the premium as a profit for writing or selling the option.
Which Options Make the Best Buys?
There isn't any specific methodology that can point to the best options to buy or sell for each investor. Everyone has his or her own objectives for maximizing profit, hedging risk, and choosing which securities make sense for investing purposes.
However, if you're searching for ideas on where to start looking, consider trading options on the most popular stocks. They will have a lot of volume—trading activity—and a lot of options-trading activity. For example, Bank of America Corp (BAC), Facebook (FB), and Micron Technology (MU) are three active stocks with over 100,000 options being traded on them every day.
You can also choose stocks with expensive options, such as Amazon (AMZN) and Google (GOOGL), especially if you decide to sell them. This can net you a nice income if the buyer doesn't execute the options, or at least get you the stock at a decent price if the buyer does execute the options, depending upon your strategy.
You could also buy options that are popular, with a lot of liquidity or trading activity, but only for stocks priced under $20. This works well if you choose to sell naked options, because it won't require you to have a large amount of margin available to buy the stock if the options are exercised.
To sell an option naked means to write or sell the option without having a position in the underlying security. To take profit, you would buy the option at a more favorable price, close out the trade, and make money on the price differential. This riskier strategy has, theoretically, unlimited downside and is best used by seasoned traders.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves, risk including the possible loss of principal.