Options 101: Terminology

For the many new traders in our camp, here is a brief primer on stock options. You will readily understand why we trade these incredible, lucrative instruments.

Options are contracts that give the holder the right, but not the obligation, to trade the underlying stock for a certain price by a specific date. Most major stocks have options, as does the SPDR S&P 500 ETF Trust (NYSEARCA: SPY). We trade SPY exclusively, the stock that follows the top 500 stocks. Given its sector diversity, volume liquidity and price predictability, day trading SPY options satisfies the need for both trading excitement and profit.

Options contracts have expiration dates, making trading thrilling. These are not “buy-and-hold” instruments. The objective is to move them quickly. With our method of trading, we buy them first, then sell them, hopefully within a few minutes.

There are only two names to remember: call options, if you expect the underlying stock to rise, and put options, if you expect the stock to drop.

The Strike Price is the predetermined price at which a specific stock may be traded by the option holder.

In-the-Money on a call option has a strike price lower than the current market price of the stock. An option holder can exercise the option by converting it to stock valued below its current market value.

Out-of-the-money on a call option means the option value is higher than the current market price, not something you would exercise as you would be paying more for the asset than what it is worth.

At-the-Money is the option price near the current market price.

The value of the call option typically rises as the underlying stock rises. Conversely, the value of the put option rises as the price of the underlying equity drops. You read that correctly. If you expect the stock to drop, you buy a put option. The converse is true. As the price of the stock drops, so does the value of the call option, and when the value of the stock rises, the put option drops. As an options trader, you can also sell these contracts, but that is for a different conversation.

As with any stock, you buy options low and sell them high. How the price moves is determined by the Greeks, some of the components, as identified below, that determine option values.

The Delta indicates the relationship between the option verses the underlying stock. A delta of 52, for example, means that the option will move 52 cents for every dollar the stock moves, at that time and price level.

The Theta measures the loss in cents that the option evaporates that day simply due to time. If you buy an option for $3, with a theta value of .60, that means that, all things being equal, that option would be worth $2.40 the next day. The theta loss rises exponentially as it nears expiration; hence the reason you would want to move an option quickly.

Implied Volatility is a predominant factor showing where the market views irresoluteness heading into the future, measuring the magnitude of the change. Very low volatility creates low price movement as opposed to extremely high volatility which will return wild price swings. While you can make a lot of money on highly volatile days, the risk also rises.

As you can imagine, with a multitude of factors affecting the price of an option, it is important to understand how they function independently and how they corelate with each other, like a machine with many moving parts.

This is a mere overview of option components. The wise trader will endeavor to dive deeper into the structure and behavior of options, knowing that those who truly understand these instruments are destined to succeed over those who don’t. Reading a single book or viewing a video on options trading will never make you an expert; it requires much time and experience to master the nuances of the market in relation to the characteristics of options.

It is for that reason that we stress the importance of joining our Trading Room, your facility for ongoing education. Veteran trader Jon Johnson and I provide you with our many years’ market experience, an exposure to the market you could never afford individually.

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Create great trades!

Hugh