Key Options Terms

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The best option trades definition to begin our introduction to options trading is to define exactly what options are. Although commonly referred to simply as options, the full term is options contracts, because they are financial contracts between two parties. In very basic terms, they specify a future transaction on a specified asset at a specified price.

The buyer of the contract has the right, but not the obligation, to initiate that specified transaction. The seller of the contract has the related obligation to carry out the transaction should the holder choose to initiate it.

There are several characteristics of options that essentially make up the terms for any given contract. The option trades definition way to define an options contract is to identify those characteristics and explain what they are. We have done exactly that below, and we have also provided some example options to give a clear idea of what they are and how they work. An options contract consists of two parties: The writer is effectively the seller of the contract, while the holder is effectively the buyer.

When the writer of the contract sells it to the buyer, they collect a payment from the buyer and that's commonly referred to as the premium. It's the holder of the contract that has the option to engage in the transaction that is specified and the writer that is obliged to engage in the transaction should the holder wish to go ahead.

If the holder chooses to initiate the transaction specified in the contract, they are said to be exercising their option. Should the holder not choose to exercise their option at any point, option trades definition the contract will eventually expire and cease to exist.

You can read more about exercising an option here. Options are a form of derivative; which basically means they derive their value from an underlying asset.

In an options contract the underlying asset is the asset which is specified in the transaction the holder has the right to carry out. For option trades definition, a contract might give the holder the right to purchase stock in Company X, in which case Company X stock is the option trades definition asset.

The term underlying security is also commonly used, but both terms refer to the same thing. There's a range option trades definition financial instruments that can be the underlying asset in an option. Stock is the most commonly used asset, but bonds, indices, foreign currencies, commodities, or futures can all be used too. There are even basket options, in which the underlying asset is a collection of option trades definition assets.

The strike price is the price at which the specified transaction is to be carried out at should option trades definition holder choose to exercise their option. Strike price is the term most commonly used, but it can also be known as the exercise price.

The expiration date of an option is, quite simply, the date on which the contract will expire. Options are typically relatively short term and last just a few weeks, although they can also last for a few months or up to a year. If the expiration date passes and the holder hasn't chosen to exercise their option, then the contract expires worthless.

There are actually many different types of options, because they can be classified in a variety of different ways. In a very broad sense though, they can be categorized based on whether they give the holder the right to buy or sell the underlying asset.

In this sense, there are basically two main types; call options which give the holder the right to buy the underlying asset at the strike price, and put options which give the holder the right to sell the underlying asset at the strike price. It should be noted that you don't have to actually own any of the underlying asset to buy a put option, but if you choose to exercise your option to sell the underlying asset you will, in theory, have to buy the underlying asset at that point.

Please see our section on the Types of Options for further details on this. Another way that options can be categorized is based on their exercise style. They can basically be one of two styles: American style or European style. Option trades definition terms have nothing to option trades definition with anything geographical though. An American style option is one where the holder can exercise their option at any time during the term of the contract, up to and including the date of expiration.

A European style option is one where the holder can only exercise their option, should they wish to, at the point of expiration. American style options clearly offer much more flexibility to the holder, and because of this they are generally more expensive to buy.

When the holder exercises their option, the contract is effectively being settled, and there are two ways in which settlement can take place. They are physical settlement and cash settlement.

Physical settlement is where the underlying asset is actually transferred between the buyer and the holder at the agreed strike price. Cash settlement is where the holder option trades definition a cash payment based on any profit they could effectively make through exercising option trades definition option.

Please see Options Settlement for more details. When the writer option trades definition an options contract sells it to a buyer, the buyer makes a payment in order to purchase it. However, the amount that the buyer pays isn't the same amount that the writer receives.

Options are typically option trades definition and sold on the public exchanges, where the transactions are facilitated by market makers. They basically exist to ensure that there's always a market for options contracts. If someone wishes to sell, and there is no buyer, then the market maker will act as the buyer and complete the necessary transaction. If someone wishes to buy, but there is no seller, then the market maker will act as the seller.

Market makers make a small profit on each transaction. Options contracts are listed on the exchanges with two prices: The bid price is the price you would receive for writing options contracts, and the ask price is the price you would pay for buying them.

It's important to note that options contracts aren't just sold to buyers at the time of being written; holders of existing options contracts can also sell them to other buyers. Again, the seller would receive the bid price and the buyer would pay the ask price. You can read more about the price of options here. To help you fully understand what an options contract is we have provided a couple of examples below, option trades definition some different characteristics.

The holder could exercise their option at any time because it's an American style options contract. If you didn't own the relevant stock, you would have to first buy it and then sell it on to the holder. If the holder chose not to exercise their option by the expiration date, option trades definition it would expire worthless and your obligation would cease. Alternatively, you could hold on to the stock if you preferred.

If you chose not to exercise your option by the expiration date, your contract would expire worthless. The holder could only exercise their option at that point as it is a European style option. Option trades definition settlement options are typically settled automatically if the holder is effectively in profit.

As a cash settlement option, you could expect it to be automatically exercised if you were in profit. Definition of an Options Contract The best way to begin our introduction to options trading is to define exactly what options are. Section Option trades definition Quick Links. Parties Involved An options contract consists of two parties: Underlying Asset Options are a form of derivative; which basically means they option trades definition their value from option trades definition underlying asset.

Strike Price The strike price is the price at which the specified transaction is to be carried out at should the holder choose to exercise their option. Expiration Date The expiration date of an option is, quite simply, the date on option trades definition the contract will expire.

Option Type There are actually many different types of options, because they can be classified in a variety of different ways. Option Style Another way that options can be categorized is based on their exercise style. Option Settlement When the holder exercises their option, the contract is effectively being settled, and there are two ways in which settlement can take place.

Bid and Ask Price When the writer of an options contract sells it to a buyer, the buyer makes a payment in order to option trades definition it. Examples of Options Contracts To help you fully understand what an options contract is we have provided a couple of examples option trades definition, featuring some different characteristics.

Example 1 Underlying Asset: Stock in Company X Strike Price: Call Option Option Option trades definition Physical Settlement Bid Price: Example 2 Underlying Asset: Stock in Company Option trades definition Strike Price: Put Option Option Style: Cash Settlement Bid Price: Read Review Visit Broker.

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Just keep forging ahead, and everything will become more apparent over time. Long — This term can be pretty confusing. After you have purchased an option or a stock, you are considered "long" that security in your account.

Short — Short is another one of those words you have to be careful about. But when you do, you may be obligated to do something at a later date. Read on to get a clearer picture of what that something might be for specific strategies. Strike Price — The pre-agreed price per share at which stock may be bought or sold under the terms of an option contract. For put options, it means the stock price is below the strike price.

This term might also remind you of a great song from the s that you can tap dance to whenever your option strategies go according to plan. For put options, this means the stock price is above the strike price. Intrinsic Value — The amount an option is in-the-money. Obviously, only in-the-money options have intrinsic value. Time Value — The part of an option price that is based on its time to expiration.

If an option has no intrinsic value i. Exercise — This occurs when the owner of an option invokes the right embedded in the option contract. Interestingly, options are a lot like most people, in that exercise is a fairly infrequent event. See Cashing Out Your Options. That means he or she is required to buy or sell the underlying stock at the strike price. Equity Options — There are quite a few differences between options based on an index versus those based on equities, or stocks.

Second, the last day to trade most index options is the Thursday before the third Friday of the expiration month. It might actually be the second Thursday if the month started on a Friday. But the last day to trade equity options is the third Friday of the expiration month. There are several exceptions to these general guidelines about index options.

See What is an Index Option? Stop-Loss Order - An order to sell a stock or option when it reaches a certain price the stop price. Past this price, you no longer want the cheese; you just want out of the trap.

When your position trades at or through your stop price, your stop order will get activated as a market order, seeking the best available market price at that time the order is triggered to close out your position. In those situations, stocks are likely to gap — that is, the next trade price after the trading halt might be significantly different from the prices before the halt.

Standard Deviation — This site is about options, not statistics. If we assume stocks have a simple normal price distribution, we can calculate what a one-standard-deviation move for the stock will be. This comes in handy when figuring out the potential range of movement for a particular stock. Most pricing models assume a log normal distribution. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options.

Options investors may lose the entire amount of their investment in a relatively short period of time. Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point.

The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors.

Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results.

All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.

The Options Playbook Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between. Third, index options are cash-settled, but equity options result in stock changing hands. Back to the top. Meet the Greeks What is an Index Option?