Option Trading Important Terminologies

In the world of options trading there are actually hundreds of terminologies that are used. As beginners we need first to understand the most important and commonly used financial language. Here they are:

Writer
This is commonly referred to as the “seller”, the one who sells of the underlying asset or the option.

Taker
It is most commonly addressed as “buyer”, the one who buys or acquires the rights to convey the option.

Option
This refers to 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
Refers to the right of the owner to buy the underlying asset.

Put Option
Refers to the right of the owner to sell the underlying asset.

Exercise
Refers to 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
This is the date where the contract ends. After the expiration and the owner do not exercise his or her rights, the contract is terminated.

In-the-money
This 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
This 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
This 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.

Strike Price
This 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 instance, 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
This 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).

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