If you're new to trading options, it's important to understand the basic terms related to buying and selling options before you blindly start investing your hard-earned money. Once you have researched and decided which online stock trading service you would like to use for option trading, it's a good idea to educate yourself. You can start here with these easy-to-understand option trading definitions, and then start digging into the resource material offered by your online broker.
What is an option?
An option is a contract to buy/sell a financial product known as the option s underlying interest or underlying instrument. The underlying instrument in an equity option is a stock, exchange-traded fund (ETF) or similar financial product.
Basic Option Terms:
Strike Price: The strike price, often called the exercise price, is the set price at which the owner of an option can buy (call) or sell (put) the underlying security or commodity. Basically, it's the price at which a stock will be bought or sold when the option is exercised.
Call: An option contract that allows the owner of the option to buy the underlying security at the strike price.
Put: An option contract that gives the owner the option of selling the underlying security at the strike price.
Exercise: To invoke the rights granted to the owner of an options contract, specifically, the ability to buy or sell the underlying stock.
Expiration Date: The date upon which an option, and the right to exercise it, expires.
Write: Or sell to open, is to sell an option that is not owned through an opening sale transaction. The investor who sells this type of option is called the writer.
Premium: The total price of the option, basic value plus time value.
Time Value: This is determined by subtracting the intrinsic value (or ITM) from the option price.
In-the-money (ITM): An option with intrinsic value.
Out-of-the-money (OTM): An option that does not have inherent value, its value is only time value.
At-the Money (ATM): This is when the stock price matches the strike price.
Volatility: The amount a stock price fluctuates in either direction.
Historical volatility: Basically, the stock price fluctuation trend during a one-year period.
Implied volatility: This is determined by looking at the historical volatility to determine possible future volatility.
Long: This term can be confusing; it means that if you own an option, you are considered long on that option in your account.
Short: The term means you have sold an option or stock that you never actually owned.
Naked Short: Same as short, but in addition to never actually owning the stock, you also do not have the money reserves in your account to cover its purchase.
Assignment: When an owner exercises the option, an option writer is assigned and must buy or sell the underlying stock at the strike price.
Index Option: Usually an index option cannot be exercised prior to expiration.
Equity Option: These types of options can often be exercised prior to the expiration date.
Stop-Loss Order: An order to sell an option when it reaches a specific price.
If you understand these basic terms, you are one step closer toward becoming a savvy investor. If you have an online broker, take advantage of their educational resources. If you have not yet chosen an online stock trading service you may want to look into optionsXpress, TradeKing, OptionsHouse, Scottrade or Fidelity, which have all placed high on our Online Stock Trading Review.
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