Basic technical terms used in options trading
Options trading allows investors to wager on the direction of an underlying asset, such as a stock, commodity, currency, or index. Options contracts give the buyer the right to buy or sell an underlying asset at a predetermined price on or before a specified date.
The most basic option to trade is the call option. Another option to trade is the put option, though there are also more complex options strategies that you can use to hedge risk or speculate on different aspects of the market.
You can trade options on exchanges and over-the-counter (OTC) markets. Exchanges have standardised contract terms and conditions, while OTC options contracts are customised to the buyer and seller’s needs.
Before trading options with real money, you need to understand the basics; here are some of the most common terms used.
Option premium
The options premium is the price of the option contract, comprising two components: the intrinsic value and the time value. The intrinsic value is the difference between the strike price and the underlying asset’s price. If the underlying asset is trading at HK$100 and the strike price is HK$95, then the intrinsic value is HK$5.
The time value is the amount by which the option premium exceeds the intrinsic value. It reflects the risk that the underlying asset will not reach the strike price by expiration. The longer the time to expiration, the higher the time value.
Strike price
The strike price is when an options contract can be exercised. For a call option, it is the price at which you can buy the underlying asset. For a put option, it is the price at which you can sell the underlying asset.
Expiration date
The expiration date is the date on which an options contract expires. At expiration, the option will be worth its intrinsic value (if any) or 0 if there is no intrinsic value. You can exercise American-style options at any time, including the expiration date, while you can only exercise European-style options on the expiration date.
Type of option
Traders can choose from two options: call options and put options. Call options give the holder the right to buy an asset at a specific price. Put options give the holder the right to sell an asset at a specific price.
Underlying asset
The underlying asset is the asset on which an options contract is based. For example, a stock options contract would be based on a particular stock.
Exercise
Exercise is the act of using an options contract to buy or sell the underlying asset. You buy the underlying asset at the strike price when you exercise a call option, and you sell the underlying asset at the strike price when you exercise a put option.
Assignment
The assignment is the process where the option holder is notified that their option has been exercised and they are obligated to buy or sell the underlying asset.
In-the-money (ITM)
An options contract is ITM if it has intrinsic value, and a call option is ITM if the underlying asset’s price is above the strike price. In contrast, a put option is ITM if the underlying asset’s price is below the strike price.
Out-of-the-money (OTM)
An options contract is OTM if it does not have intrinsic value, and a call option is OTM if the underlying asset’s price is below the strike price. In contrast, a put option is OTM if the underlying asset’s price is above the strike price.
At-the-money (ATM)
An options contract is at-the-money if the underlying asset’s price equals the strike price.
Volatility
Volatility measures how much the underlying asset’s price moves over time. Traders often use it as a measure of risk, and a higher volatility means more significant risk.
Gamma
Gamma measures how much the delta of an option changes in response to a change in the underlying asset’s price. Gamma is highest when an option is ATM and declines as the option moves further into or out of the money.
Theta
Theta measures how much the value of an option declines as time passes. Theta is highest when an option is ATM and declines as the option moves further into or out of the money.
Conclusion
Understanding basic technical terms is vital for each trader who intends to advance in their trading journey, as they are essential in chart analysis. Making informed decisions when trading will increase the potential for making profits.