Options terms explained: the definitions to know before you trade

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Options contract

An option is a financial instrument that gives you the right, but not the obligation, to buy or sell an underlying market (eg the S&P 500 index) at a certain price on a certain date.

Call option

A call option gives you the right to buy the underlying market at a certain price (the strike price) on a certain date (the expiry date).

Put option

A put option gives you the right to sell the underlying market at a certain price (the strike price) on a certain date (the expiry date).

Strike price

The strike price (also called exercise price) is the set price in an options contract at which the underlying market can be bought (when it’s a call option) or sold (when it’s a put option).

Expiry date

The end of life of an option.

Premium

The price that you’ll pay to buy an option, or the money you’d receive to sell an option.

In-the-money (ITM) option

A call is ITM when the underlying market price is above the call’s strike price. A put is ITM when the underlying market price is below the put’s strike price.

At-the-money (ATM) option

An option is ATM when the underlying market price is at (or very close to) the option’s strike price.

Out-of-the-money (OTM) option

A call is OTM when the underlying market price is below the call’s strike price. A put is OTM when the underlying market price is above the put’s strike price.

The Greeks

The Greeks is a term used in the options markets to describe the different risk parameters involved in taking an options position. There are 5 main Greeks: Delta, Gamma, Vega, Theta and Rho.

Delta

Delta represents the sensitivity of an option's price to a change in the underlying market price.

Gamma

Gamma represents the sensitivity of an option's delta to a change in the underlying market price.

Vega

Vega represents the sensitivity of an option's price to a change in implied volatility.

Theta

Theta represents the sensitivity of an option's price to a change in time until the option’s expiry.

Rho

Rho represents the sensitivity of an option's price to a change in interest rates.

Intrinsic value

Intrinsic value is the amount by which an option is in the money. For a call the intrinsic value is the underlying market price minus the call’s strike price. For a put the intrinsic value is the put’s strike price minus the underlying market price.

Extrinsic value

Extrinsic value is the difference between an option’s premium and its intrinsic value. The premium of an out-of-the-money option will be all extrinsic value (ie the intrinsic value of an OTM option is zero).

Implied volatility

Implied volatility is the market’s view on likely movement in the price of an option, as calculated using the Black Scholes or similar option pricing model.

Historic volatility

Historical volatility (or simply ‘actual’ volatility) is the measure of the distribution of returns for a given underlying market using historical data.


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