Options Terms You Need to Know
You've decided to start talking to your clients about options - or maybe you're looking to reintroduce options strategies to your client base. Either way, that's great news. Those of us at The Options Industry Council spend a lot of time discussing this topic with advisory firms, conducting research and sharing resources about these versatile assets. We're always here to help with options education, just as our principles mandate, having been set forth in 1992 when we established our unbiased outreach program.
Over the years, we've learned a few things, and one of them is this: If you're going to have a conversation with your clients, it's imperative to be familiar with options vernacular and the industry lingo. It's not as if you need to grind over it to remember all the terminology from the Series 7, but we do want to mention a few main terms that we believe you will find useful. So, let's pour a cup of java and get focused, because we're going to cover a lot of ground.
Call option: One of the two main option types is a call option. If an investor is long a call option, they have the right, but not an obligation, to buy an underlying asset, such as a stock or ETF, at the strike price. If they're short a call, they have the obligation to sell the underlying at the strike if they get assigned. A single call generally controls 100 shares of the underlying. Buying a call is a way to take part in a price increase of a stock or ETF underlying an option, without the same required upfront capital investment of outright ownership. If the underlying rises, the call buyer may be able to sell the call at a profit before expiration. Options also provide more leverage, meaning a call buyer has the potential for higher percentage gains – but leverage also works the other way and can at times contribute to significant losses.
Put option: The other main type of option. If an investor is long a put option, they have the right, but not the obligation, to sell an underlying asset at the strike price. If they're short a put, they have the obligation to buy it if they get assigned. One put typically controls 100 shares of the underlying. Being long a put means your client can require that the put seller buy the underlying at the strike price.
Exercise: When your client owns an option, they can decide to exercise. With a call, the option owner would buy the underlying stock or ETF. If the client owns a put, the option owner would be exercising the right to sell the underlying stock or ETF. The exercise price is the price where the owner of a call can buy the stock or ETF underlying an option, or the price where the owner of a put can sell the stock or ETF underlying an option. The exercise price is also called the strike price.
Premium: The premium is simply the purchase price an option buyer pays to the seller of an option. The seller, in turn, receives the premium as income. It does not mean excess.
In-the-money, at-the-money and out-of-the-money: A call option is in-the-money when its underlying asset is trading above the exercise price. A put option is in-the-money when its underlying is below the exercise price. When a call's underlying is below the exercise price, it's out-of-the-money. When a put's underlying is above the exercise price, it's out-of-the-money. At-the-money means an option's underlying is trading at the exercise price.
Intrinsic value and time value: When intrinsic value and time value are added together, they equal the option's premium – the premium is the price of an option. If the asset underlying a call option is above the strike price, the amount it's above will be reflected in the premium as the intrinsic value. If the underlying is below the strike price for a put, the amount it's below is the intrinsic value. Time value is the part of the option premium that's in addition to any intrinsic value. An option that is out-of-the-money only has time value. OIC's site provides a deeper discussion of time value and intrinsic value in the section called Time Erosion vs. Delta Effect.
Expiration: You have to know when an option is expiring before a client buys or sells it. On the expiration date an option, as well as the right for a holder to exercise the option, comes to an end. For many options, but not all of them, expiration dates are on the third Friday of the month that the option expires. OIC provides an annual Expiration Calendar that details expiration dates.
American-style and European-style: American-style options can be exercised any time before they expire. European-style options can only be exercised at a specific time. Despite the name, European-style options are often traded in the U.S. markets, along with American-style.
Assignment: When a call's underlying rises above its strike price or a put's underlying goes below its strike, the holder can exercise. If your client is short an option, they may get assigned, which means they'll have to deliver the underlying security or, in certain situations, cash. Assignment risk is one of the key risks when it comes to option selling, so you'll need to know if an option is in-the-money, out-of-the-money or at-the-money. A client can be adversely impacted if they're not aware of assignment risk.
Greeks: Options have several inputs to arrive at their price, and the Greeks are a major part. They're meant to measure the impact of things like how long the option has before it expires and changes in rates. Delta, gamma, theta, vega and rho are the ones to know. OIC has a wonderful video, led by my colleague Joe Burgoyne, that's sure to help you understand the Greeks. You can also read more about the Greeks on OIC's site.
Delta: This is one of the Greeks, and it deals with how much an option could change in price based on a $1 move in the underlying security. It's between 0 and 1 for calls and between 0 and -1 for puts. Here's a quick example from OIC's site: An XYZ 20 call has a 0.50 delta. The call is trading at $2, and XYZ shares are trading at $20.50. Those XYZ shares climb to $21.50. Because of the 0.50 delta, the investor's expectation would be for the call to rise in value, from $2 previously to $2.50.
Volatility: You've got two types. First is historical volatility. That's how much an asset has actually changed in the past. Then there's implied volatility. This is how much the market believes an asset will move. Implied and historical volatility are key aspects of options to understand. More information can be found in an OIC video on both types of volatility.
Black-Scholes formula: This formula is probably the best known pricing model for options, but it's not the only one. It factors in several components, including the underlying price, interest rates and time to expiration, for pricing options. The Cox-Ross-Rubinstein binomial pricing model is another method.
OCC: Founded in 1973, OCC is the world's largest equity derivatives clearing organization. OCC is dedicated to promoting stability and financial integrity in the marketplaces that it serves by focusing on sound risk management principles. By acting as guarantor, OCC ensures that the obligations of the contracts it clears are fulfilled. OCC also sponsors OIC, and last year, it cleared more than 5 billion options contracts.
The bottom line is this: Getting comfortable with options requires a solid foundation, for advisors and for their clients. And part of the way to get there is by knowing the lingo. Think about when you're talking to your barista. You've got to know what everything means to get your order perfect - coffee's not just coffee anymore, right? Maybe it took you some time at first, but once you got the language mastered, it became part of your daily routine.
Spend some time with OIC's site, which includes an entire Options Glossary, to help you navigate the options space. The best part? Unlike the coffee bars and cafes, optionseducation.org is never closed. That means you can learn when you want, how you want – articles, videos, podcasts or even signing up for our regular educational events.
Although understanding options is a journey that never truly ends, it doesn't have to be an unpleasant grind. Know the key terms, and it can get you started toward having a meaningful discussion with your clients.
Be sure to watch for our next Coffee With Cott blog: How Practitioners Can Get Started With Options. Do you have a topic you want to see covered in the Coffee With Cott blog? Let us know by writing to firstname.lastname@example.org.