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10.5.1 Options Terminology

Gain a thorough understanding of essential options terminology including strike price, option premium, expiration date, trading unit, and other key concepts.

Options terminology encompasses several key phrases essential to navigating the world of options trading. Below, we articulate these terms in detail and provide supplementary materials to support your learning.

Key Terms and Definitions

Strike Price

The strike price (or exercise price) is the agreed-upon price at which the underlying asset can be purchased or sold in the future, as established in the option contract.

Option Premium

The option premium is the payment an option buyer makes to the option seller. This fee grants the buyer the right to buy or sell the underlying asset without further obligation unless they decide to exercise the option. The maximum loss for an option buyer is the premium paid, whereas option writers must always be ready to fulfill their obligations.

Expiration Date

Options have specific expiration dates, usually set on the third Friday of the expiration month. Options can have different expiration periods, including weekly options which expire any of the five Fridays following their listing week.

Trading Unit

A trading unit specifies the amount of the underlying asset represented by one option contract. Standard stock options in North America usually cover 100 shares, which means one call option gives the buyer the right to purchase 100 shares of the underlying stock.

American-Style Options

American-style options allow the holder to exercise at any time up to and including the expiration date.

European-Style Options

European-style options can only be exercised on the expiration date. They are common for index options.

Long-Term Equity Anticipation Securities (LEAPS)

LEAPS are long-term options providing the same risks and rewards as regular options contracts.

Option Transactions

Opening Transactions

An opening transaction establishes a new options position. Bought options result in long positions, while sold options result in short positions. Positions close via offsets, exercise, or expiration.

Offsetting Transactions

Offsetting involves creating an opposite position of the same type and number of contracts to effectively cancel the initial position.

Exercised Options

In exercised options, the party holding the long position buys or sells the underlying asset at the strike price to the assigned counterparty.

Options Expire Worthless

Should the option not be exercised before expiration, it expires worthless, causing the option buyer to lose the paid premium and allowing the writer to keep it.

Option Value Concepts

In-the-Money

An option is said to be in-the-money if exercising it is financially advantageous.

  • A call option is in-the-money when the underlying asset’s price > strike price.
  • A put option is in-the-money when the underlying asset’s price < strike price.

Out-of-the-Money and At-the-Money

  • A call option is out-of-the-money if the underlying asset’s price < strike price.
  • A put option is out-of-the-money if the underlying asset’s price > strike price.
  • Call and put options are at-the-money if the price of the underlying asset equals the strike price.

Intrinsic Value

Intrinsic value denotes the in-the-money portion of an option.

  • Intrinsic Value for a Call Option: $$ \text{Intrinsic Value} = \text{Price of Underlying} - \text{Strike Price}$$
  • Intrinsic Value for a Put Option: $$ \text{Intrinsic Value} = \text{Strike Price} - \text{Price of Underlying}$$

Example Calculation

Option Type Price of Underlying Strike Price Intrinsic Value Formula Intrinsic Value
Call Option $60 $55 $60 - $55 $5
Put Option $60 $65 $65 - $60 $5
Call Option $60 $65 No intrinsic value (price < strike) $0
Put Option $60 $55 No intrinsic value (price > strike) $0

Time Value

Time value signifies the premium of an option above its intrinsic value. It reflects the value of holding an option until its expiration.

$$ \text{Option Premium} - \text{Intrinsic Value} = \text{Time Value}$$

Example Calculation

For a call option on XYZ stock with a strike price of $55 and trading at $6 while the underlying asset’s price is $60:

$$ \text{Time Value} = \text{Option Premium} - ( \text{Price of Underlying} - \text{Strike Price})$$

$$ \text{Time Value} = \$6 - (\$60 - \$55) $$

$$ \text{Time Value} = \$1 $$

Key Takeaways

  • The strike price determines the execution price for buying or selling the underlying asset.
  • The option premium is the fee paid for the potential right in the option contract.
  • Expiration date restrictions clarify the exercising timelines of options.
  • Option trading units affect the contract size in the underlying asset.
  • American-style options allow more flexible exercise capabilities than European-style options.
  • The option’s worth is derived from both its intrinsic and time values.

Frequently Asked Questions (FAQs)

Q: What’s the difference between American-style and European-style options?

A: American-style options can be exercised any time before the expiration date, while European-style options can only be exercised on the expiration date.

Q: How is an option premium calculated?

A: The premium is the market price of the option, which includes both intrinsic value (if any) and time value.

Q: What happens if an option is out-of-the-money at expiration?

A: The option expires worthless, causing the buyer to lose the premium and the writer to gain it.

Q: What are LEAPS?

A: LEAPS are long-term equity anticipation securities, essentially providing the same benefits as regular options but with a longer time horizon.

Options Terminology

    graph TB
	    A[Options Terminology]
	    A --> B[Strike Price<br><i>Executed Price</i>]
	    A --> C[Option Premium<br><i>Fee for Potential Right</i>]
	    A --> D[Expiration Date<br><i>Specific Exercise Date</i>]
	    A --> E[Trading Unit<br><i>Size of Contract</i>]
	    A --> F[American-Style Options<br><i>Exercisable Anytime Before Expiration</i>]
	    A --> G[European-Style Options<br><i>Exercisable Only at Expiration</i>]
	    A --> H[LEAPS<br><i>Long-term Equity AnticiPation Securities</i>]

By understanding these concepts, you’ll be better equipped to analyze options and make informed trading decisions. Happy studying!


📚✨ Quiz Time! ✨📚

🧐 Assess and Solidify Your Understanding

Welcome to the Knowledge Checkpoint! You’ll find 10 carefully curated quizzes designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you’re on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck! 🍀💪

## What is the strike price in an options contract? - [ ] The price at which the option can be renewed - [ ] The initial price of the option - [ ] The price of the option's premium - [x] The price at which the underlying asset can be purchased or sold in the future > **Explanation:** The strike price (or exercise price) is the predetermined price at which the underlying asset can be bought or sold upon exercising the option. ## What is the option premium? - [ ] The price at which an option can be bought at expiration - [x] The fee paid by the buyer to the seller to obtain the right to buy or sell the underlying asset - [ ] The difference between the strike price and market price - [ ] The interest rate applied to the option > **Explanation:** The option premium is the amount paid by the option buyer to the option seller (writer) in exchange for the rights conveyed by the option. ## When do exchange-traded options typically expire? - [ ] The first Friday of the expiration month - [ ] The last calendar day of the expiration month - [x] The third Friday of the expiration month - [ ] Exactly nine months after issuance > **Explanation:** Exchange-traded options typically expire on the third Friday of the expiration month. ## How many shares of the underlying stock does one standard North American stock option contract represent? - [ ] 50 shares - [ ] 200 shares - [ ] 150 shares - [x] 100 shares > **Explanation:** One standard stock option contract in North American markets represents 100 shares of the underlying stock. ## What defines an American-style option? - [x] It can be exercised at any time up to and including the expiration date - [ ] It can only be exercised on the expiration date - [ ] It must be renewed quarterly - [ ] It can be traded only within North America > **Explanation:** American-style options can be exercised at any time up to and including the expiration date, giving greater flexibility to the option holder. ## Which type of options can only be exercised on the expiration date? - [x] European-style options - [ ] American-style options - [ ] Long-term equity anticipation securities - [ ] Weekly options > **Explanation:** European-style options can only be exercised on their expiration date. ## What is an opening transaction in options trading? - [x] Establishing a new position in an option contract - [ ] Closing an existing option position - [ ] Exercising an option - [ ] Offsetting an option position > **Explanation:** An opening transaction occurs when an investor establishes a new position in an option contract. ## When is a call option considered in-the-money? - [ ] When the underlying asset price is equal to the strike price - [ ] When the underlying asset price is lower than the strike price - [x] When the underlying asset price is higher than the strike price - [ ] When the premium paid is higher than the intrinsic value > **Explanation:** A call option is in-the-money when the current price of the underlying asset is higher than the strike price of the option. ## What constitutes the intrinsic value of an option? - [ ] The time left until expiration - [ ] The volatility of the underlying asset - [ ] The premium paid for the option - [x] The in-the-money portion of a call or put option > **Explanation:** The intrinsic value is the value of the in-the-money portion of an option. For a call option, it is calculated as the current price of the underlying asset minus the strike price. For a put option, it is calculated as the strike price minus the current price of the underlying asset. ## How is the time value of an option determined? - [ ] Strike price - underlying asset price - [x] Option price - intrinsic value - [ ] Underlying asset price - strike price - [ ] Option price + intrinsic value > **Explanation:** The time value of an option is the amount by which the price of the option exceeds its intrinsic value. It represents the value of the uncertainty and potential for price movement until expiration.

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Saturday, July 13, 2024