Many of my readers are not only new to Options Floor Trader but are new to options trading, but even if you’re not, it’s never a bad idea to review your terminology and key concepts. Instead of simply giving you definitions of options terms, I’m going to tell you why you need to know the following terms and how they might come into play in this service. By the way – I’m constantly adding to this list, so if you don’t see a term on here that you’d like to know more about, let me know, and I’ll add it.
Call: When we buy a call, we want the underlying asset to go up. Going up very slowly will usually not get the job done, as we have a time limit on our call. We won’t ever sell calls in this service.
Put: Everything that I said above about calls except substitute “up” with “down”. In my opinion, it is far easier to buy puts than to short sell stocks if you are bearish. For example, you don’t need a margin account to buy puts, but you do in order to short sell stocks.
Strike: When we own a call, we want the underlying asset to go higher than this price and vice versa for a put.
Expiration: The month/day our option (call or put) expires. The longer it takes for an option to expire, the more you have to pay for that option.
Premium: The price we pay for the option. Keep in mind, one options contract is the same as controlling 100 shares of stock, so we have to multiply the premium by $100 to get our out-of-pocket price. (For example, a $1.25 premium on an option will cost us $125 per option to purchase.)
Time Decay: Options eventually expire. If we own an option, the option loses a little value every day if the underlying stock/ETF doesn’t move. This is called time decay. The decay picks up as we get closer to expiration but only has a small effect when there are multiple months to go until expiration.
Volatility: How much the underlying stock/ETF moves and how fast it moves can have a huge impact on the price of its options. The more volatile the stock is, the more you have to pay for the options. That’s generally why we don’t trade highly volatile stocks, like Tesla (TSLA), for example. I talk about volatility a lot, but we generally don’t factor it into our trading decisions in this service (outside of avoiding very expensive options).
Bid/Ask Spread: For every option, there’s a bid price and an ask price. As a customer, it’s normal to think we have to sell at the bid price and buy at the ask price. We don’t sell options in this service, but that doesn’t mean we have to pay the ask price when we buy a call or put. Usually, if you set your buy price at the midpoint of the bid/ask spread, your trade can get executed at that price or right around there.
ATM/OTM/ITM (At-the-money/out-of-the-money/in-the-money): Terms used to describe where the option is relative to the price of the underlying asset (also called “moneyness”). We focus on OTM and ATM options in this service.
LEAP: The common name for a long-term, exchange-traded option. They are usually a year or two out until expiration and generally not something we trade in this service (but I do get asked about them regularly, so I thought it would make sense to include the term in this list).
Exercise: If you have an option that is in the money (a call with the strike higher than the current stock price or a put with the strike lower than the current price), you may exercise that option into shares at expiration. For a call, that means you will own 100 shares per contract of the underlying instrument at the strike price. For a put, you’ll be short the shares at the strike price. In this service, we will never exercise options and will always close them prior to expiration. Keep in mind, you have to have the money in your account to cover buying (or selling short) the shares you receive on an exercise.
Early Exercise: With individual stocks, you have the potential to exercise your shares into stock (see “exercise” entry above) prior to expiration. Essentially, the only reason to do this is to attempt to capture the dividend ahead of the ex-dividend date. In 99% of the cases, there is no reason to ever do this. Also, we won’t ever do this sort of thing in this service, but it’s always important to know what your choices are.
Front Month: The trading month that is closest to expiration. For example, on December 17th the front month is still December (since December monthly expiration is on December 20th). After December 20th, the front month will become January. Front-month options are typically the most heavily traded.
Back Month: The inverse of the front month. A month that has longer to go to get to expiration is generally considered a back month. We use both front-month and back-month options in this service. For instance, we may place short-term trades using a front-month option (with roughly 30 days or under to expiration). Other times will give our options 45-90 days until expiration, and thus we are trading back month options.
Rollout: Closing a current position and opening a new one with a different expiration and/or strike. This is typically done as a single transaction but can be done separately. A rollout is generally used to extend the life of a trade or adjust it after a big move in the underlying asset. It’s generally done as a single transaction to lower transaction costs and simplify the process.
Some quick reminders:
Filled = Executed
Long = Buy
Short = Sell
Vol = Common industry term for volatility (see definition above)
Theta = Another way to say time decay (see definition above)