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Options 101: The Language of Options

February 3, 2015

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Welcome back to our Options 101 Series presented by Tackle Trading! In this series, we cover the core concepts that makeup options themselves. During this segment, I’ll dive into some of the language and definitions you’ll hear as an options trader including calls, puts, in-the-money, out-of-the-money, at-the-money, intrinsic and extrinsic value, and strike prices.

Call Options & Put Options

As has been stated before, call options are a type of option. Calls are located on the left side of the option chain in your brokerage and option programs. Any stock that has options will have call options. When you trade a call, it’s neither bullish, bearish, nor neutral. It all depends on what you do with it as well as what other positions you’re using it for. Buyers of call options have the right to call the underlying security to their account. Buyers own the rights. When you buy calls – which will be described in much more detail in a later session – you are going long the calls. You’ll hear these terms from traders regularly. Call options are one of the products you’ll use frequently when trading options. What you need to do to develop a strategy or action plan is determine how you will trade the calls.

Calls can also be sold. When you sell a call, you’re taking on the obligation of assignment to your strike. Don’t let that make you nervous, assignment only happens at expiration or if a call is deep in-the-money (more on that in a few moments). Selling calls alone are referred to as short calls or naked calls. Naked calls require a level 4 account with an options broker and should only be done by a very experienced trader. Generally, when a beginner sells a call it’s because the trader already owns the underlying security. This is a covered call. In the next installment of this series, we’ll discuss covered calls in length.

Put options are the other main type of option. Puts are used in many ways. The instrument itself is not complex when you examine it. Puts are a contract where the buyer owns the right to sell the underlying security at a set price (strike) at or before a set date. When you buy puts you are going long the puts. This is a bearish position. When you sell puts you are going short the puts. This would be a bullish position. With options, it’s very important to understand that you can be bullish, bearish, or neutral on any option position because it all depends on if you buy, sell, or combine a buy or sell with another position.

One of the best strategies in the markets is through selling put options on securities you are bullish on. When we get into strategies later in this series, I will examine the naked put in detail.

In-, Out- and At-The Money (Options Moneyness)

Many times, when a trader refers to an option, you’ll hear them say it’s either “in” “out” or “at” the money. This is in reference to where the strike price is that you have either bought or sold relative to the underlying stock, index, or other instrument’s price that you’ve traded the option on. Here are some tips on how to remember which one is which. In my experience, traders who put in 50 trades in paper trading learn this lingo just from the practice of trading.

In-the-money call options are those strikes on the call chain that have a lower strike number than the stock price itself. For example, if the stock is at 52.10, then the 50, 45, 40, 35 and 30 strikes would ALL be in-the-money strikes. This is only for calls. It’s the opposite for puts because each option represents the opposite rights and obligations.

In-the-money put options are those strikes on the call chain that have a higher strike number than the stock price itself. For example, if the stock is at 87.90, then the 90, 95, 100, 105, and 110 strikes would be IN-the-Money. On most option graphs, the in-the-money and out-of-the-money chains have different color codes to them so that a trader can identify the difference quickly. At Tackle Trading, we generally recommend traders build their rules based on delta numbers so that it becomes easier to find the strike to use. We’ll discuss Delta during each strategy outline and during the last session of this series.

Out-of-the-money options are simply any option that is not in the money. In the examples above, for the stock at 52.10 for the Call options, out of the money would be at 55, 60, 65 and 70. For the put option example, the out of the money option would be 85, 80, 75 and 70.

At-the-money options only occur when the strike price is exactly, to the penny, equal to the stock price. So if you use a 90 strike, and the stock is 90.00. That option is AT-the-Money. At the money is sometimes referred to by traders as any strike that is ‘close to’ the stock price.

Extrinsic & Intrinsic Values

Extrinsic value is the value of the option that does not reflect the underlying strike price’s value. Here’s a quick formula before we delve into this further:

Intrinsic Value + Extrinsic Value = Option Price

Now, to bring some of these concepts together, we’re going to use some examples to explain them better.

If you own a 170 strike put option on a $164 stock. That option is $6 In-the-Money (170-164=6). If the option premium is $11, all you have to do is plug in the numbers in the formula to calculate extrinsic value.

Intrinsic Value (6) + Extrinsic Value (?) = Option Price (11)

So if Intrinsic Value + Extrinsic Value must equal the option price then the extrinsic value is 5. This is the amount of money that will be subject to time decay. This is an extra cost the market maker builds through the Black-Scholes model to develop the option price. Generally, extrinsic value is also a reflection of Implied Volatility.

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If you’re a new trader, stick to your rules and try to process these concepts as you go. You don’t have to know everything to be able to follow your rules and make a trade. Generally, playbooks—like our own Trading Playbook (for PRO Members only) —are invaluable resources for new traders so that you don’t get your head spinning too much on the definitions.

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12 Replies to “Options 101: The Language of Options”

  1. Ming Bai says:
    January 9, 2015 at 3:22 pm

    Good intro. Thanks Matt.

  2. Edgardo Melendez says:
    January 10, 2015 at 10:42 am

    Thanks for that piece Tim!

    I”d like to ask; as a credit spread, theta positive trader…

    Am I selling out of the money options and buying them back after time decay has affected the extrinsic value of the option?

    Should we be scanning for high implied volatility stocks, with the idea that they may have a greater amount of extrinsic value to loose through time decay, therefore may offer more credit?

    Thanks again, Edgar M.

    1. Troy Mitchell says:
      January 10, 2015 at 12:01 pm

      This is what I do and it works pretty good for me.

  3. Edgardo Melendez says:
    January 10, 2015 at 12:10 pm

    Thanks for confirming I am on the correct direction Troy!

  4. Dan Benavidez says:
    January 11, 2015 at 3:57 pm

    Thanks Tim, good stuff, when you do covered calls will you please explain the TOS covered stock option chain as well as properly setting stop loss?

  5. Sheila Purim says:
    January 13, 2015 at 11:51 pm

    thanks Tim! This series so far has been very helpful! Like Dan’s comment above I am also interested in learning better how to properly setup target and stop loss in options. Should I place bracket orders like for stocks? If you can provide some info on that in the next chapters that would be great!

  6. Pingback: Options 101: The Language of Options
  7. Trina Thames-Brown says:
    February 12, 2015 at 2:17 pm

    This has been a great refresher course. Designed and written to give a clear understanding. As I was reading I reflected on what was taught in class. Areas of unclear understanding started to make sense and the connections were made.

    Thank you for the blog. I look forward to the next session of options 101.

  8. STEWGILGIS says:
    November 13, 2015 at 12:10 pm

    Very helpful for this newcomer to options trading.

  9. Tim Justice says:
    November 13, 2015 at 1:37 pm

    Glad you enjoyed it Stew!

  10. LUISRODRIGUEZ says:
    November 30, 2015 at 10:56 am

    I’m still confused with terms such as Sell to open, buy to open, sell to close, buy to close. They throw me off a bit in my Merril Lynch account.

  11. Tim Justice says:
    November 30, 2015 at 1:48 pm

    Sell to open is when you’re selling something that you don’t have a position on currently. Buying to open is buying something you don’t have a position on.

    To Close, reflects that you do have a position and you’re sending an order to close your trade.

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