Last update: July 2021
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.
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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