Options trading is an exciting way to profit from the stock market, and although it isn’t for everyone, many people have generated six- and seven-figure profits from it. I use it when I’m teaching my strategies for The 10-Minute Millionaire Pro publications, and I encourage you to at least try it if you want to diversify your investments.
Before you jump into the options trading waters, however, familiarize yourself with the key terms and jargon related to this type of security. The more you understand it, the better your trades will perform.
What are Options?
Let’s get the most basic term out of the way. An option is a contract that gives the buyer or seller the right to buy or sell a set share of stocks at an agreed-upon price.
Unlike futures, options don’t require the buyer or seller to complete the contract. If you decide that the stock price has risen or fallen too far, you can simply let the expiration date pass.
In options trading, you get the opportunity to forecast a stock’s movement in the future. Most options trading contracts last for less than one month, and can be exercised at any point during that time. Some options last until the expiration date, which I’ll cover later, but like futures, they’re often exercised long before it to mitigate risk.
Some people consider options trading too risky to bother with, while others believe they can’t generate sufficient profit. However, lots of people make good money on options trading if they follow the charts and pay careful attention to fundamentals.
A call option is a contract that gives a buyer the opportunity to buy a set of shares of a particular stock by the expiration date. Call options can also apply to other securities, such as commodities, but we’ll stick with the stock market for now.
In a call option, the shares in question are considered the underlying asset. Essentially, the buyer believes that the stock price will increase prior to the expiration date and hopes to profit off that increase.
A put option is the opposite of a call option. It gives the seller the right to sell a set number of shares of a given stock within a specific period of time. The only benefit of exercising the option is when the stock falls below the strike price, which I’ll cover next.
What is a Strike Price?
The strike price represents the price of a given share of stock at which a call or put option can be exercised. For instance, if you’ve created a call option, you can buy the shares at the strike price until the option’s expiration date.
A buyer or seller determines the strike price at the time of placing the option. It can’t be changed or negotiated after that point.
What Does Expiration Date Mean in Options Trading?
The expiration date is the date at which the options period ends. It’s typically set on the third Friday of the month. If the buyer or seller doesn’t exercise the option by that date, the contract ends.
Expiration dates confuse many investors because they believe they must wait for that date to come. On the contrary, you could exercise a call or put option the day after the contract is written. There is no minimum time that must elapse before you take advantage of your option.
What Are Contracts?
In options trading, a contract is an agreement to buy or sell a set number of shares of stock. Unlike traditional contracts, options contracts don’t have to be fulfilled. You have the right to carry through the contract, but not the obligation.
An options contract typically contains several vital pieces of information, including the name of the security, the strike price, and the expiration date. Once the contract is written, both parties are in agreement. A person who places a call or put option doesn’t have to exercise the right, but the specifics don’t change.
What is Hedging?
In the stock market, investors often use hedging to cover losses. It’s essentially an insurance policy against factors outside the investor’s control, such as industry regulation changes and anything else that might influence a stock’s price.
Options traders can hedge by going long on one security and short on another. I’ll explain what those two terms mean later, but fundamentally, you’re hoping to get a gain on one option even if you take a loss on the other. The net result is a modest gain if you hedge correctly.
What Does Derivative Mean?
Options trading is considered a form of derivative security. This means that the trade itself is derived from the underlying asset’s price.
We’ve already covered the strike price. That’s the price on which the option is dependent. This is different from traditional stock trades in which there is no set price at which you’ll buy or sell a security.
What’s a Covered Call?
A covered call happens when you buy shares of a stock — usually in lots of 100 — and sell call options on each lot. You then hold onto the stock until you decide to sell. You can sell all of your stock if you wish, or you can sell only part and hang on to the rest of the stock.
That way, if the call option doesn’t work out in your favor, you can still make money off the stock you’ve retained. Additionally, you’ll make money off the premium the buyer is paying you until the expiration date.
What Does “In the Money” Mean?
When a call option is in the money, it means that the stock’s strike price has fallen below market value. For a put option, the stock’s price has risen above market value. Either way, it’s a good thing for the investor because it means you can profit from it by exercising the option.
When an option is in the money, its intrinsic value is the price of the stock at its current position minus the strike price. In other words, if the current stock price is $50 and the strike price is $100, the intrinsic value is $50.
What Does a Premium Refer To?
In options trading, the premium refers to the amount of money an investor makes from a call or put option based on a dollar value per share. For instance, the seller in a call option might have a premium of $1 per share. If the buyer has created a contract for 100 shares, the seller can earn $100 on the contract even if the option is never exercised.
What is Time Value in Options Trading?
When you subtract an option’s premium from its intrinsic value, you get the time value. Time value decreases as a contract gets closer to expiry because there’s a greater chance that the stock price will fall below or rise above the strike price, depending on whether it’s a call or put option.
What’s a “Long Position”?
In options trading, short and long positions have different definitions than they do for traditional stock market trading. A long position means that you’re either holding or buying a call or put option. For instance, you might go long on a call option for a specific stock. This means that you are buying it.
What’s a “Short Position”?
By contrast, a short position in options trading occurs when you agree to sell on a call or put option. In other words, if you’ve agreed with someone in a long position to buy or sell shares in a stock if that person exercises the option, you’re short.
What Does “Out of the Money” Mean?
Out of the money is the exact opposite of in the money in options trading. It means that the conditions are not favorable to you as the investor because the stock price has risen above or fallen below the strike price, depending on whether you have a call or put option.
Who is the “Writer” in Options Trading?
When you sell an options contract, you’re considered the writer. This is true whether it’s a call or put option, and you’re the one who gets the premium. You’ve agreed to buy or sell the underlying asset — in this case, the stock — if the other person exercises the option.
If you’re interested in options trading, I encourage you to explore it further. The above list of options trading terms can help you understand your research and navigate trades more effectively.
While options carry certain risks, you can mitigate your risk by conducting research and hedging your investments. Covering your calls can also help you maintain at least a modest profit after each trade concludes.
I encourage you to sign up for my free newsletter, The 10-Minute Millionaire, to learn more about options trading and other investment opportunities. It’s one of the most popular financial newsletters available today, and you’ll learn the various methods I’ve used to grow my wealth over the years.