Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
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Options trading can appeal to traders who are interested in more advanced investment strategies and who wish to hedge against risk in their existing portfolios or attempt to benefit from different price movements and strategies. It’s important to know, however, that options trading is, in some ways, its own world, with its own jargon.
When an investor trades options, they aren’t trading individual shares of stock. Instead, they’re trading contracts to buy or sell stocks and other securities under specific conditions. Beyond this, there are a number of important options trading strategies that investors commonly use. In order to effectively deal in options, an investor should familiarize themselves with certain lingo and understand the potential risks involved in these strategies.
Key Points
• Options trading involves buying (or selling) contracts that allow traders to buy or sell assets under specific conditions.
• A call option gives the purchaser the right to buy shares at a fixed price, while a put option gives the buyer the right to sell shares at a fixed price.
• The strike price is crucial in options trading, determining whether an investor is “in the money” or “out of the money” based on the stock’s actual price.
• Options trading offers potential advantages such as a lower entry point, possible downside protection, and greater flexibility in investment strategies.
• Options trading also carries higher risk, particularly for sellers who may face significant losses from uncovered trades.
First, Understand What You Are Trading
Before learning the trading terms, it helps to have a firm grasp of what options trading is and what it involves. In layman’s terms, when you’re trading options, you’re investing in an option to buy or sell a stock, rather than the stock itself.
Options are a form of derivative trading, and there are many options trading strategies that traders can use, too. It’s not exactly the same as trading stocks, and is often more complicated. For that reason, investors should have a strong grasp of the various elements of options trading as well as the potential risks before they start trading options.
Options Trading Terms to Know
When beginning to learn about options trading, these are some of the most important trading terms to know.
Call Option
A call option is an options contract that gives the purchaser of the option the right, though not the obligation, to buy shares of a stock or another security at a fixed price. This price is called the “strike price.”
When an investor buys a call option, the option is open for a set time period. While the option buyer may choose whether or not to buy the underlying asset in that time period, the seller is obligated to fulfill the terms of the contract if the buyer chooses to exercise the option.
The expiration date is the date when the call option is voided — though some options positions are automatically exercised if they are in the money. Standard options contracts often expire within a few months, though durations can vary.
Put Option
A put option gives a purchaser the right to sell shares of a stock at the strike price by a specified day. When getting to know puts and calls definitions, it’s important to remember that each one has:
• A strike price
• An expiration date,
• And a premium.
Strike Price
With a call option or put option, the strike price is one of the most important trading terms to know.
In a call option, the strike price is the price at which an investor may buy the underlying stock associated with the contract. In a put option, the strike price is the price at which they may sell the underlying stock.
The gap between the strike price and the market price of a stock determines whether an option is “in the money” (ITM) or “out of the money” (OTM). More on this below.
Expiration
Every option contract comes with an expiration date, which is the last day that the contract is in effect. American options may be exercised up to and on the expiration date of an option. In contrast, European-style options can only be exercised on the expiration date.
Premium
The option premium is the current price of the option, and thus the amount that the buyer pays to the option seller for the contract. The premium is determined by intrinsic factors, including whether an option is currently in-the-money and how far, as well as extrinsic factors, including the time remaining until expiration and implied volatility.
Exercise
Exercising an option is when the buyer chooses to utilize their right to buy or sell the underlying security, depending on whether they hold a call or a put.
In the Money
When discussing stock movements, it’s typical to think in terms of whether a stock’s price is up, down, or flat. With options, on the other hand, there’s different language used to describe whether an investment may pay off or not, and it’s often described as “in the money” versus “out of the money.”
An option is in the money when the relationship between the strike price and the stock’s market price would make exercising the option financially beneficial to the buyer. Which way this movement needs to go depends on whether they have a call option or put option.
With a call option, a buyer is in the money if the strike price is below the stock’s actual price. Say, for example, you place a call option to purchase a stock at $50 per share (the strike price), but its market price is $60 per share. In this case, the option would be in the money by $10 per share.
Put options are the opposite. An option buyer is in the money with a put option if the strike price is higher than the actual stock price.
Out of the Money
Being out of the money with call or put options means the option buyer doesn’t stand to see any financial gain from exercising the option, based on the current market price. Whether a call or put option is out of the money depends on the relationship between the strike price and the actual stock price.
A call option is out of the money when the strike price is above the actual stock price. A put option is out of the money when the strike price is below the actual stock price.
At the Money
Being “at the money” is another scenario an options buyer could run into with options trading.
In an at-the-money situation, the strike price and the stock’s actual price are the same (or very nearly the same). If the buyer of the option sells the option, they could potentially make or lose money. If they exercise the option, they may lose money, since the strike price offers no financial advantage over the current market price, and they have already paid the premium.
Implied Volatility
When trading options, it’s important to understand stock volatility and how it can impact trading outcomes.
Volatility is the degree and frequency of fluctuations in an asset’s price over a given time period. In options, higher volatility typically increases the option’s premium since increased volatility may raise the likelihood that the contract becomes profitable before expiration.
Implied volatility is a way of measuring or estimating the future volatility of an option’s underlying asset. Higher implied volatility suggests that the underlying asset may see bigger price swings in the future, which in turn influences the option’s premium.
Implied Volatility Crush
An implied volatility crush, also known as an IV crush, happens when there’s a sharp decline in a stock’s implied volatility that affects an option’s value. Specifically, this means a downward trend that can reduce a call or put option’s value.
Volatility crushes tend to occur after a major announcement that affects or could affect the implied volatility of a stock’s price. For example, investors might see a volatility crush after a company releases its latest earnings report or announces a merger with a competitor. The release may reduce uncertainty surrounding the company prior to the announcement, thereby lowering both the stock’s expected volatility and the option’s premium.
Time Decay
Time decay, also known as theta in the options Greeks, is the decrease in an option contract’s value as its expiration date approaches. The rate of time decay tends to increase when an option is close to expiration since there is little time left for an option to potentially move into the money.
Bid/Ask Price
When trading options, it’s helpful to know how bid and ask prices work.
The bid price is the highest price a buyer is willing to pay for an option. The ask price is the lowest price a seller is willing to accept for an option. The difference between the bid price and ask price is known as the spread.
Holder and Writer
Other trading terms investors may hear associated with options are “holder” and “writer.” The person or entity buying an options contract may be referred to as the holder. The seller of an options contract can also be referred to as the writer of that contract.
It’s crucial to know when trading options that the buyer (or holder) has the right, but not the obligation, to exercise the option contract they purchased. The seller (or writer), on the other hand, is obligated to fulfill the terms of the contract, whether that involves buying or selling the underlying asset, depending on whether the option is a call or a put.
đź’ˇ Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.
Pros and Cons of Options Trading
Options trading can offer both advantages and disadvantages for investors.
Pros of Options Trading
• Lower entry point. Unless an investor is able to purchase fractional shares, purchasing individual stock shares with higher price points can get expensive. Investing in certain options trades, on the other hand, may be more accessible for investors with a limited amount of money to put into the market. However, while option trading may amplify gains, it can also amplify losses, making them high risk.
• Downside protection for buyers. If the stock’s price isn’t moving in the direction a buyer anticipated, they don’t have to exercise their option to buy, in which case their maximum loss is the premium they paid. Note that this is not the case for option sellers, who must fulfill the terms of the contract if exercised.
• Greater flexibility. Options trading can offer an investor flexibility. A buyer may choose to exercise an option to buy or sell shares, or may be able to sell the option contract, depending on the market conditions and strategy. Advanced traders may implement different options trading strategies, such as spreads, to express a view on a stock’s potential movement or to manage risk.
Cons of Options Trading
Options trading can be high risk. Trading options offers leverage, or the ability to gain exposure to stocks’ price movements through relatively small premiums, but that also means options trading may amplify losses.
Options are particularly risky for sellers. While the maximum loss for an option buyer is the premium paid, the option seller could face substantial losses if the price of the underlying asset moves in an adverse direction and their trade is not protected, or covered, by owning sufficient shares of the underlying stock.
The Takeaway
Trading options may be attractive to investors who anticipate meaningful movement in an asset, or who want to offset risk from other holdings. But before an investor engages in options trading, it’s important to get familiar with put and call definitions and other options trading terms.
Knowing the specific jargon and terminology used by options traders can help investors cut through the noise and make better decisions. Of course, if you’re uneasy or unfamiliar with options terminology, you’d probably be better off learning more before starting to make trades. Options trading is typically best for experienced investors with a higher tolerance for risk.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
What are the most common options trading terms?
Some of the most common options terms include call option and put option, which are the two main types of contracts, as well as strike price (the price at which an option buyer may buy or sell an option’s underlying shares), expiration date (when the option contract expires), and premium (the price a buyer pays a seller for the option). Other common terms include exercise, in-the-money, out-of-the-money, at-the-money, time decay, and implied volatility.
What are the basics of options trading?
Options trading is a form of trading that can provide investors with leverage, meaning they can gain exposure to the price movements of the number of shares covered by the contract (typically 100) without having to buy those shares outright. While their gains may therefore be magnified, so too may their potential losses. Options traders may employ several different strategies to try to profit from stock movements and manage risk.
What’s the easiest option trade to make?
The most straightforward options trade would typically be buying a call or put option. A buyer of a call or a put may profit if the price of the underlying asset moves in their favor (above the strike price with a call or below the strike price with a put) and if gains exceed the premium paid. The most they would stand to lose is the premium they pay when they enter the trade.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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