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Derivatives

Options A-Z: The Basics to The Greeks

Kaitlyn Kiernan
Options A-Z: The Basics to The Greeks

To the uninitiated, the options market can seem to have its own language, with a number of unfamiliar terms. Here are some basic terms to help you become conversant in the language of options.

Options trading can be risky, and trading the products requires specific approval from an investor’s broker. For more information about the inherent risks and characteristics of the options market, check out the industry handbook the Characteristics and Risks of Standardized Options.

The Basics

Option Holder: The purchaser of an options contract.

Write: To sell an option contract. The investor who sells an option contract is called the writer. They are also considered to be short the option.

American-Style Contract: A contract that may be exercised at any time between the date of purchase and the expiration date. U.S. equity option contracts are American-Style contracts.

European-Style Contract: A contract that may only be exercised during a period of time on its expiration date. Some U.S. index option contracts are European-Style contracts.

Call: An options contract that conveys the right to buy the underlying security at a set price (the strike price) by a designated date (the expiration date). When an investor sells (or writes) a call contract on a stock, the seller is obligated to sell stock at that price if the option is exercised.

Put: An options contract that conveys the right to sell the underlying security at a set price (strike price) by a designated date (expiration date). When an investor sells a put contract on a stock, the seller is obligated to buy stock at that price if the option is exercised.

Premium: The price paid by the purchase of an options contract or the price received by the seller of an options contract. It is determined by a number of factors, including the amount of time left until the contract expires and expectations for future volatility in the price of the underlying asset. The premium is a nonrefundable payment in full from the buyer to the seller in exchange for the rights conveyed by the option.

Expiration Date: The date on which an option expires. If the purchaser of an option doesn’t exercise the contract prior to expiration, he or she loses the premium paid for the contract. The purchaser no longer has any rights and the option no longer has value.

Strike price (or exercise price): The price per share at which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the contract.

Exercise: When the buyer of the contract implements the right to buy (in the case of a call) or sell (in the case of a put) the underlying security.

Assignment: The receipt of an exercise notice by an option writer (seller) that obligates the writer to sell (in the case of a call) or purchase (in the case of a put) the underlying security at the specified strike price.

At-the-money: When the market price of the underlying security is equal to the strike price of an option contract.

Out-of-the-money: When the market price of the underlying security is below the strike price of a call option, or above the strike price of a put, giving the contract no intrinsic value.

In-the-money: When the market price of the underlying security is above the strike price of a call option, or below the strike price of a put, giving the contract intrinsic value.

Intrinsic value: The value of an option if it were to expire immediately with the underlying stock at its current price. This is the amount by which an option is in-the-money. See also In-the-Money and Time Value.

Open Interest: The number of outstanding contracts in a particular options market or an options contract. This information can be broken down by puts and calls, strike price and expiration date for options tied to a particular security.

Time Value: The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option has in addition to its intrinsic value.

Time Decay: A term used to describe how the theoretical value of an option "erodes" or reduces with the passage of time. Time decay is referred to in trading parlance as Theta.

Volatility: In options, a measurement of the fluctuation in the market price of the underlying security. Mathematically, volatility is the annualized standard deviation of returns.

Implied Volatility: A measure of the expected volatility in the price of an underlying security that is calculated from current market options prices rather than from historical data about price changes of the underlying stock. The commonly quoted CBOE Volatility Index, or VIX, is a measure of market expectations of near-term volatility, meaning it is a calculation of the implied volatility of the S&P 500 based on the price of options tied to that benchmark index.

The Greeks

The Greeks are a number of key factors that influence the price of options contracts and are called such because of their names, which are all derived from Greek letters of the alphabet. The Greeks are all intimately related, but in the interest of simplicity, we describe them below based on what would be true for one Greek, holding all else constant.

Delta: The amount an option price is expected to change based on a $1 change in the underlying stock. For call options, this is a positive number between 0 and 1. For put options, this is a negative number between 0 and -1. This number is not static, and changes as an options contract nears expiration and if it becomes in-the-money. Delta will approach 1, or -1, for a call or put option, respectively, if it is near expiration and in-the-money, while it will approach 0 for contracts that are out-of-the-money as expiration nears. Technically, delta is an instantaneous measure of the option's price change, so that the delta will be altered for even fractional changes in the underlying instrument.

Gamma : The rate of change in an option’s delta based on a $1 change in the price of the underlying security. The price of a contract with high gamma, a reading near 1, will be very responsive to changes in the price of the underlying security. A contract with low gamma, a reading near 0, won’t be very responsive to price changes. Gamma is typically highest for at-the-money stocks near expiration.

Theta: The rate of change in an option’s theoretical value for every one-day change in the time remaining until expiration, holding all else constant. Theta becomes larger as an option nears expiration. Theta is also known as a contract’s time value. Time has value, because with more time until expiration, there is a greater probability of the underlying security’s price moving enough for the contract to pay off. See also Time Decay.

Vega: The rate of change in an option’s theoretical value in response to a one-point change in implied volatility. Vega typically increases as implied volatility increases, because a more volatile stock has a greater chance of moving enough to end up in-the-money- before expiration.

Rho: The amount the theoretical price of an options contract is expected to change based on a one percentage-point change in interest rates, holding all else constant. Rho typically matters most for longer-term options, where a change in interest rates can lead to a greater “cost of carry,” or a greater opportunity cost associated with making the trade versus pursuing another investment.