Options trading is a great way for traders to find new and diverse opportunities in financial markets. As a tool for hedging and speculating, they can enhance trader portfolios and provide an added level of protection on existing positions. In this article, we will explain the terminology of options contracts, how options units work, and the types of orders traders can place.
What is an option?
An option is a contract that gives buyers the right to buy or sell a specified underlying asset at a predetermined price on a predetermined date (the expiration date). Options contracts are not obligated to exercise this right – they simply have the ‘option’ to do so.
Options trading can be used to hedge stock positions when markets are volatile or when traders cannot predict future market direction. Traders buy an options contract with a small amount of money, which is called the premium.
Traders can also use options trading to speculate on the future price movement within financial markets. Assets on which traders can speculate include – but are not limited to – forex, shares, indices, and commodities.
For more context, you can read more about options trading and how to buy and sell options.
The components of an options contract
An options contract is made up of many different components, and it is essential to understand its terminology so you can trade effectively. Below are some terms you will come across when you purchase a contract:
As mentioned, this is a small amount of money paid by the trader purchasing the options contract. This money is paid at the outset, and it essentially gives the trader the right to exercise their right to speculate or hedge a position in the future.
An options holder is the person who purchases the options contract and has the right to buy or sell from the underlying market. The options writer is the person who sells the contract.
The strike price on the contract is the predetermined price at which the options contract holder can execute the trade on a predetermined date. This is usually determined based on a trader’s speculation of where the market will go.
The expiration date is the predetermined date before (or on) which the contract terminates. There are two types of options contracts: American style and European style. They have different conditions regarding the expiration date.
In American-style options contracts, the holder can exercise their right to buy or sell the underlying asset at any time prior to the expiration date. On the other hand, in European-style options contracts, the holder can only exercise this right on the expiration date.
Understanding options units of different underlying assets
In every options contract, the trader denotes the underlying asset on which they are speculating. Depending on the asset type and its origin, different units per options contract are sold. In the US, each contract controls 100 shares of the underlying asset. In the UK, each contract represents 1,000 shares.
Therefore, in the US, when you see a stock call option premium of 1.50, you will have to pay $1.50 x 100 = $150 for one contract. This is the minimum you can trade. In the UK, if you see a stock call option for £1.50, you will have to pay £1.50 x 1,000 = £1,500. This is the premium you pay in exchange for the right to buy 1,000 shares of the predetermined stock.
Beyond stocks, there are also different price points for different assets. To ensure you do not end up trading much more (or less) than you had planned to, you must understand how much one options contract covers for each instrument.
Terminology related to the strike price
There are a few positions the strike price can take in relation to the market value of the underlying asset. These are employed by the trader depending on their trading strategy, and they are described as an option’s ‘moneyness’.
In the Money
The money is abbreviated to ITM. This is when the strike price has surpassed the current market price of the underlying asset. ITM options are mostly used for hedging an existing position as they have intrinsic value.
Out of the Money
Out of the Money is abbreviated to OTM. This is when a strike price is a number that the current market price has yet to reach. OTM options are used in all types of options strategies as they have no intrinsic value.
At the Money
Finally, the money is abbreviated to ATM. This is when the strike price is the same as the current market price. ATM options are common and there is a lot of activity surrounding them, as the strike price being close to the current market price means there is potential for profit soon. ATM options have no intrinsic value but are beginning to acquire value.
Terminology related to trade order timing
Beyond the simple calls and puts that indicate whether you want to buy or sell an underlying asset, there are also unique trade orders in options trading when you exercise your right to buy or sell. These orders are time-related, and they provide more specific instructions for floor traders. This can be helpful as options prices are not always clean-cut.
Good Till Cancelled
When you exercise an options contract, Good Till Cancelled (GTC) deems an order is valid until it is filled, or you cancel it.
When you place an order indicating Day Only, the order is cancelled if it is not filled by the end of the day. This could be due to the inability to find a price match.
Similarly, when you place an order indicating Week Only, the order is cancelled if it is not filled by the end of the week.
All or None
An All or None order is the requirement that the entire order must be filled or none of it should be filled. This instructs floor traders that you only want to deal in the same lot sizes as your order.
Fill or Kill
Finally, Fill or Kill instructs floor traders that if an order is not filled immediately, the order must be cancelled. These orders are most time-sensitive and urgent.
Options trading provides many opportunities for traders, and they can be great for both hedging and speculating. However, they can be quite complex for beginners who are used to placing trades directly and in the moment. To trade options successfully, traders must not only learn the ropes of how the market works, but also how to read, interpret, and purchase contracts. Having a well-rounded knowledge of options can ultimately minimise the risks taken in trading.