In the last article, we went over the basic structure of an option. Now, we’ll go through the more professional terminology for what everything is.
As we said before, an option is a contract that agrees to buy a stock at a certain price. The stock that you are agreeing on about the price is called the underlying asset. Think of it this way; you are trading a contract based on a stock, so the stock should be “under” that contract.
The price you are agreeing to buy the stock at is called the strike price. You are “striking” a deal when you agree to the contract, so the price in the contract is part of the deal that you “struck”.
The price that you are paying for the right but not the obligation to buy the underlying at the strike price is called the premium. In simple terms, the premium is the price you pay for the contract.
The date the contract expires is called the expiry date. It’s similar to how your milk expires. Once that date is met, your contract goes bad. You lose the right to buy the underlying at the strike price. If you want to use your right to buy the underlying asset at the strike price, you can exercise your contract and buy the shares. On the expiry date, if your strike price is below the current price of the stock, your contract will be automatically exercised, and if you don’t have enough funds to buy the shares, the profit of the difference between current and strike price will be given to you.
Another important distinction to know is the difference between Out of the money (OTM), In the money (ITM), and at the money (ATM). This gives a good descriptor of “where” your contract is. Out of the money means that your contract is currently worthless if it were to expire right now. The price of the underlying asset is below your strike price. It would be cheaper to buy the underlying at the market price than at your strike price. At the money is when the current market price of the stock is at the same price of your strike price. In the money means that if the contract were to expire now, your contract has value. The current market price is above your strike price.
In our first article, we talked about how the contract was an agreement to buy shares of a stock at a certain price. In this contract, if the stock goes up, your contract will gain value. This type of contract is called a call options contract or just a call. There is another type of contract that works in a similar way, except that it profits when the stock goes down. This type of contract is called a put options contract or just a put. For put contracts, instead of agreeing to buy shares at a certain strike price, you are agreeing to sell shares at a certain strike price. You want the price of the underlying to go down. Think of it like sell high buy low instead of buy low sell high.