This is how I define the terms that I use in my blog. I’ve tried to write each definition as much in layman’s terms as possible. If something is still confusing, email me and I’ll do my best to clarify. Check out my blog to see real life examples of how I use these terms.
At the money (ATM) – A strike price that is at the same price as the current stock’s price.
Call Option – Generally just referred to as a “call”. A call gives the buyer insurance against the stock if it rises while she is short. Buyers can either own the stock and buy insurance (a call) in case the stock price does NOT rise or a buyer can buy a call without owning the stock if they think it’s going to rise. The latter is the equivalent of owning the rights to a stock for a predetermined time with different risk. The stock might drop $10, but the only loss the call seller would take would be the amount paid for the premium. It’s a 100% loss, but less dollars. For example a call buyer thinks the stock will rise and is leveraging her money to enter the position. She might pay $300 for a call with a $50 strike that is at the money (ATM). Not accounting for commissions, she makes money for every penny the stock rises over $53 (the strike price plus the premium).
Contract – An agreement to buy or sell a stock at a set price. Each option contract is equal to 100 shares of the underlying stock. This means that a put seller is assigned 100 shares of the stock if it is assigned to him and a call seller has to sell 100 shares for each contract that expires above his strike.
Covered Calls – Selling a call while owning the stock (being long) is called a covered call means you sell back the stock that you previously bought if the price of the stock finishes higher than the strike price. That’s where the risk is in a covered call. Sellers limit potential profits if the stock rises over the strike with a difference greater than the premium the seller sold the call. Covered call sellers gained extra profit if the stock does not rise above the strike price. This means that the seller of the call gets to keep the premium and the underlying stock, thereby reducing her cost of the stock. This is used if the seller doesn’t think the stock is going to rise very fast and is trying to eke out a little extra profit.
Covered Puts – Selling a put while being short the stock means you buy back the stock that you previously sold when it was shorted. The seller of the put does not own the stock, in fact she has sold shares that she doesn’t own. A covered put takes an early profit (or reduces a loss) on a stock that’s been shorted already. This is used if the seller doesn’t think the stock is going to fall very fast and is trying to eke out extra profit from a short position.
In the money (ITM) – A strike price that has a premium that includes intrinsic value. A call’s strike that is below the below the price of the stock is in the money as is a put’s strike that is above the price of the stock. For example, a put with a strike of 30 while the stock is trading at 28 has $2 of intrinsic value or is $2 in the money. The percentage gains for buying options ITM are smaller, but the dollar amount gained can be bigger if the underlying stock goes in your favor. Selling options ITM can give you bigger percentage and dollar gains while the risk goes up substantially.
Intrinsic Value – The amount of the premium that is based on the amount the option is in the money. For example, a put with a strike of 30 while the stock is trading at 28 has $2 of intrinsic value or is $2 in the money.
Long – Being in a position where you hope the stock will rise to make you money. This is the opposite of being short. Examples are owning a stock or call or selling a put.
Limit – A predetermined price a trader is willing to buy or sell a stock or option.
Naked Puts – Selling a put without being short the stock is called a naked put. If the stock drops the put is assigned to the seller meaning that the seller is forced to buy it at the strike price. Selling a put below the current strike price gives the seller a little cushion if the stock does dip. This is a bullish position. (This was my bread and butter during the bull market. I’m the insurance company for people who want protection for their stocks.)
Naked Calls – Selling a call without being long the stock is called a naked call. If the stock rises it is called away from the seller meaning that the seller is forced to sell it at the strike price. A seller profits when the stock does rise above the strike and to a lesser extent if it does rise above the strike, but not more than the premium received. This is a bearish position. Selling a naked call with a strike above the current stock price (out of the money) gives the seller a little cushion if the stock does rise some.
Near the money – A strike price that is near the same price as the current stock’s price.
Out of the money (OTM) – A strike price that has a premium consisting only of time value, no intrinsic value. For example, a put with a strike of $30 while the stock is trading at $32 has $2 of intrinsic value or is $2 out of the money. Selling puts OTM gives the seller more cushion before the stock is assigned. Selling covered calls OTM gives the seller more potential profit since part of the increase in stock value will be profit on top of the premium. Buyers of OTM options get a lower price while still gaining a position on the stock. The percentage gains are bigger OTM, but the dollar amount is lower.
Premium – The amount of money received from selling an option or paid from buying an option.
Put Option – Generally just referred to as a “put”. A put gives the buyer insurance against the stock if it falls while the buyer owns the stock and hopes it will go up (long on the stock). Buyers can either own the stock and buy insurance (a put) in case the stock price drops or a buyer can buy a put without owning the stock if they think it’s going to drop. The latter is the equivalent of shorting a stock with a different risk. The risk in buying a put is that the stock may not drop and the entire premium could be lost. A 100% loss on a smaller amount purchased. The stock might rise $10, but the only loss the put buyer would take would be the amount paid for the premium. If the put buyer had actually shorted the stock instead of buying the put, he would lose $10 on every share. Although shorting was the wrong move to make on this stock, buying the put was a better move than shorting the stock itself since the loss was limited. Had the stock moved down, the put buyer would have made a much bigger percentage gain than if she had sold the stock. Selling a put without being short the stock is a naked put, described below.
Short – Being in a position where you hope the stock will fall to make you money. This is the opposite of being long. Examples are selling a stock you don’t own or buying a put.
Stock Option – Generally just referred to as an “option”. Think of options as the insurance premium on stocks. Some people sell insurance and others buy insurance. When you buy insurance you pay a premium, just like for your car insurance. When you sell insurance you collect the premium, just like an insurance company like State Farm or Geico. Buying an option is like buying protection against a stock (aka equity) moving in a direction, up or down, that is different than what you planned. Option sellers hope to collect premiums from the buyers while hoping not to have to pay out a claim in the event of an accident. Again, just like State Farm, they hope the buyers continue to pay their premiums and never cause an accident they have to cover for you. It’s worth it for the buyers to have piece of mind that in an accident their losses are limited. It’s worth it for the sellers if they have other premiums they are collecting that cover their losses on each accident. Options are sold in lots of 100 shares. So on call or put equals 100 shares of the stock. I believe options are the only way to enter stock positions. Sellers are helped by time value and buyers are helped with the ability to better leverage their positions without using margin. Options are the ultimate tool in leveraging your money.
Straddle – Buying (long) or selling (short) a call and a put on a stock or ETF at the same strike and expiration. A straddle buyer expects the stock to move big either way and hopes to have enough profit from the move to pay for the loss to the other side. A straddle seller expects the equity to stay flat and have enough profit from one side to offset the loss from the other leg.
Strangle – Buying (long) or selling (short) both a call and a put on the same stock or ETF with different strike prices and/or expirations.
Strike Price – The predetermined price that a stock will be sold or bought if the option expires in the money.
Stop – A predetermined price a trader is willing to sell a stock if it drops. For example, if a stock is trading at 40 and the owner wants to avoid missing a downturn, he could set up a stop to sell the stock if it hits 35. The risk with a stop is that a stock may dip to 35 (as in this example) and you sell based on the stop and then in the same hour it climbs again. I don’t like using stops, but have a friend who uses stops on all positions because he doesn’t have a job that lets him keep an eye on his positions every day.
Time Value – The amount of the premium that is based on the time remaining before expiration. Time value can be a key part an options seller’s profit.