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Defining Some Terms

If you are already familiar with options (what they are, what gives them value, the terms that describe them and how they are traded), you can probably skip this chapter. However, if you are uncertain about some of the terms or concepts, this chapter will probably answer your questions. We start with some basic definitions.

Call: a contract in which the buyer pays a premium for the right but not the obligation to buy the stock (usually 100 shares) at the exercise (or strike) price anytime until the expiration of the contact. (Calls are so named because the call buyer can “call” the stock from the option seller at the exercise price.)

Put: a contact in which the buyer pays a premium for the right but not the obligation to sell the stock (100 shares) at the exercise price anytime over the life of the option. (Puts are so named because the put buyer can “put” stock to the option seller at the exercise price.)

Premium: this is the price that the buyer pays for the call or for the put. An option premium consists of time value (basically an insurance premium) and, if the option is in-the-money, tangible value.

Tangible value: This is the amount that you get if you exercise the option. For a call, it is the difference between the stock price and the strike price if the stock is above the strike. For a put, it’s the difference between strike and the stock price if the strike is above the stock. Since you are not obliged to exercise an option if it is not profitable to do so, an option can never have negative tangible value.