Terminology Recap and Moneyness

TERMINOLOGY  RECAP

Options, like other contracts, have specific terms and we need to have a clear understanding of them before we advance into more complex concepts. Here is a recap of the most important terms in an options contract;

Option type:

· All exchange-listed options are one of two types: calls or puts.

· A call option gives you the right to its owner to purchase a specified quantity of the underlying stock, at a predetermined price, for a predetermined amount of time.

· A put option gives you the right to sell a specified quantity of the underlying stock, at a predetermined price, for a predetermined amount of time. Both calls and puts are traded on each underlying stock.

Option style:

The most important styles of Exchange-listed options refer to when their holders can exercise them. Here are the two most important ones;

American-style: The options may be exercised on any business day before its expiration date. Currently, all equity options in the U.S., including those we will be discussing in this course, have this American-style exercise feature.

European-style option contracts have a slightly different exercise feature. These options may be exercised only during a specific period of time, usually just before the option expires.

Underlying security:

An equity option’s underlying security is the stock that will change hands when the option is exercised. An option is classified as a derivative security because its value is derived from the value of this underlying stock listed and traded on a U.S. stock exchange.

Unit of trade:

An option’s unit of trade also called the contract size, is simply the number of shares that change hands when the holder chooses to exercise the contract. Generally, this unit is a standardized 100 shares of the option’s underlying stock.

Exercise (strike) price:

Is simply the price per share at which the option holder or writer has the right or obligation to either purchase or sell shares of the underlying stock. These prices and the intervals between them have been standardized by the exchanges trading options.

Expiration date

American-style option contracts have a specific lifetime during which their owners may exercise them and have standardized expiration dates. Each option listed on a U.S. exchange has a particular month during which it expires. Most options that expire in a given month usually expire on the third Friday of the month. To an investor, this third Friday is a significant date. It is on this day that equity options last trade, and on which an option may be exercised by its owner.

Moneyness Recap

All equity options may be classified as being in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). These terms refer to a particular option’s exercise price in relation to its current underlying stock price.

So the question is, why would an option contract be considered in-the-money?

The term suggests that there would be some benefit in exercising such an option at that moment. An option can be considered in-the-money because the owner who exercises it would pay or receive a better price (the Strike price) than by actually buying or selling shares of underlying stock outright in the stock market at the time.