Understanding Options Terminology – Part 1/2

Given the amount of information I would like to discuss, this part has been split into two sections to make it a manageable read.  Options terminology is important to understand because it will allow you to communicate and discuss options with fellow traders as well as brokers when placing/closing orders.

1.  Strike Price

The strike price is the price at which the option transaction occurs.  For example, a 55 call strike gives a buyer the right to purchase 100 shares of the underlying at $55/share.

2.  Option Expiration

Option contracts are only valid for a certain time period and when the contract expires, the option ceases to exist. Therefore, options expiration is the date on which the contracts expires.  There are weekly, monthly and even yearly options available and the expiration date for monthly/yearly equity options is the 3rd Friday of the given month.  For example, a Jan 10 monthly option would expire on the 3rd Friday (Jan 15th) in January 2010.

3. Intrinsic / Extrinsic Value

An options price is composed of both extrinsic and intrinsic value.  The intrinsic value is the “real” value contained within an option.  For example, when you buy a 55 call strike (expires in Dec 2010) for $6.50 with the underlying at $60, the option contains $5 of “real” value, while the remaining $1.50 is extrinsic value or “time” value (TV).

Intrinsic Value = “Real” Value                     Extrinsic Value = “Time” Value

Why is the concept of extrinsic/intrinsic value important?  Because @ expiration, options ONLY contain “real” value as all the time value evaporates by that point. Therefore, the concept of time value is really important because thats what you pay for when trading options.

Continue reading Understanding Options Terminology – Part 2/2.