Trading Option Basics FAQ
Here are some of the frequently asked questions and our answers about trading option basics.
Q: What is a stock option?
A: A stock option is a contract that gives the owner the right, but not the obligation, to buy or sell a particular financial instrument (stock) at a fixed price (the strike price) for a specific period of time (the expiration date). The contract also obligates the seller or writer to meet the terms of delivery if the owner exercises the right granted by this contract.
Q: What is a call?
A: A call is an option contract that gives the owner the right to buy the underlying financial instrument (stock) at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For example, an ABC Company August 60 call entitles the buyer to purchase 100 shares of ABC stock at $60 per share at any time prior to the option's expiration date in August. For a call option writer, or seller, the contract represents an obligation to sell the underlying financial instrument (stock) if the option is assigned.
Q: What is a put?
A: A put is an option contract that gives the owner the right to sell the underlying financial instrument (stock) at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For example, an XYZ Company August 50 put entitles the owner to sell 100 shares of XYZ stock at $50 per share at any time prior to the option's expiration date in August. For the writer, or seller, of a put option, the contract represents an obligation to buy the underlying stock from the option owner if the option is assigned.
Q: What is a strike price?
A: The price at which the owner of an option can purchase (call) or sell (put) the underlying stock. Used interchangeably with exercise price.
Q: What do "Buy to Open" and "Sell to Close” mean?
A: “Buy to Open” means that an investor has no previous position in a specific option contract, so you as the investor are buying an option contract to open your position. Conversely, should an investor wish to close or exit an existing position that was purchased, that investor would be selling his contract to close that position.
Q: What is the Bid / Ask spread?
A: The Bid is the current price the market is willing to pay to buy an option you are trying to sell. The Ask is the current price the market is willing to sell an option you are trying to buy. The spread is the difference between these two prices and represents the difference between what you can buy an option for and what you can sell that same option for. The represents the margin earned by the market maker for providing liquidity to that market. Often, the tighter the spread, the more liquid a market is. For example: a Bid 1.00 Ask 1.05 is tighter (or more liquid) than a Bid 1.00 Ask 1.10.
Q: What does liquidity mean?
A: Liquidity refers to the availability of stock near the last sale price. When the bid-ask on an option is wider than "normal," it usually means that the market-makers are not sure where they can reliably buy or sell shares of the underlying stock to hedge possible option transactions. Sometimes that means that the stock is more volatile, but not always. It is possible, for example, to have a volatile stock that is very liquid, meaning that there are usually lots of stock shares to buy or sell at prices near the last sale. In that case, the options' bid-ask would most likely be narrow. When the market in an option is narrow, it may mean that shares of the underlying stock can either be bought or sold in quantity near the last sale price or the option itself has a lot of buyers and sellers near the last sale price of the option. Usually if an option is liquid, the underlying stock is also liquid.
Q: What is the difference between volume and open interest?
A: Volume is the number of contracts of a particular option contract that have traded on a given day, similar to it meaning the number of shares traded on a particular stock on a given day. Open interest is the number of option contracts for a particular stock at a specific strike price and a specific expiration date that were open at the close of trading on the prior trading day. While some traders look at this information as an indication of liquidity of a particular option or option chain, a more reliable indicator may be the tightness of the bid / ask spread.
Q: What does the term "delta" mean?
A: A measure of the rate of change in an option's theoretical value for a one-unit change in the price of the underlying stock.
For example, if the delta of a Call option is 50 (or .50 to be more precise), for each one point move in the stock, the expected movement of the option would be a half point - or 50%.(The deltas for Put options are negative percentages since their price movement is in the opposite direction from the underlying security.)
Q: What is volatility?
A: Volatility represents the standard deviation of day-to-day price changes in a security expressed as an annualized percentage. Two measures of volatility are commonly used in options trading: historical and implied. Historical volatility represents the degree of price change in an underlying security observed over a specified period of time using standard statistical measures. It is not a forecast of future volatility. Implied volatility is the market's prediction of expected volatility, which is indirectly calculated from current options prices using an option-pricing model.
Q: What is the meaning of "skew" as it relates to options trading?
A: The basic idea behind skew is that options with different strike prices and different expirations tend to trade at different implied volatilities. When implied volatilities for options with the same expiration are plotted, the graph resembles a smile, with at-the-money volatility in the middle and out-of-the-money options forming the gently-rising sides. As options go into the money they gradually approach their intrinsic value, and an option trading at its intrinsic value has an implied volatility of zero, so for our graph we use call prices for strikes above the current underlying stock price and put prices for strikes below the current underlying stock price.
Q: How do LEAPS differ from conventional options?
A: LEAPS or Long-term Equity AnticiPation Securities are options, both calls and puts, with expirations as far out as two and one-half years. Conventional options typically present contracts with expirations up to nine months in the future. Equity LEAPS normally will have two series at any time with January expirations.
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