Learn the Terminology to Avoid Confusion
Someone who wants to lean how to trade options or futures must first understand the options and futures terminology. These two trading markets are quite different from trading or investing in stocks and bonds and use their own sets of jargon and terms. Before diving into some training seminars and setting up a practice trading account the prospective trader should understand the basic terminology.
Terminology for Trading Options
Option contracts give the option holder the right to buy or sell the underlying security at a specific price. There are two types of option contracts: puts and calls. The most well know options trading is for contracts on stocks and ETFs. Standardized option trading is also available using market indexes and futures contracts as the underlying asset. To start, this article will stick to stock options.
Call Options: Call options give the contract holder the right to buy the underlying stock at a set price up until a certain date. Call options will generally increase in value of the underlying stock price goes up. Each stock option contract is for 100 shares of the underlying stock and the option value is 100 times the quoted price.
Put Options: A put option contract gives the contract holder the right to sell 100 shares of the underlying stock at a set price. Put option contracts will increase in value when the underlying stock declines in price.
Strike Price: The strike price is the price of the underlying at which a contract will be exercised. If trader holds a call option on IBM with a strike price of $100, the trader can exercise the contract and buy 100 shares of IBM for $100. If the market value of IBM is $120, the trader will still buy the shares for $100 and have an instant profit of $20 per share.
Expiration Date: All option contracts are valid for a limited period of time, ranging from a few days up to two years. Each contract will be listed with a specific expiration month. Stock options expire on the Saturday following the third Friday of the expiration month.
ATM, ITM, OTM: These acronyms stand for at-the-money, in-the-money and out-of-the-money. The terms refer to the underlying stock price in relation to the strike price of an option contract. A call option is ITM if the underlying stock is above the strike price and a put option is ITM if the stock is below the strike price. Call options are OTM if the stock is below the strike and puts are OTM if the stock is above the contract’s strike price. If the strike price and underlying stock price are the same, an option is ATM.
Premium: The premium is the cost or price of an option contract. An option premium can consist of two values: intrinsic value and time premium. Intrinsic value is the amount an option is in the money. If IBM is at $101 and a call contract has a strike of $100, the contract has the intrinsic value of $1.00. Time premium is any value of a contract that is not intrinsic value. If the IBM call option has a price of $2.00, the other dollar of value is time premium. OTM and ATM options have prices that consist entirely of time premium.
Long and Short: Option traders can open a trading position by either buying or selling contracts. An option buyer is said to be long the purchased contracts. The long trader pays the premium for the contracts and has the right to exercise the long positions. A trader goes short by selling option contracts and collecting the premium. The short trader must be ready to deliver the underlying stock–call options–or buy the underlying stock–put options–if the individual on the other side of the trade–the long position–elects to exercise the contracts.
Combinations: Because options on each stock are available in a wide range of strike prices and expiration dates, traders use combinations of options to set up specific trading strategies. These strategies go by names like bull spreads, bear spreads, calender spreads, butterfly spreads, condors and collars.
Terminology for Trading Futures
Futures contracts trade on the futures and commodities markets and let traders take positions in a wide range of commodity and financial values. Popular futures contracts trade on grains, food products, energy products, interest rates, stock market indexes and foreign currencies. Futures trading has its own set of terminology.
Standardized contracts: The futures markets use standard sized contracts for each product that trades. Individual contracts have a specific size or value. As examples, a corn futures contract is for 5,000 bushels of corn; a crude oil contract is for 1,000 barrels of oil; a S&P 500 futures contract is worth $250 times the S&P 500 stock index and a Treasury bond futures contract is for $1 million of Treasury bonds. Trading is done in numbers of contracts.
Margin Deposits: Futures traders do not have to put up the full price for a 1,000 barrels of oil or a million dollars worth of Treasury bonds. The futures markets require traders put up a margin deposit for each contract traded. The margin deposits are set by the commodity exchanges and are typically 5 to 10 percent of the contract’s value. For example, with oil at $75 a barrel, the light, sweet crude contract is worth $75,000 and the margin deposit would be about $5,000.
Long or Short: Futures traders and open trading positions with a buy or long order if they believe the future will increase in value or a sell or short position to provide from falling futures values. There is no difference in margin requirements or exchange rules to go long or short. Traders can close out their positions by entering a offsetting trade; selling short to close a long position or a long trade to close a short position.
Tick Size: Each different futures contract has a minimum price change for the contract. This min value change is called a tick, and is used by traders to measure profits and losses. For light, sweet crude the minimum price change is a penny, so on a 1,000 barrels a tick is worth $10.00 per contract. For S&P 500 contracts, the min price change is 0.10 and a tick is worth $25.
Expiration Dates: Future contracts are available with a wide range of contract months, out to years in the future for some commodities. The most liquid trading is available in the near month futures and traders will use the near month contracts and roll out to the next contract when expiration nears. The longer term contracts are used more by commodity producers to lock in prices for their production.
E-Mini Contracts: The futures exchanges have introduced a range of e-mini futures contracts that trade against the most popular commodities and indexes. These contracts only trade electronically and have smaller contract sizes and margin deposits. Individual traders often prefer the e-mini contracts because they can trade with smaller sized trading accounts.
optionseducation.org Getting Started in Options: https://www.optionseducation.org/basics/default.jsp
CME Group: https://www.cmegroup.com/