Options Trading Terms and Lingo

Stock

A type of security (is generally a fungible, negotiable financial instrument representing financial value) that signifies ownership in a corporation and represents a claim on part of the corporation’s assets and earnings.

There are two main types of stock: common and preferred. Common stock usually entitles the owner to vote at shareholders’ meetings and to receive dividends. Preferred stock generally does not have voting rights, but has a higher claim on assets and earnings than the common shares. For example, owners of preferred stock receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated.

Also known as “shares” or ”equity”.

Investopedia explains Stock as a holder of stock (a shareholder) has a claim to a part of the corporation’s assets and earnings. In other words, a shareholder is an owner of a company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have claim to 10% of the company’s assets.

Stocks are the foundation of nearly every portfolio. Historically, they have outperformed most other investments over the long run.

Dividends

Payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses:

It can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

For a joint stock company, a dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. For the joint stock company, paying dividends is not an expense; rather, it is the division of after tax profits among shareholders.

Retained earnings (profits that have not been distributed as dividends) are shown in the shareholder equity section in the company’s balance sheet – the same as its issued share capital. Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from the fixed schedule dividends.

Understanding Options

An Option is a promise. A promise to buy or sell a security.

You can buy or sell a promise to buy or sell a security at a certain price on or before a certain date regardless of what the stock is selling for on the open market.

Call

An option giving the holder the right to buy the underlying security at a specified price for a certain, fixed period of time.

Put

An option granting the holder the right to sell the underlying security at a certain price for a specified period of time.

The price agreed on is called the “Strike Price.” The date agreed on is called “expiration.” A contract (promise) is then placed between the buyer and seller.

When the contract is placed, a “premium” is collected for the seller. The seller collects the cash immediately. Options come in bundles of 100 shares; this is the contract. You can buy or sell as many contracts as you can afford.

Call vs Put Scenario

If you sell a call, you are selling the promise to sell the stock. (it gets Called away) If you buy a call, you are buying that promise, and you have the “Option” of “exercising” it, if you wish.

If you sell a Put, you are selling the promise to buy the stock (it can be “Put” to you) or you can buy the Put and force the seller to buy it at the strike price, regardless of what the stock is selling for on the open market, if you wish. Only the seller has the obligation. The buyer has the Option. This is called an “Open” position.

Open

Open means the promise is live and in effect.

For example: if I “sell to open” the June 2011, IBM $50 Put, I have just “opened” a promise to buy IBM for $50 per share, anytime between now and the 3rd Friday in June 2011, as the buyer desires — and for that I collected a premium of $1.00 (per share).

I got paid $100 (there are 100 shares in the contract) and $5000 dollars of my money per contract sold goes into an escrow account, to be available (to “Cover” the promise) if the buyer decides to exercise the option and force me to buy 100 shares of IBM at $50 per share.

If I decide any time before the Buyer exercises the option, that I don’t want to do that anymore, I can “Buy to close” the position, and pay whatever the premium is at that time and close that position.

Closed

Closed means the promise is canceled.

The 3rd Friday of every month is “Options expiration Friday” and all options that expire that month, are either exercised or become worthless.

Terms we use for “Strike Prices”

There are 3 terms we use for options “Strike Prices”:

  • At The Money (ATM) – IBM @ $50 is “at the money.” The buyer will probably exercise the option if it is “At The Money”.
  • In The Money (ITM) – If IBM is trading at $49 or lower, the buyer of a Put will exercise his option and make at least $1 per share, minus the premium he paid for the option.
  • Out of the Money (OTM) – If IBM is trading for $51 per share or higher, the buyer is going to let the option expire worthless. If he did exercise the option and force me to buy it from him at $50 per share he would lose $1 per share or more, plus the premium he paid for the option.

In any case, the seller keeps the premium. Calls work the opposite way. (“Covered” just means you own the stock or have the Cash if we are talking about a Put). If you don’t own the stock or have the Cash, it would be called “Naked” and they only let really experienced traders do that. (I included it here, so you know what it means if you see it somewhere.) The most famous Option of all time is the “Covered Call.” Let’s say I already own 100 shares of IBM and it is trading at $50 per share. I can …

“Sell to Open”

“Sell to Open” (The) June 11 $55 Call for $1.00.

This means I promise to sell my IBM stocks for $55 any time before the 3rd Friday in June 2011, regardless of what the stock is selling for on the open market. Now ITM and OTM are the opposite of the Put example above; ATM “At The Money” stays the same. So if IBM is trading higher than $55, it is “In the Money” because my buyer can exercise the option, force me to sell it to him (“call it away from me”) for just $55 per share, and then he can sell it for an immediate profit.

If IBM is trading for less than $55, it is “Out of the Money” because why would he buy it for $55 per share from me, when he can buy it for less than that on the open market? So, I can sell another Covered Call next month, and basically collect “rent” for my stock when it trades “sideways,” which means the price does not move much.