Options Pricing: A Review of Basic Terms

When learning about options, it can be helpful to understand basic options pricing terms. Here's a review of basic option terminology. Use it as a reference throughout this tutorial. 

American Options – Options that can be exercised at any point during the life of the contract. Most exchange-traded options are American.

At-the-Money – An option whose strike price is equal to the market price of the underlying security.

Call – An option that gives the holder the right to buy the underlying security at a particular price for a specified, fixed period of time.

Contract – An option that represents 100 shares of an underlying stock.

Covered Call – An option strategy in which the writer of a call option holds a long position in the underlying security on a share-for-share basis.

Covered Put – An option in which the writer of a put option holds a short position in the underlying security on a share-for-share basis.

Covered Writer – An option seller who owns the option's underlying security as a hedge against the option.

Date – The date that an option becomes void. Most options expire at the close of business (4:00 p.m. ET) on the third Friday of the expiration month.

Derivative – An investment product that derives its value from an underlying asset. Options are derivatives.

Early Exercise – The exercise of an option before its expiration date. Early exercise can occur with American-style options.

European Options – An option that can only be exercised during a particular time period just before its expiration.

Holder – An investor who buys an option and makes a premium payment to the writer.

In-the-Money – An option that has an intrinsic value. A call option is considered in-the-money if the underlying security is higher than the strike price.

LEAPS (Long-term Equity Anticipation Securities) – LEAPS are publicly traded options that have expiration dates longer than one year.

Listed Option – A put or call option that is traded on an options exchange. The terms of the option, including strike price and expiration date, are standardized by the exchange.

Naked Option – An option position in which the writer of the option does not have an offsetting position in the underlying security, thereby having no protection against adverse prices moves.

Open Interest – The total number of outstanding option contracts in the exchange market on a particular day.

Option – A financial derivative that gives the holder the right, but not the obligation, to either buy or sell a fixed amount of a security or other financial asset at an agreed-upon price (the strike price) on or before a specified date.

Out-of-the-Money – An option with no intrinsic value, that would be worthless if it expired on that day. A call option is out-of-the-money when the strike price is higher than the market price of the underlying security. A put option is out-of-the-money when the strike price is lower than the market price of the underlying security.

Over-the-Counter – An option that is not traded over an exchange. An over-the-counter option has no standardization of strike prices and expiration dates.

Premium – The total cost of the option. An option holder pays a premium to the option writer in exchange for the right, but not the obligation, to exercise the option. In general, the option's premium is its intrinsic value combined with its time value.

Put – An option that gives the holder the right to sell the underlying security at a particular price for a specified, fixed period of time.

Strike Price – The agreed-upon price at which an option can be exercised. The strike price for a call option is the price at which the security can be bought (prior to the expiration date); the strike price for a put option is the price at which the security can be sold (before the expiration date). The strike price is sometimes called the exercise price.

Terms – The collective conditions of an options contract that define the strike price, expiration date and the underlying security.

Underlying Security – The security that is subject to being bought or sold upon the exercise of an option.

Writer – An investor who sells an option and who collects the premium payment from the buyer. Writers are obligated to buy or sell if the holder chooses to exercise the option.