Most investors are familiar with stocks and know the language associated with equity investing. But the world of options requires an understanding of a few more terms that may not be familiar to the ordinary investor.
First we shall start out with the basics:
1. Call Option is the right to buy 100 shares of stock for a fixed price during a fixed period of time. Note that owning a call option conveys a right to buy the stock but not an obligation. The holder of the option also has the choice to do nothing.
2. Put Option is the right to sell 100 shares of stock for a fixed price during a fixed period of time. . Note that owning a put option conveys a right to sell the stock but not an obligation. The holder of the option also has the choice to do nothing.
3. Strike Price is the fixed price at which one can buy or sell the shares covered by the option.
4. Option Exercise is the action an investor takes by buying the stock at the Strike Price via the call option. Alternatively if the investor held a put option he would exercise the put option by selling the stock at the Strike Price.
5. Expiration Date is the date on which the option expires and is no longer able to be exercised. Expiration Dates for most options are on the Saturday after the third Friday of the Month. Effectively this means that the last day to trade options is the third Friday of the month. There are exceptions to the third Friday rule, for example there are options that expire at the end of the quarter as well as other time frames.
6. 1 IBM March 100 call option: This is the right to buy 100 shares of IBM at the Strike Price of 100 per share anytime between now and the third Friday of March.
7. 1 IBM April 90 put option: This is the right to sell 100 shares of IBM at the Strike Price of 90 anytime between now and the third Friday of April.
8. Dividend treatment. Options do not pay or receive dividends that may occur on the underlying stock. Thus the option investor should be careful to factor this reality into his price decision. Most option calculator software takes dividends into account when evaluating the fair value for an option.
9. Black Sholes model. The Black Scholes model is considered the standard model for valuing options. It was derived by Professors Fisher Black and Myron Scholes – hence the name. Their derivation was based on solving a partial differential equation which describes a dynamic riskless arbitrage. Fortunately one does not have to know calculus to use the Black Scholes model.
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