Options Terminology

Options Terminology

Options can be either calls or puts, American or European, long or short. So what is
the difference?

A call option gives the owner (taker) the right but not obligation to buy an underlying good at a specified price for a specified time from the seller (writer), a put option gives the owner (taker) the right but not obligation to sell an underlying good at a specified price for a specified time from the seller (writer).

The aforementioned specified price at which the owner of the option contract can purchase/sell the underlying good is known as the exercise (or strike) price. Of course, this right to buy or sell does not come free of charge. Option contracts come with a price attached, this price is known as the option premium (or risk premium).

The life of an option is simply the difference between the time of purchase and the expiration (termination) date - which is agreed upon at the time of purchase.

Moneyness is an option concept that is as important as the word is awkward. It refers to the potential profit or loss from the immediate exercise of an option. An option may be in-the-money, out-of-the-money or at-the-money. A call (put) option is in-the-money if the price of the underlying good exceeds (is less than) the exercise price. A call (put) option is out-of-the-money if the price of the underlying good is less than (exceeds) the exercise price. A call (put) option is in-the-money if the price of the underlying good is equal the exercise price.

There are two fundamental kinds of options: the American option and the European option. American options permits the owner to exercise at any time before or at expiration. The owner of a European option can exercise only at expiration. Thus, the two types of options differ since the American option permits early exercise.

To this point, we have considered option values only at expiration. If the option is at expiration, American and European options will have the same value. Both can be exercised immediately or be allowed to expire worthless. Prior to expiration, we will see that the two options are conceptually distinct. Further, they may have different values under certain circumstances.