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Lesson Introduction to options trading
Options terminology
Get familiar with options terminology with this handy reference guide.
While trading options, there are some key terms or phrases to remember. Check out the section below for some simplified explanations of these complex terms, listed from A-Z:
Assign(ment)
When a seller fulfills the obligations of the option contract if the buyer of the option exercises their rights.
Depending on if the option is a Call or a Put, this may involve buying shares (also known as ‘taking delivery’), or selling shares (sometimes referred to as “called away”).
At-the-money
When the option’s strike price is identical to the current price per share of the underlying asset.
Buy-to-Open (BTO)
The act of buying a call or a put that you have not previously sold (also referred to as taking the Long position).
Buy-to-Close (BTC)
The act of buying a call or a put that you have sold previously. Since you have “closed” the option contract by buying it (back), you realize any gains/losses, and no longer have obligations to buy or sell the stock.
Delta
A ratio that compares the change in price of the underlying asset to the change in price of the option contract. Call options have a positive Delta, and Put options have a negative delta.
For example: If a Call option has a delta of 0.65, this means that if the underlying stock increases by $1 a share, the call option will rise by $0.65 per contract. (Everything else being equal) If a Put option has a delta of -0.45, and the underlying decreases by $1 a share, the put option’s market value will rise by $0.45.
Expiration
The date when an option contract expires. If the option is OTM, it will become worthless and cannot be exercised after the end of the trading day on expiration day.
If the option is ITM, or ATM, it may be automatically exercised by the relevant clearing corporation, or counterparty. Please check out the last section of this article, and our Options FAQ below for more details on what happens during expiration day.
Extrinsic value
The difference between an option’s market price, and it’s intrinsic value.
Gamma
Gamma is a derivative of the Delta. This measures the change of the option’s delta resulting from a change to the underlying stock price.
Gamma is greatest when the option is at-the-money, and decreases the further away the option is from being either in-the-money, or at-the-money.
The calculation of gamma is fairly complex and requires complex spreadsheets or software to find it’s value, but let’s show an approximate example.
Example: You have a call option with a delta of 0.4, if the underlying increases by $1, the option will increase in value by $0.40, and it’s delta will also change after this price move on the underlying. After the $1 increase let’s assume the option’s delta is now 0.53. The 0.13 difference between the “first” and “second” delta can be considered an approximate value for Gamma.
In-the-money (ITM)
When the option contract has a positive value if exercised.
Intrinsic value
The difference between the price per share of the underlying stock and the strike price of an option. In-the-money is the term used when the intrinsic value is positive.
Implied volatility
The estimated expected volatility of the underlying security’s price, shown as a percentage. A higher volatility means a more unstable security price that “swings” from highs to lows more frequently.
Long
A term that refers to ownership of securities. For example, if you are long 100 shares of XYZ, this means you own 100 shares of XYZ company. Likewise if you are long a Call option, this means you have bought the option, and acquired the rights to exercise.
Out-of-the-money
When the option has no intrinsic value, and is generally not exercised.
Open interest
How many options contacts have been created at this strike price and expiration date. Since options are created by sellers in the open market, some strike prices and expirations may have more contracts “out there in the wild” compared to less popular strike prices or expiration dates. Generally speaking, options with low open interest have very wide bid-ask spreads, and lower volume.
Premium
The amount per share the option buyer pays to the option seller to purchase the option contract. Alternatively, this is the amount the seller receives from the buyer of the option.
Rho
Measures the rate of change of an option’s price resulting from a change in the risk-free interest rate. Rho measures the ‘sensitivity’ of an options contract relative to a change in the risk-free interest rate.
For example: If an option has a Rho of 1.0, then for every 1 percentage increase in the risk-free interest rate, the value of the option would increase by 1%. Options that are most sensitive to interest rate changes from the central banks are those that are at-the-money, and with the longest time to expiration.
Rolling (over, up, or down)
Rolling an option refers to closing an existing position, while opening a new position on the same underlying asset. Sometimes the new option will have the same strike price but a different expiry, or a different expiry, but the same strike price, or any combination of these.
Generally “over” refers to the same strike price, but a longer-dated expiry, while “up/down” refer to a different strike price, but the same expiry.
For example: Frank sells his XYZ Sep 10th $120 Call, and “rolls it over” by simultaneously buying a XYZ Oct 12th $120 Call. He is realizing the gain/loss on his original option, and using it to purchase the same option, but expiring one month later.
Sell-to-Open (STO)
The act of selling a call or a put that you didn’t previously own. Also known as writing an option (or taking the Short position).
Sell-to-Close (STC)
The act of selling a call or a put that you bought previously. Since you have “closed” the option contract by selling it, you realize any gains/losses, and no longer have rights to buy or sell the stock.
Short
The act of selling a stock or option that you do not own. Read all about the basics in our short selling article. Someone who is short an option is the original seller of the contract, and has taken on the obligations of the contract if assigned by the buyer.
Strike (price)
The price at which the owner of an option can purchase, or sell the underlying security if the contract is exercised.
Time value
The difference between an option’s premium and its intrinsic value.
Theta
Measures the daily rate of decline in an options contract due to the passage of time. This is also known as the measurement of “time decay”. The further away in time you are from expiry, the more “time-value” an option will have.
For example: If the theta is -0.05, the option contract’s price will decline by $0.05 each day.
Vega
Vega is the measurement of an option’s price sensitivity compared to changes in the volatility of the underlying asset. As the volatility of the underlying asset increases, so does the value of the option. Vega is the change in the option’s price compared to every 1% change in volatility.
For example: If the value of an option is $7.50, implied volatility is at 20%, and the option has a Vega of 0.12. If the Implied volatility moved from 20% to 21.5%, this is a 1.5% volatility increase. Therefore the option’s value will increase by 1.5(Vol) * 0.12(vega) to $7.68.
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