Options Terminology Part 2

The time has now come to cover some more options terminology.

UNDERLYING:

The Commodity, or Stock or whatever “thing” that the trader wants to trade in on which the Option is written. Remember the Option is an Insurance Contract and gets written on a specific trading instrument. The underlying is the trading instrument on which the contract is concluded.


CALL OPTION:

Gives the buyer of the option the right, the option, the choice to BUY the underlying at the strike price, on or before the option expiry date, provided that the underlying trades at a price higher than the strike price.


PUT OPTION:

Gives the buyer of the option the right, the option, the choice to SELL the underlying at the strike price, on or before the option expiry date, provided the underlying trades at a price lower than the strike price


STRIKE PRICE:

The price agreed upon when the Option was written. Note that you may buy an option at any strike price you like (however it is regulated, every commodity has a certain interval over which there are option strike prices available e.g. every $5 interval, $1 or even $0.50 intervals, depending on which instrument you are looking at).


EXPIRY DATE:

A pre-determined date upon which the Option contract will expire. On the expiry date, all options for which the underlying trades, at a price exceeding the strike price (above the strike price for a Call Option or below the strike price for a Put Option) will be exercised automatically by the Exchange. After that, the Option expires.


EXERCISE:

The action of executing the right that the option contract gives the owner of the contract. Only the owner (the person that bought the Option, who is Long the Option) can choose to exercise the option. For a Call Option, the owner will Buy (Long) the underlying at the strike price. The seller of the option (person who sold the option, who is short the option) has no choice in this, he is under obligation and will be given a Short position in the underlying.

For a Put Option, the owner (long the option) will Short the underlying at the strike price. The person short the Option has no choice in this matter and will be given a Long position in the underlying futures at the strike price.


BEING ASSIGNED AN EXERCISE:

Only the owner of the option (the person who bought the option) can decide to exercise the option if he wants to exercise and when he wants to exercise – provided that he is able to (the price of the market needs to have exceeded the strike price). The person at the other end of the transaction is at the mercy of the option owner. When the owner does decide to exercise an option (his right), the other party – the party that has written the option – has no choice, they gave the guarantee.

At this point, the option writer will just get an unfavourable position in the underlying market. When this happens we say that you are being “assigned and exercise” – it is the action of being assigned the opposite position in the underlying market than the position the person who exercised the option was given.

(Note: There is nothing sinister or scary about it, the option writer knows prices are exceeding the strike price, he knows it is going to happen sooner or later and he is on the lookout for when this happens. Most of the time it will only happen on the last day, after the close of trade on that day – traders do not normally exercise options, they wait for the Exchange to do it on their behalf, by default on the last day).