Key Terms & Phrases
In this final part of our introduction to options trading we explain a number of the key terms and phrases that are used. These are terms that aren't specifically covered in other parts of the site, but are important enough that you need to understand what they are and what they mean.
Some of these terms are relatively straightforward, and we have described these on this page, while others are a bit more complicated. We have linked to specific articles explaining them. For a complete list of the terminology that's used in options trading, you can refer to our Glossary of Terms. The following terms and phrases are all covered in detail on this page:
- Liquidity & Volume
- Bull Markets & Bear Markets
- Fundamental Analysis & Technical Analysis
- Contract Size
- Options Tables & Options Chains
- Time Decay
- Options Premium
- Options Symbols
Liquidity & Volume
Volume in options trading is a very simple; it basically refers to the number of transactions being made that involve a particular contract. If a specific contract is being heavily traded i.e. bought and sold many times throughout the course of a trading day, then it's said to have a high volume. If there are very few transactions involving a specific contract, then it's said to have a low volume.
The trading volume of a contract is important, because it affects the liquidity. It isn't the only factor that affects it, but it does play a significant part and, as with any form of investment, liquidity is definitely something that you should be considering when trading options. The liquidity of an option is a measure of how easily it can be traded at the market price; high liquid means it can be readily bought or sold.
Ideally you want to be trading contracts that have a high liquidity, for a number of reasons. First, the bid ask spread on highly liquid contracts will usually be much smaller than those with low liquidity, and a small bid ask spread will ultimately save you money. You can also be confident that any order you place for liquid contracts is likely to be filled quickly and very close to the market price. While if you are trying to sell contracts that aren't very liquid you may struggle to find a buyer.
Bull Markets & Bear Markets
The terms bull market and bear market are often used in most forms of investment, and relate to what's happening to the price of securities, or expected to happen. When a financial market is experiencing rising prices, or is expected to, it's said to be a bull market. When a financial market is experiencing falling prices, or is expected, it's said to be a bear market.
Whether there is a bull market or a bear market obviously affects what kind of investment, if any, you make. It's particularly relevant in options trading as many strategies are specifically for use in certain market conditions. A strategy that might work well in a bear market, for example, wouldn't necessarily be suitable in a bull market.
Fundamental Analysis & Technical Analysis
Fundamental analysis and technical analysis are the two most widely used forms of analysis that investors can use to decide what investments to make. Their terms are commonly used when talking about buying stocks, but both fundamental analysis and technical analysis for trading any kind of financial instrument, including options.
In very simple terms, fundamental analysis is about carrying out research securities to establish their inherent value. For example, you could use fundamental analysis to determine whether a particular stock is overvalued or undervalued by thoroughly researching the company. Its financial strength and any advantages or disadvantages they have in their industry are things to look out for.
Technical analysis is more about studying past performance and looking for trends and patterns that may exist in the price of a particular security. Technical analysts typically presents that all the factors that affect the price of a security are already factored into the market price, and it's more beneficial to look for patterns and trends that might suggest future price momentum.
Both forms of analysis have their advantages and disadvantages, and it's largely a matter of personal preference as to which might be better for you.
A common misconception among beginner options traders is that one contract is based on one unit or share of the underlying asset. However, most options contracts actually cover multiple units of the underlying asset; for example, a call options contract based on stock in Company X may give you the right to purchase 100 shares in Company X.
The amount of the underlying asset that's covered by a contract is known as the contract size, and is typically 100. You should be aware that the contract size affects how much you pay for it. For example, if an options contract is quoted on the exchanges at $2 and the contract size is 100, then one contract would actually cost $200 (100 x $2).
In simple terms, the moneyness of an options contract defines the relationship between the strike price of that contract and the current price of the underlying security. The moneyness of a contract can be described as being in one of the three states: in the money, at the money and out of the money.
The price of a contract is closely related to its state of moneyness, and moneyness is also relevant to most trading strategies. As such, it's a concept that you should be familiar with and you can read more on the following page: Moneyness.
The use of leverage in options trading is one of the biggest advantages of this form of trading. In very simple terms, leverage is basically when you multiply the power of your starting capital to increase the size of your potential profits. Because of the way options work, they can easily be used to effectively invest in a larger number of stocks, or other underlying security, than you would be able to by actually buying the underlying security.
We explain leverage in more detail on the following page – Leverage.
The use of margin in investment is something of a complicated subject, not because the word has a number of different meanings and can be used differently depending on what form of investment you are making. This often leads to confusion among investors, particularly relatively inexperienced ones, and people often misunderstand what margin means in options trading.
You can read more about this particular subject on the following page: Margin.
Options Tables & Options Chains
Reading options tables is an important part of trading, because this is how you get the relevant information regarding various different contracts. There are actually a number of different ways in which this information, which includes the price, can be displayed but it's usually in the form of a table. Such tables are referred to commonly as either options tables or options chains.
For more information on this aspect of trading please read the following page: Options Tables & Options Chains.
Time decay refers to how the extrinsic value of a contract will diminish as the expiration date gets closer. The effect of time decay can significantly impact the returns you make when trading, so it's a concept that you really need to understand. You find out more about this subject on the following page: Time Decay.
Options premium is a term that often gets misused, even by experienced investors. It has been so widely used to mean different things that it's now basically accepted that the term has more than one meaning. It can be used to refer to the price paid for an options contract, or the extrinsic value component of that price, of the amount received by the writer of the contract.
For further clarification on this subject, please refer to the following page: Options Premium.
An options symbol is essentially the name of an option; it's the string of characters that's used to represent specific contracts, in the same way that characters are used to represent specific stocks on the stock market. An options symbol is usually five characters long, with the first three defining the underlying security. The fourth character defines the expiration month of the contract and the fifth relates to the strike price.