Option Basics - Calls, Puts, and Payoffs › Key Option Terminology

Before diving into payoffs and pricing, you need a precise vocabulary for discussing options. The following terms appear throughout derivatives literature and trading platforms.

The essential parameters that define an option contract are:

• Underlying asset: The security or instrument on which the option is based. For equity options, this is typically 100 shares of stock per contract.
• Strike price (K): The fixed price at which the underlying can be bought (call) or sold (put) upon exercise. Also called the exercise price.
• Expiration date (T): The last date on which the option can be exercised. After expiration, the option ceases to exist.
• Premium: The price paid by you to acquire the option. This is determined by supply and demand in the market.
• Contract multiplier: The number of units of the underlying per contract. For standard equity options, this is 100 shares.

Options differ in when they can be exercised:

• European style: Can only be exercised at expiration. Most index options and options on futures are European.
• American style: Can be exercised at any time up to and including expiration. Most equity options on individual stocks are American.
• Bermudan style: Can be exercised on specific dates before expiration, typically monthly or quarterly. Common in interest rate markets.

For European options, the exercise decision is simple: exercise if and only if the option is profitable to exercise at expiration. American options add complexity because early exercise may sometimes be optimal, particularly for deep in-the-money puts or calls on dividend-paying stocks. We'll focus primarily on European options in this chapter, as they're simpler to analyze and their pricing forms the foundation for understanding American options.