Because this blog is primarily for option rookies, today’s post contains a glossary of many important terms used by option traders.
American style option – An option that may be exercised at any time before the option expires.
Assigned (an exercise notice) – Notification that the recipient is obligated to fulfill the conditions of the contract because the owner exercised his/her rights.
At-the-money – An option whose strike price equals (or is near) the price of the underlying asset.
Bear spread – A position consisting of two or more options on the same underlying asset, designed to earn a profit when the underlying stock declines.
Bull spread – A position consisting of two or more options on the same underlying, designed to earn a profit when the underlying stock rallies.
Butterfly spread – A position consisting of three different options (all calls or all puts) on the same underlying with the same expiration date. You construct a butterfly spread by buying one option, selling two options at a lower strike price and buying one option at a still lower strike price. The options sold are equidistant from the options bought.
Example: buy one Oct 50 call, sell two Oct 55 calls, buy one Oct 60 call.
Buy-Write Transaction – The simultaneous purchase of 100 shares of stock and sale of one call option.
Call – An option contract giving its owner the right to buy the underlying asset at the strike price for a limited time.
Cash settled – An option whose owner receives (and whose seller pays) the intrinsic value of the option – at expiration.
Covered Call – A short (i.e., sold) call option backed by an equivalent number of shares. Long 100 shares, short one call.
Credit spread – A position consisting of two calls or two puts on the same underlying and with the same expiration date in which the option with a higher premium is sold and the option with a lower premium is bought, resulting in the trader collecting a cash credit.
Debit spread – A position consisting of two calls or two puts on the same underlying and with the same expiration date in which an option with a higher premium is bought and an option with a lower premium is sold, resulting in the trader paying a debit.
European style option – An option that may be exercised at expiration (also referred to as “settlement”), and not earlier. It is cash-settled and no shares are exchanged.
Exercise – The election by the owner of an option to do what the option contract allows: either buy or sell the underlying at the strike price.
Exercise Notice – The means by which an investor is notified that the option
owner has exercised the contract. Also known as an assignment.
Expiration – The time, after which, the option is no longer a valid contract. For most stock options, it is the 3rd Friday of the specified month. However, many options expire on a weekly basis (i.e., expiration is the specified Friday. Some index options expire on Wednesday. Be aware that some options expire at the close of business (PM settled) while others have an expiration time that coincides with the morning opening prices (AM settled).
Expire Worthless – When an option is not exercised by the time that expiration arrives.
Hedge – An investment made to reduce the risk of holding another investment.
Historical Volatility – The past volatility of a stock over a specified pereiod of time. HV is a a property of the underlying stock and not of the option.
Implied Volatility – The volatility that, when inserted into the equation for calculating the theoretical value of an option, makes the theoretical value equal to the market price of the option. Implied volatility is a property of the option, not the stock.
In-the-money – A call option with a strike price lower than the underlying price, or a put option with a strike price higher than the underlying price. An option with an intrinsic value greater than zero.
Intrinsic Value – The amount by which the stock price exceeds the strike price
of a call option, or is below the strike price of a put option.
Iron Condor – A combination built by selling one call credit spread and one put credit spread on the same underlying. All options expire at the same time. In addition, the distance between the two calls equals the distance between the two puts.
Buy Nov60 call, sell Nov 50 call. Also sell Nov55 put and buy Nov45 put.
LEAPS – Acronym for Long Term Equity AnticiPation Series. These are Puts and calls with a January expiration. The expirate more than eight, and less than 36, months in the future.
NOTE: the acronym is always capitalized and the singular form is LEAPS, not LEAP or leap.
Leg – One part of a spread position
Long – A position resulting from ownership.
Margin – The amount that must be deposited into an account in the form of cash or eligible securities. The deposit is required to protect the broker against the risk of loss. NOTE: This limits the broker’s exposure to a loss; not your exposure.
Margin Account – An account in which an investor can (but is not required to) buy securities on credit, using other securities held in the account as collateral. The needed cash is borrowed from the broker and interest is charged. A margin account is required for all options trades.
Obligations – Attributes forced upon the seller of an option.
Offsetting – Moving in the opposite direction. A position acting as a hedge.
Option – A legal contract that gives its owner the right, but not the obligation, to buy or sell a specified asset at a specified price (strike price) for a specified time (until expiration).
Options Clearing Corporation (OCC) – an organization that keeps records for
every outstanding option contract. When someone exercises an option, the OCC verifies that the person has the right to exercise. The OCC then randomly assigns an exercise notice to a broker who then assigns (randomly) it to one of the accounts that is currently short the option.
Optionspeak – My term for the language of options.
Out-of-the-money – A call option with a strike price higher than the price of the underlying, or a put option with a strike price lower than that of the underlying asset. An option with no intrinsic value.
Premium – The price of an option. It is the sum of the intrinsic value (if any) and the time value.
Put – An option contract giving its owner the right to sell the underlying asset at the strike price for a specified time.
Rights – Attributes given to the owner of an option.
Rolling a Position – The process of buying to cover a previously sold option, and selling a different option with a more distant expiration. It is often done near expiration as a method for reducing current risk.
Series – a specific option, with a specific strike and expiration. ex: JNJ OCT70 put
Short – The position resulting from selling an asset that is not owned. There is a future obligation to repurchase — unless it is an option that expires worthless.
Spread – Two simultaneous trades in which you buy one option and sell another. The underlying is the same for both options, but the expiration may vary.
Spread Transaction – A simultaneous options trade consisting of 2 (or more) legs. The legs are such they they partially offset each other. A hedged position.
Standard Deviation – A statistic describing how closely data points are distributed around the average of those data points
Straddle – A position consisting of one call and one put on the same underlying stock or index. Both options have the same strike price and expiration.The straddle is long when the options are bought and short when when the options are sold.
Strangle – Similar to a straddle, but the call and put options have different strike prices.
Strike Price – The price at which an option owner can buy or sell the underlying asset.
Theoretical Value (Fair value) – The price an option is worth, based on a mathematical calculation and some assumptions. In the real world, the actual price usually differs from the fair price.
Time Spread (Calendar spread) – A position in which one option is bought and another sold – both with the same strike price and underlying, but with a different expiration.
Time Value – The part of the option premium derived from the volatility and the
time remaining until expiration. It is the part of the option premium that is NOT intrinsic value.
Uncovered Call – A call option that is sold when the trader does not own the underlying. Also called a naked call.
Underlying – The asset from which the option derives its value and which the call owner may buy, or the put owner may sell.
Volatility – A measure of the price change of a stock over time.
Write – Sell.