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Options Trading Strategy Guide: Glossary

Have a question about an options trading or financial term? This is the place to look! Dive in...

A

ADJUSTED STRIKE PRICE

Strike price of an option, created as the result of a special event such as stock split or a stock dividend. The adjusted strike price can differ from the regular intervals prescribed for strike prices.

ADJUSTING

A dynamic trading process by which a floor trader with a spread position buys or sells options or stock to maintain the delta neutrality of the position. See DELTA

ALL OR NONE (AON) ORDER

A type of order that specifies that the order can only be activated if the full order will be filled. A term used more in securities markets than futures markets.

AMERICAN STYLE OPTION

A call or put option contract that can be exercised at any time before the expiration of the contract.

ARBITRAGE

A trading technique that involves the simultaneous purchase and sale of identical assets or of equivalent assets in two different markets with the intent of profiting by the price discrepancy.

ASK, ASKED PRICE

This is the price that the trader making the price is willing to sell an option or security.

ASSIGNMENT

Notification by Stock Exchange Clearing to a clearing member and the writer of an option that an owner of the option has exercised the option and that the terms of settlement must be met. Assignments are made on a random basis by the Stock Exchange Clearing. The writer of a call option is obligated to sell the underlying asset at the strike price of the call option; the writer of a put option is obligated to buy the underlying at the strike price of the put option.

AT PRICE

When you enter a prospective trade into a trade parameter, the "At Price" (At.Pr) is automatically computed and displayed. It is the price at which the program expects you can actually execute the trade, taking into account "slippage" and the current Bid/Ask, if available.

AT-THE-MONEY (ATM)

An at-the-money option is one whose strike price is equal to (or, in practice, very close to) the current price of the underlying.

AVERAGING DOWN

Buying more of a stock or an option at a lower price than the original purchase so as to reduce the average cost.

B

BACKSPREAD

A Delta-neutral spread composed of more long options than short options on the same underlying stock. This position generally profits from a large movement in either direction in the underlying stock.

BACK MONTH

A back month contract is any exchange-traded derivatives contract for a future period beyond the front month contract. Also called FAR MONTH.

BEAR, BEARISH

A bear is someone with a pessimistic view on a market or particular asset, e.g. believes that the price will fall. Such views are often described as bearish.

BEAR CALL SPREAD

A vertical credit spread using calls only. This is a net credit transaction established by selling a call and buying another call at a higher strike price, on the same underlying, in the same expiration. It is a directional trade where the maximum loss = the difference between the strike prices less the credit received, and the maximum profit = the credit received. Requires margin.

BEAR PUT SPREAD

A vertical debit spread using puts only. A net debit transaction established by selling a put and buying another put at a higher strike price, on the same underlying, in the same expiration. It is a directional trade where the maximum loss = the debit paid, and the maximum profit = the difference between the strike prices less the debit. No margin is required.

BETA

A prediction of what percentage a position will move in relation to an index. If a position has a BETA of 1, then the position will tend to move in line with the index. If the beta is 0.5 this suggests that a 1% move in the index will cause the position price to move by 0.5%. Beta should not be confused with volatility. Note: Beta can be misleading. It is based on past performance, which is not necessarily a guide to the future.

BELL CURVE See NORMAL DISTRIBUTION.

BID

This is the price that the trader making the price is willing to buy an option or security for.

BID-ASK SPREAD

The difference between the Bid and Ask prices of a security. The wider (i.e. larger) the spread is, the less liquid the market and the greater the slippage.

BINOMIAL PRICING MODEL

Methodology employed in some option pricing models which assumes that the price of the underlying can either rise or fall by a certain amount at each pre-determined interval until expiration For more information, see COX-ROSS-RUBINSTEIN model.

BLACK-SCHOLES PRICING MODEL

A formula used to compute the theoretical value of European-style call and put options from the following inputs: stock price, strike price, interest rates, dividends, time of expiration, and volatiity. It was invented by Fischer Black and Myron Scholes.

BOX SPREAD

A four-sided option spread that involves a long call and short put at one strike price as well as a short call and long put at another strike price. In other words, this is a synthetic long stock position at one strike price and a synthetic short stock position at another strike price.

BREAK-EVEN POINT

A stock price at option expiration at which an option strategy results in neither a profit or a loss.

BROKER

A person acting as an agent/middleman for making securities transactions in stock exchanges. An "account executive" or a "broker" at a brokerage firm deals with customers.

BULL, BULLISH

A bull is someone with an optimistic view on a market or particular asset, e.g. believes that the price will rise. Such views are often described as bullish.

BULL CALL SPREAD

A vertical debit spread using calls only. This is a net debit transaction established by buying a call and selling another call at a higher strike price, on the same underlying, in the same expiration. It is a directional trade where the maximum loss = the debit paid, and the maximum profit = the difference between the strike prices, less the debit. No margin is required.

BULL PUT SPREAD

A vertical credit spread using puts only. This is a net credit transaction established by buying a put and selling another put at a higher strike price, on the same underlying, in the same expiration. It is a directional trade where the maximum loss = the difference between the strike prices, less the credit, and the maximum profit = the credit received. Requires margin.

BUTTERFLY SPREAD

A strategy involving four contracts of the same type at three different strike prices. A long (short) butterfly involves buying (selling) the lowest strike price, selling (buying) double the quantity at the central strike price, and buying (selling) the highest strike price. All options are on the same underlying, in the same expiration.

BUY WRITE See COVERED CALL.

C

CBOE

The Chicago Board Options Exchange. CBOE opened in April 1973, and is the oldest and largest listed options exchange.

CFTC

The Commodity Futures Trading Commission. The CFTC is the agency of the federal government that regulates commodity futures trading.

CALENDAR SPREAD

The simultaneous purchase and sale of options of the same type, but with different expiration dates. This would include the strategies: horizontal debit spreads, horizontal credit spreads, diagonal debit spreads, and diagonal credit spreads.

CALL

This option contract conveys the right to buy a standard quantity of a specified asset at a fixed price per unit (the strike price) for a limited length of time (until expiration).

CALL RATIO BACKSPREAD

A long backspread using calls only.

CANCELED ORDER

A buy or sell order that is canceled before it has been executed. In most cases, a limit order can be canceled at any time as long as it has not been executed. (A market order may be canceled if the order is placed after market hours and is then canceled before the market opens the following day). A request for cancel can be made at anytime before execution.

CARRYING COST

The interest expense on money borrowed to finance a stock or option position.

CASH SETTLEMENT

The process by which the terms of an option contract are fulfilled through the payment or receipt in Rupees of the amount by which the option is in-the-money as opposed to delivering or receiving the underlying stock.

CHRISTMAS TREE SPREAD

A strategy involving six options and four strike prices that has both limited risk and limited profit potential. For example, a long call Christmas tree spread is established by buying one call at the lowest strike, skipping the second strike, selling three calls are the third strike, and buying two calls at the fourth strike.

CLOSING TRANSACTION

To sell a previously purchased position or to buy back a previously purchased position, effectively canceling out the position.

COLLAR

A collar is a trade that establishes both a maximum profit (the ceiling) and minimum loss (the floor) when holding the underlying asset. The premium received from the sale of the ceiling reduces that due from the purchase of the floor. Strike prices are often chosen at the level at which the premiums net out. An example would be: owning 100 shares of a stock, while simultaneously selling a call, and buying a put.

COLLATERAL

This is the legally required amount of cash or securities deposited with a brokerage to insure that an investor can meet all potential obligations. Collateral (or margin) is required on investments with open-ended loss potential such as writing naked options.

COMBINATION SPREAD

An option technique involving a long call and a short put, or a short call and a long put. Such strategies do not fall into clearly defined categories, and the term combination is often used very loosely. This tactic is also called a fence strategy. SEE FENCE.

COMMISSION

This is the charge paid to a broker for transacting the purchase or the sale of stock, options, or any other security.

COMMODITY

A raw material or primary product used in manufacturing or industrial processing or consumed in its natural form.

CONDOR

A strategy similar to the butterfly involving 4 contracts of the same type at four different strike prices. A long (short) condor involves buying (selling) the lowest strike price, selling (buying) 2 different central strike prices, and buying (selling) the highest strike price. All contracts are on the same underlying, in the same expiration.

CONTRACT SIZE

The number of units of an underlying specified in a contract. In stock options the standard contract size is 100 shares of stock. In futures options the contract size is one futures contract. In index options the contract size is an amount of cash equal to parity times the multiplier. In the case of currency options it varies.

CONVERSION

An investment strategy in which a long put and a short call with the same strike price and expiration are combined with long stock to lock in a nearly risk less profit. The process of executing these three-sided trades is sometimes called conversion arbitrage. See reverse conversion.

COST OF CARRY

This is the interest cost of holding an asset for a period of time. It is either the cost of funds to finance the purchase (real cost), or the loss of income because funds are diverted from one investment to another (opportunity cost).

COVERED

A covered option strategy is an investment in which all short options are completely offset with a position in the underlying or a long option in the same asset. The loss potential with such a strategy is therefore limited.

COVERED CALL

Both long the underlying and short a call. The sale of a call by investors who own the underlying is a common strategy and is used to enhance their return on investment. This strategy is short option (covered) using calls only.

COVERED PUT

An option strategy in which a put option is written against a sufficient amount of cash to pay for the stock purchase if the short option is assigned.

COVERED COMBO

A strategy in which you are long the underlying, short a call, and short a put. Often used by those wishing to own the underlying at a price less than today's price.

COVERED STRADDLE

An option strategy in which one call and one put with the same strike price and expiration are written against 100 shares of the underlying stock. In actuality, this is not a "covered" strategy because assignment on the short put would require purchase of stock on margin.

COVERED STRANGLE

A strategy in which one call and one put with the same expiration - but different strike prices - are written against 100 shares of the underlying stock. In actuality, this is not a "covered" strategy because assignment on the short put would require purchase of stock on margin. This method is also known as a covered combination.

COX-ROSS-RUBINSTEIN

A binomial option-pricing model invented by John Cox, Stephen Ross, and Mark Rubinstein.

CREDIT

The amount you receive for placing a trade. A net inflow of cash into your account as the result of a trade.

CREDIT SPREAD

A spread strategy that increases the amount's cash balance when it is established. A bull spread with puts and a bear spread with calls are examples of credit spreads.

CYCLE See EXPIRATION CYCLE.

D

DAY ORDER

An order to purchase or sell a security, usually at a specified price, that is good for just the trading session on which it is given. It is automatically cancelled on the close of the session if it is not executed.

DAY TRADE

A position that is opened and closed on the same day.

DEBIT

The amount you pay for placing a trade. A net outflow of cash from your account as the result of a trade.

DEBIT SPREAD

A spread strategy that decreases the amount's cash balance when it is established. A bull spread with calls and a bear spread with puts are examples of debit spreads.

DELTA

Measures the rate of change in an option's theoretical value for a one-unit change in the underlying. Calls have positive Deltas and puts have negative Deltas. Delta for non-futures based options is the Rupee amount of gain/loss you should experience if the underlying goes up one point. For futures-based options, Delta represents an equivalent number of futures contracts times 100.

DELTA NEUTRAL

A strategy in which the Delta-adjusted values of the options (plus any position in the underlying) offset one another. To help an existing position become Delta neutral at the current price of the underlying.

DIAGONAL CREDIT SPREAD

A type of calendar spread. It is a debit transaction where options are purchased in a nearer expiration and options of the same type are sold in a farther expiration, on the same underlying. It is diagonal because the options have different strike prices.

DIAGONAL DEBIT SPREAD

Type of calendar spread. It is a credit transaction where options are sold in a nearer expiration and options of the same type are purchased in a farther expiration, on the same underlying. It is diagonal because the options have different strike prices.

DIRECTIONAL TRADE

A trade designed to take advantage of an expected movement in price.

DISCOUNT

An adjective used to describe an option that is trading below its intrinsic value.

DYNAMIC HEDGING

A short-term trading strategy generally using futures contracts to replicate some of the characteristics of option contracts. The strategy takes into account the replicated option's delta and often requires adjusting.

E

EARLY EXERCISE

A feature of American-style options that allows the owner to exercise an option at any time prior to its expiration date.

EDGE

(1) The spread between the bid and ask price. This is called the trader's edge. (2) The difference between the market price of an option and its theoretical value using an option-pricing model. This is called the theoretical edge.

EQUITY OPTION

An option on shares of an individual common stock. Also known as a stock option.

EUROPEAN STYLE OPTION

An option that can only be exercised on the expiration date of the contract.

EX-DIVIDEND DATE

The day before which an investor must have purchased the stock in order to receive the dividend. On the ex-dividend date, the previous day's closing price is reduced by the amount of the dividend because purchasers of the stock on the ex-dividend date will not receive the dividend payment.

EXCHANGE TRADED

The generic term used to describe futures, options and other derivative instruments that are traded on an organized exchange.

EXERCISE

The act by which the holder of an option takes up his rights to buy or sell the underlying at the strike price. The demand of the owner of a call option that the number of units of the underlying specified in the contract be delivered to him at the specified price. The demand by the owner of a put option contract that the number of units of the underlying asset specified be bought from him at the specified price.

EXERCISE PRICE

The price at which the owner of a call option contract can buy an underlying asset. The price at which the owner of a put option contract can sell an underlying asset. See STRIKE PRICE.

EXOTIC OPTIONS

Various over-the-counter options whose terms are very specific, and sometimes unique. Examples include Bermuda options (somewhere between American and European type, this option can be exercised only on certain dates) and look-back options (whose strike price is set at the option's expiration date and varies depending on the level reached by the underlying security).

EXPIRATION, EXPIRATION DATE, EXPIRATION MONTH

This is the date by which an option contract must be exercised or it becomes void and the holder of the option ceases to have any rights under the contract. All stock and index option contracts expire on the Saturday following the third Friday of the month specified.

EXPIRATION CYCLE

Traditionally, there were three cycles of expiration dates used in options trading:
JANUARY CYCLE (1): January / April / July / October
FEBRUARY CYCLE (2): February / May / August / November
MARCH CYCLE (3): March / June / September / December

Today, equity options expire on a hybrid cycle which involves a total of four option series: the two nearest-term calendar months and the next two months from the traditional cycle to which it has been assigned.

F

FAIR VALUE See THEORETICAL PRICE, THEORETICAL VALUE.

FAR MONTH, FAR TERM See BACK MONTH.

FENCE

A strategy involving a long call and a short put, or a short call and long put at different strike prices with the same expiration date. When this strategy is established in conjunction with the underlying stock, the three-sided tactic is called a risk conversion (long stock) or a risk reversal (short stock). This strategy is also called a combination. See conversion and reverse conversion.

FILL

When an order has been completely executed, it is described as filled.

FILL OR KILL (FOK) ORDER

This means do it now if the option (or stock) is available in the crowd or from the specialist, otherwise kill the order altogether. Similar to an all-or-none (AON) order, except it is "killed" immediately if it cannot be completely executed as soon as it is announced. Unlike an AON order, the FOK order cannot be used as part of a GTC order.

FLEXIBLE EXCHANGE OPTIONS (FLEX)

Customized equity and equity index options. The user can specify, within certain limits, the terms of the options, such as exrcise price, expiration date, exercise type, and settlement calculation. Can only be traded in a minimum size, which makes FLEX an institutional product.

FRONT MONTH

The first month of those listed by an exchange - this is usually the most actively traded contract, but liquidity will move from this to the second month contract as the front month nears expiration. Also known as the NEAR MONTH.

FRONTRUNNING

An illegal securities transaction based on prior nonpublic knowledge of a forthcoming transaction that will affect the price of a stock.

FOLLOW-UP ACTION

Term used to describe the trades an investor makes subsequent to implementing a strategy. Through these adjustments, the investor transforms one strategy into a different one in response to price changes in the underlying.

FUNDAMENTAL ANALYSIS

A method of determining stock prices based on the study of earnings, sales, dividends, and accounting information.

FUNGIBILITY

Interchangeability resulting from standardization. Options listed on national exchanges are fungible, while over-the-counter options generally are not.

FUTURE, FUTURES CONTRACT

A standardized, exchange-traded agreement specifying a quantity and price of a particular type of commodity (soybeans, gold, oil, etc.) to be purchased or sold at a pre-determined date in the future. On contract date, delivery and physical possession take place unless the contract has been closed out. Futures are also available on various financial products and indexes today.

G

GAMMA

Gamma expresses how fast Delta changes with a one-point increase in the price of the underlying. Gamma is positive for all options. If an option has a Delta of 45 and a Gamma of 10, then the option's expected Delta will be 55 if the underlying goes up one point. If we consider Delta to be the velocity of an option, then Gamma is the acceleration.

GOOD TILL CANCELED (GTC) ORDER

A Good Till Canceled order is one that is effective until it is either filled by the broker or canceled by the investor. This order will automatically cancel at the option's expiration.

GREEKS

The Greek letters used to describe various measures of the sensitivity of the value of an option with respect to different factors. They include Delta, Gamma, Theta, Rho, and Vega.

GUTS

The purchase (or sale) of both an in-the-money call and in-the-money put. A box spread can be viewed as the combination of an in-the-money strangle and an out-of-the-money strangle. To differentiate between these two strangles, the term guts refer to the in-the-money strangle. See box spread and strangle.

H

HAIRCUT

Similar to margin required of public customers this term refers to the equity required of floor traders on equity option exchanges. Generally, one of the advantages of being a floor trader is that the haircut is less than margin requirements for public customers.

HEDGE

A position established with the specific intent of protecting an existing position. Example: an owner of common stock buys a put option to hedge against a possible stock price decline.

HISTORIC VOLATILITY

A measure of the actual price fluctuations of the underlying over a specific period of time. We use the term statistical volatility, reserving the word historic to refer to our past historical data for both Implied Volatility (IV) and Statistical Volatility (SV).

HORIZONTAL CREDIT SPREAD

A type of calendar spread. It is a credit transaction where you buy an option in a nearer expiration month and sell an option of the same type in a farther expiration month, with the same strike price, and in the same underlying asset.

HORIZONTAL DEBIT SPREAD

A type of calendar spread. It is a debit transaction where you sell an option in a nearer expiration month and buy an option of the same type in a farther expiration month, with the same strike price, and in the same underlying asset.

I

IMMEDIATE-OR-CANCEL (IOC) ORDER

An option order that gives the trading floor an opportunity to partially or totally execute an order with any remaining balance immediately cancelled.

ILLIQUID

An illiquid market is one that cannot be easily traded without even relatively small orders tending to have a disproportionate impact on prices. This is usually due to a low volume of transactions and/or a small number of participants.

IMPLIED VOLATILITY (IV)

This is the volatility that the underlying would need to have for the pricing model to produce the same theoretical option price as the actual option price. The term implied volatility comes from the fact that options imply the volatility of their underlying, just by their price. A computer model starts with the actual market price of an option, and measures IV by working the option fair value model backward, solving for volatility (normally an input) as if it were the unknown.

In actuality, the fair value model cannot be worked backward. By working forward repeatedly through a series of intelligent guesses until the volatility is found which makes the fair value equal to the actual market price of the option.

INDEX

The compilation of stocks and their prices into a single number. E.g. The BSE SENSEX / S&P CNX NSE NIFTY.

INDEX OPTION

An option that has an index as the underlying. These are usually cash-settled.

IN-THE-MONEY (ITM)

Term used when the strike price of an option is less than the price of the underlying for a call option, or greater than the price of the underlying for a put option. In other words, the option has an intrinsic value greater than zero.

INTRINSIC VALUE

Amount of any favorable difference between the strike price of an option and the current price of the underlying (i.e., the amount by which it is in-the-money). The intrinsic value of an out-of-the-money option is zero.

IRON BUTTERFLY

An option strategy with limited risk and limited profit potential that involves both a long (or short) straddle and a short (or long) strangle.

L

LAST TRADING DAY

The last business day prior to the option's expiration during which purchases and sales of options can be made. For equity options, this is generally the third Friday of the expiration month.

LEAPS

Long-term Equity Anticipation Securities, also known as long-dated options. Calls and puts with expiration as long as 2-5 years. Only about 10% of equities have LEAPs. Currently, equity LEAPS have two series at any time, always with January expirations. Some indexes also have LEAPs.

LEG

Term describing one side of a spread position.

LEGGING

Term used to describe a risky method of implementing or closing out a spread strategy one side ("leg") at a time. Instead of utilizing a "spread order" to insure that both the written and the purchased options are filled simultaneously, an investor gambles a better deal can be obtained on the price of the spread by implementing it as two separate orders.

LEVERAGE

A means of increasing return or worth without increasing investment. Using borrowed funds to increase one's investment return, for example buying stocks on margin. Option contracts are leveraged as they provide the prospect of a high return with little investment.

LIMIT ORDER

An order placed with a brokerage to buy or sell a predetermined number of contracts (or shares of stock) at a specified price, or better than the specified price. Limit orders also allow an investor to limit the length of time an order can be outstanding before canceled. It can be placed as a day or GTC order. Limit orders typically cost slightly more than market orders but are often better to use, especially with options, because you will always purchase or sell securities at that price or better.

LIQUID

A liquid market is one in which large deals can be easily traded without the price moving substantially. This is usually due to the involvement of many participants and/or a high volume of transactions.

LONG

You are long if you have bought more than you have sold in any particular market, commodity, instrument, or contract. Also known as having a long position, you are purchasing a financial asset with the intention of selling it at some time in the future. An asset is purchased long with the expectation of an increase in its price.

LONG POSITION

A term used to describe either (1) an open position that is expected to benefit from a rise in the price of the underlying stock such as long call, short put, or long stock; or (2) an open position resulting from an opening purchase transaction such as long call, long put, or long stock.

LONG BACKSPREAD

It involves selling one option nearer the money and buying two (or more) options of the same type farther out-of-the-money, using the same type, in the same expiration, on the same underlying. Requires margin.

LONG OPTION

Buying an option. See LONG.

LONG STRADDLE See STRADDLE.

LONG STRANGLE See STRANGLE.

LONG SYNTHETIC See SYNTHETIC.

LONG UNDERLYING

Buying the underlying (i.e. stock). See LONG.

M

MARGIN

The minimum equity required to support an investment position. To buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm.

MARKET BASKET

A group of common stocks whose price movement is expected to closely correlate with an index.

MARK TO MARKET

The revaluation of a position at its current market price.

MARKET MAKER

A trader or institution that plays a leading role in a market by being prepared to quote a two way price (Bid and Ask) on request - or constantly in the case of some screen based markets - during normal market hours.

MARKET ORDER

Sometimes referred to as an unrestricted order. It's an order to buy or sell a security immediately at the best available current price. A market order is the only order that guarantees execution. It should be used with caution in placing option trades, because you can end up paying a lot more than you anticipated.

MARKET PRICE

A combination of the Bid, Ask, and Last prices into a single representative price. When the Bid, Ask, and Last are all available, the default formula for MARKET PRICE is (10*Bid + 10*Ask + Last) / 21.

MARKET-NOT-HELD ORDER

A type of market order that allows the investor to give discretion regarding the price and/or time at which a trade is executed.

MARKET-ON-CLOSE (MOC) ORDER

A type of order which requires that an order be executed at or near the close of a trading day on the day the order is entered. A MOC order, which can be considered a type of day order, cannot be used as part of a GTC order.

MARRIED PUT STRATEGY

The simultaneous purchase of stock and the corresponding number of put options. This is a limited risk strategy during the life of the puts because the stock can be sold at the strike price of the puts.

MID IMPLIED VOLATILITY (MIV)

Implied volatility computed based on the mid-point between the Bid and Ask prices. See IMPLIED VOLATILITY.

N

NAKED

An investment in which options sold short are not matched with a long position in either the underlying or another option of the same type that expires at the same time or later than the options sold. The loss potential of naked strategies can be virtually unlimited.

NEAR TERM See FRONT MONTH.

NET MARGIN REQUIREMENT

The equity required in a margin account to support an option position after deducting the premium received from sold options.

NEUTRAL

An adjective describing the belief that a stock or the market in general will neither rise nor decline significantly.

NORMAL DISTRIBUTION

A statistical distribution where observations are evenly distributed around the mean. Studies have shown that stock prices are very close to being log normally distributed over time. When you choose bell curve as a price target in the program, a lognormal distribution based on price, volatility, and time until valuation date is constructed.

NOT-HELD ORDER

An order that gives a broker discretion as to the price and timing in executing the best possible trade. By placing this order, a customer agrees to not hold the broker responsible if the best deal is not obtained.

O

OFFER See ASK.

ONE-CANCELS-THE-OTHER (OCO) ORDER

Type of order which treats two or more option orders as a package, whereby the execution of any one of the orders causes all the orders to be reduced by the same amount. Can be placed as a day or GTC order.

OPEN INTEREST

The cumulative total of all option contracts of a particular series sold, but not yet repurchased or exercised.

OPEN ORDER An order that has been placed with the broker, but not yet executed or canceled.

OPENING TRANSACTION

An addition to, or creation of, a trading position.

OPTION

A contract that gives the buyer the right, but not the obligation, to buy or sell a particular asset (the underlying security) at a fixed price for a specific period of time. The contract also obligates the seller to meet the terms of delivery if the contract right is exercised by the buyer.

OPTION CHAIN

A list of the options available for a given underlying.

OPTIONS CLEARING CORPORATION (OCC)

A corporation owned by the exchanges that trade listed stock options; OCC is an intermediary between option buyers and sellers. OCC issues and guarantees all option contracts.

OPTION PERIOD

The time from when an option contract is created to the expiration date.

OPTION PRICING CURVE

A graphical representation of the estimated theoretical value of an option at one point of time, at various prices of the underlying asset.

OPTION PRICING MODEL

A mathematical formula used to calculate the theoretical value of an option. See BLACK-SCHOLES MODEL and BINOMIAL MODEL.

OPTION WRITER

The seller of an option contract who is obligated to meet the terms of delivery if the option holder exercises his right.

OUT-OF-THE-MONEY (OTM)

An out-of-the-money option is one whose strike price is unfavorable in comparison to the current price of the underlying. This means when the strike price of a call is greater than the price of the underlying, or the strike price of a put is less than the price of the underlying. An out-of-the-money option has no intrinsic value, only time value.

OVERVALUED

An adjective used to describe an option that is trading at a price higher that its theoretical value. It must be remembered that this is a subjective evaluation, because theoretical value depends on one subjective input - the volatility estimate.

OVERWRITE

An option strategy involving the sale of a call option against an existing long stock position. This is different from the covered - write strategy, which involves the simultaneous purchase of stock and sale of a call.

P

PARITY

An adjective used to describe the difference between the stock price and the strike price of an in-the-money option. When an option is trading at its intrinsic value, it is said to be trading at parity.

POSITION

The combined total of an investor's open option contracts and long or short stock.

POSITION LIMITS

The maximum number of open option contracts that an investor can hold in one account or a group of related accounts. Some exchange express the limit in terms of option contracts on the same side of the market, and others express it in terms of total long or short delta.

POSITION TRADING

An investing strategy in which open positions are held for an extended period of time.

PREMIUM

(1) Total price of an option: intrinsic value plus time value. (2) Often this word is used to mean the same as time value.

PROFIT GRAPH

A graphical presentation of the profit-and-loss possibilities of an investment strategy at one point in time (usually option expiration), at various stock prices.

PUT

This option contract conveys the right to sell a standard quantity of a specified asset at a fixed price per unit (the strike price) for a limited length of time (until expiration).

PUT/CALL RATIO

This ratio is used by many as a leading indicator. It is computed by dividing the 4-day average of total put VOLUME by the 4-day average of total call VOLUME.

PUT RATIO BACKSPREAD

In the Trade Finder, a long backspread using puts only.

R

RATIO CALENDAR COMBINATION

A term used loosely to describe any variation on an investment strategy that involves both puts and calls in unequal quantities and at least two different strike prices and two different expirations.

RATIO CALENDAR SPREAD

An investment strategy in which more short-term options are sold than longer-term options are purchased.

RATIO SPREAD

(1) Most commonly used to describe the purchase of near-the-money options and the sale of a greater number of farther out-of-the-money options, with all options having the same expiration date. (2) Generally used to describe any investment strategy in which options are bought and sold in unequal numbers or on a greater than one-for-one basis with the underlying stock.

REALIZED GAINS AND LOSSES

The profit or losses received or paid when a closing transaction is made and matched together with an opening transaction.

RESISTANCE

A term used in technical analysis to describe a price area at which rising price action is expected to stop or meet increased selling activity. This analysis is based on historic price behavior of the stock.

REVERSAL

A short position in the underlying protected by a synthetic long.

REVERSE CONVERSION

An investment strategy used by professional option traders in which a short put and long call with the same strike price and expiration are combined with short stock to lock in a nearly risk less profit. The process of executing these three-sided trades is sometimes called reversal arbitrage.

RHO

The change in the value of an option with respect to a unit change in the risk-free rate.

RISK-FREE RATE

The term used to describe the prevailing rate of interest for securities issued by the government of the country of the currency concerned. It is used in the pricing models.

ROLLOVER

Moving a position from one expiration date to another further into the future. As the front month approaches expiration, traders wishing to maintain their positions will often move them to the next contract month. This is accomplished by a simultaneous sale of one and purchase of the other.

ROUND TURN

When an option contract is bought and then sold (or sold and then bought). The second trade cancels the first, leaving only a profit or loss. This process is referred to as a round turn. Brokerage charges are usually quoted on this basis.

S

SCALPER

A trader on the floor of an exchange who hopes to buy on the bid price, sell on the ask price, and profit from moment to moment price movements. Risk is limited by the very short time duration (usually 10 seconds to 3 minutes) of maintaining any one position.

SEC

The Securities and Exchange Commission. The SEC is the United States federal government agency that regulates the securities industry.

SECTOR INDICES

Indices that measure the performance of a narrow market segment, such as biotechnology or small capitalization stocks.

SETTLEMENT PRICE

The official price at the end of a trading session. This price is established by The Options Clearing Corporation and is used to determine changes in account equity, margin requirements, and for other purposes. See mark-to-market.

SHORT

An obligation to purchase an asset at some time in the future. You are short if you have sold more than you have bought in any particular market, commodity, instrument, or contract. Also known as having a short position. An asset is sold short with the expectation of a decline in its price. Can have almost unlimited risk. Short option (covered), short option (naked), and short underlying are strategies available in the Trade Finder. Uncovered short positions require margin.

SHORT BACKSPREAD

It involves buying one option nearer the money and selling two (or more) options of the same type farther out-of-the-money, with the same expiration, on the same underlying. Requires margin.

SHORT OPTION (COVERED) See COVERED CALL.

SHORT OPTION (NAKED)

Selling an option you don't own. See SHORT.

SHORT STRADDLE See STRADDLE.

SHORT STRANGLE See STRANGLE.

SHORT SYNTHETIC See SYNTHETIC.

SHORT UNDERLYING

Selling an asset you don't own. See SHORT.

SLIPPAGE

Thinly traded options have a wider Bid-Ask spread than heavily traded options. Therefore, you have to "give" more in order to execute a trade in thinly traded options; less in heavily traded ones. This "give" is what we refer to as slippage. The slippage model is a sophisticated formula that takes into account the volume of your prospective trade in relation to the average daily volume in the option. You can choose four different degrees of slippage; large, moderate, small or none. Adjustments should be made base on your trading experience.

SPREAD

A trading strategy involving two or more legs, the incorporation of one or more of which is designed to reduce the risk involved in the others.

SPREAD ORDER

This is an order for the simultaneous purchase and sale of two (or more) options of the same type on the same underlying. If placed with a limit, the two options must be filled for a specified price difference, or better. It can be critical in this type of order to specify whether it is an opening transaction or a closing transaction.

STANDARD DEVIATION

The square root of the mean of the squares of the deviations of each member of a population (in simple terms, a group of prices) from their mean. In a normal distribution (or bell curve), one standard deviation encompasses 68% of all possible outcomes.

STATISTICAL VOLATILITY (SV)

Measures the magnitude of the asset's recent price swings on a percentage basis. It can be measured using any recent sample period. The default is 20 days. Regardless of the length of the sample period, SV is always normalized to represent a one-year, single Standard Deviation price move of the underlying.

Note: It is important to remember that what is needed for accurate options pricing is near-term future volatility, which is something that nobody knows for sure.

STRAP

A strategy involving two calls and one put. All options have the same strike price, expiration, and underlying stock.

STOCK INDEX FUTURES

A futures contract that has as its underlying entity a stock market index. Such futures contracts are generally subject to cash settlement.

STOP ORDER

"Stop-Loss" and "Stop-Limit" orders placed on options are activated when there is a trade at that price only on the specific exchange on which the order is located. They are orders to trade when its price falls to a particular point, often used to limit an investor's losses. It's an especially good idea to use a stop order if you will be unable to watch your positions for an extended period.

STRADDLE

A strategy involving the purchase (or sale) of both call and put options with the same strike price, same expiration, and on the same underlying. A short straddle means that both the call and put are sold short, for a credit. A long straddle means that both the call and put are bought long, for a debit.

STRANGLE

A strategy involving the purchase or sale of both call and put options with different strike prices - normally of equal, but opposite, Deltas. The options share the same expiration and the same underlying. A strangle is usually a position in out-of-the-money options. A short strangle means that both the calls and puts are sold short, for a credit. A long strangle means both the calls and puts are bought long, for a debit.

STRATEGY, STRATEGIES

An option strategy is any one of a variety of option investments. It involves the combination of the underlying and/or options at the same time to create the desired investment portfolio and risk.

STRIKE PRICE

The price at which the holder of an option has the right to buy or sell the underlying. This is a fixed price per unit and is specified in the option contract. Also known as striking price or exercise price.

SUPPORT

A term used in technical analysis to describe a price area at which falling price action is expected to stop or meet increased buying activity. This analysis is based on previous price behavior of the stock.

SYNTHETIC

A strategy that uses options to mimic the underlying asset. Both long and short synthetics are strategies in the Trade Finder. The long synthetic combines a long call and a short put to mimic a long position in the underlying. The short synthetic combines a short call and a long put to mimic a short position in the underlying. In both cases, both the call and put have the same strike price, the same expiration, and are on the same underlying.

T

TECHNICAL ANALYSIS

Method of predicting future price movements based on historical market data such as (among others) the prices themselves, trading volume, open interest, the relation of advancing issues to declining issues, and short selling volume.

THEORETICAL VALUE, THEORETICAL PRICE

This is the mathematically calculated value of an option. It is determined by (1) the strike price of the option, (2) the current price of the underlying, (3) the amount of time until expiration, (4) the volatility of the underlying, and (5) the current interest rate.

THETA

The sensitivity of the value of an option with respect to the time remaining to expiration. It is the daily drop in Rupee value of an option due to the effect of time alone. Theta is Rupees lost per day, per contract. Negative Theta signifies a long option position (or a debit spread); positive Theta signifies a short option position (or a credit spread).

TICK

The smallest unit price change allowed in trading a specific security. This varies by security, and can also be dependent on the current price of the security.

TIME DECAY

Term used to describe how the theoretical value of an option "erodes" or reduces with the passage of time. Time decay is quantified by Theta.

TIME SPREAD See CALENDAR SPREAD.

TIME PREMIUM

Also known as "Time Value", this is the amount that the value of an option exceeds its intrinsic value. It reflects the statistical possibility that an option will reach expiration with intrinsic value rather than finishing at zero Rupees. If an option is out-of-the-money then its entire value consists of time premium.

TRADER

(1) Any investor who makes frequent purchases and sales. (2) A member of an exchange who conducts his buying and selling on the trading floor of the exchange.

TRADE HALT

A temporary suspension of trading in a particular issue due to an order imbalance, or in anticipation of a major news announcement. An industry-wide trading halt can occur if the BSE SENSEX falls below parameters set by the BSE.

TRADING PIT

A specific location on the trading floor of an exchange designated for the trading of a specific option class or stock.

TRADING ROTATION

A trading procedure on exchange floor in which bids and offers are made on specific options in a sequential order. Opening trading rotations are conducted to guarantee all entitled public orders an execution. At times of extreme market activity, a closing trading rotation can also be conducted.

TRANSACTION COSTS

All charges associated with executing a trade and maintaining a position, including brokerage commissions, fees for exercise and/or assignment, and margin interest.

TRUE DELTA, TRUE GAMMA

More accurate than standard Delta and Gamma. Projects a change in volatility when projecting a change in price. Taking this volatility shift into account gives a more accurate representation of the true behavior of the option.

TYPE

The type of option. The classification of an option contract as either a call or put.

U

UNCOVERED

A short option position that is not fully collateralized if notification of assignment is received. See also NAKED.

UNDERLYING

This is the asset specified in an option contract that is transferred when the option contract is exercised, unless cash-settled. With cash-settled options, only cash changes hands, based on the current price of the underlying.

UNREALIZED GAIN OR LOSS

The difference between the original cost of an open position and its current market price. Once the position is closed, it becomes a realized gain or loss.

UNDERVALUED

An adjective used to describe an option that is trading at a price lower than its theoretical value. It must be remembered that this is a subjective evaluation because theoretical value depends on one subjective input - the volatility estimate.

V

VEGA

A measure of the sensitivity of the value of an option at a particular point in time to changes in volatility. Also known as "Kappa" and "Lambda". Vega is the Rupee amount of gain or loss you should theoretically experience if implied volatility goes up one percentage point.

VERTICAL CREDIT SPREAD

The purchase and sale for a net credit of two options of the same type but different strike prices. They must have the same expiration, and be on the same underlying.

See also BULL PUT SPREAD and BEAR CALL SPREAD.

VERTICAL DEBIT SPREAD

The purchase and sale for a net debit of two options of the same type but different strike prices. They must have the same expiration, and be on the same underlying.

See also BULL CALL SPREAD and BEAR PUT SPREAD.

VOLATILITY

Volatility is a measure of the amount by which an asset has fluctuated, or is expected to fluctuate, in a given period of time. Assets with greater volatility exhibit wider price swings and their options are higher in price than less volatile assets.

Volatility is not equivalent to BETA.

VOLATILITY TRADE

A trade designed to take advantage of an expected change in volatility.

VOLUME

The quantity of trading in a market or security. It can be measured by Rupees or units traded (i.e. number of contracts for options, or number of shares for stocks).

W

WASH SALE

When an investor repurchases an asset within 30 days of the sale date and reports the original sale as a tax loss. The Internal Revenue Service prohibits wash sales since no change in ownership takes place.

WASTING ASSET

An investment with a finite life, the value of which decreases over time if there is no price fluctuation in the underlying asset.

WRITE, WRITER

To sell an option that is not owned through an opening sale transaction. While this position remains open, the writer is obligated to fulfill the terms of that option contract if the option is assigned. An investor who sells an option is called the writer, regardless of whether the option is covered or uncovered.

Y

YATES MODEL The Yates pricing model is a refined version of the Black-Scholes pricing model that takes into account dividends and the possibility of early exercise.

Copyright 2001 by Hiten Jhaveri, StockWhizo Investments. All rights reserved worldwide.

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