Wednesday, 9th June 2010

Options Glossary

Written by George Traganidas Topics: Options, Wealth Building

Options Glossary

American style: Options contracts that can be exercised at any time after purchase and before the expiration date.

Assignment: When the options writer (also called the seller) is forced to buy (for a put writer) or sell (for a call writer) the underlying stock. Essentially, your counterparty has exercised its option contract, which you wrote, to buy or sell the underlying stock.

At-the-money: An option whose underlying stock is trading at its strike price.

Bearish: An options strategy (and outlook) that achieves its maximum payoff when the underlying stock drops in price. For example, if you are bearish on a stock you know well, you could buy a put or a bear put spread.

Binomial Model: An options pricing model that’s useful for American-style options because it can help predict those rare occasions when early exercise is possible. It uses an iterative process that allows for pricing options at different points prior to expiration.

Black-Scholes Model: The most well-known options pricing model. It’s used for pricing European-style options, though it still provides a useful approximation of American-style option values, as long as the investor is aware of the model’s limitations.

Break-even point: The price the underlying stock needs to reach at expiration for an option investor to neither make nor lose any money. In strategies involving more than one option, there can be more than one break-even point.

Bullish: An options strategy (and outlook) that achieves its maximum payoff when the underlying stock appreciates in price. For example, if you are bullish on a stock you know well, you could buy a call or a bull call spread.

Buy to close: The brokerage command to exit an option contract in which you originally wrote (“sold to open”) the put or call.

Buy to open: The brokerage command to enter an option contract in which you intend to buy a put or call.

Call option: The right, but not the obligation, to buy the underlying stock at a set price (the strike price) at or before the option’s expiration date. A call rises in value as the stock price rises and declines in value when the stock price falls.

Close: Exit an option contract. See also “buy to close” and “sell to close.”

Contract: Each standard option contract represents 100 shares of the underlying stock, provided no splits or other adjustments (i.e., corporate mergers) take place. A contract is quoted at the price for one share, so multiply by 100 to get the full contract value. For example, buying two option contracts for $1.50 actually represents 200 (2 x 100) shares of stock and would therefore cost $300 ($1.50 x 200).

Delta: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this indicates an option’s sensitivity to changes in the underlying stock price. A call option with a delta of 0.6 tells you that the option’s value will increase $0.60 for every $1 move in the stock price. Since the option is less expensive than the stock, the $0.60 increase represents a greater percentage change for the option than the $1 change in the stock.

European style: Option contracts that can only be exercised at expiration.

Exercise: Invoking the right (as granted by the option contract) to buy (if a call) or sell (if a put) shares of stock at the strike price.

Exercise price: See “strike price.”

Expiration date: The date on which the option contract becomes void, and the option holder no longer has the right to buy or sell stock granted by the option.

Gamma: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this shows how fast delta changes with respect to the underlying stock price. The larger the gamma, the faster delta changes; gamma is maximized when the stock price equals the option’s strike price.

Greeks: This refers to delta, gamma, rho, theta, and vega, risk measurements used to monitor the sensitivity of an option’s price with respect to a change in one of the underlying contributors to option valuation — stock price, volatility, time-to-maturity, and interest rates.

Hedge: An offsetting position meant to reduce the price volatility or risk of an investment.

Implied volatility: A prediction of the volatility of an underlying stock; it’s calculated using the current market trading price of the option. Implied volatility may or may not bear any resemblance to actual historical volatility. See also “volatility.”

In-the-money: Indicates that an option has intrinsic value. Calls are in-the-money when the underlying stock is above the option’s strike price (a stock is at $22 and the call has a strike price of $14, allowing the holder to buy the stock at $14). Puts are in-the-money when the underlying stock is below the option’s strike price (a stock is at $22 and the put has a strike price of $30, allowing the holder to sell the stock at $30).

Intrinsic value: An option’s value if it were to expire immediately; i.e., the value in direct proportion to the underlying stock’s current price. For calls, intrinsic value is the current stock price minus the strike price. For puts, intrinsic value is the strike price minus the current stock price.

Last trading day: The final day where trading takes place on an option contract prior to the settling of the contact, usually the third Friday of the expiration month.

LEAPS (Long-Term Equity Appreciation Securities): Options that, when first offered, expire at least two years in the future. Most new LEAPS become available between September and November, depending on which option cycle the underlying company is on. We like LEAPS because they provide longer-term choices for an investment thesis to play out.

Leg: One piece of multi-option strategy. It also refers to entering or exiting a multi-option strategy (“leg in” or “leg out”) at disparate times and prices chosen to benefit the intended strategy, but with the potential risk that better prices will never be available.

Limit order: A modification to a brokerage command to buy or sell that allows you to buy or sell at a set price or better. These are particularly useful for illiquid stocks, as well as the option markets, for
which there is often limited liquidity.

Naked: Also known as “uncovered”, a naked position is one taken by an option writer (also know as the seller) who doesn’t have a corresponding position in the underlying stock. Some naked strategies — writing calls on rocket-ship growth stocks, for example — are very risky, as they expose you to potentially unlimited losses.

Neutral: An options strategy (and outlook) that achieves its maximum payoff when the underlying stock doesn’t change in price.

Open: Refers to entering an option contract. See also “buy to open” and “sell to open.”

Open interest: The total outstanding open contracts on any particular option. If you buy or sell to open, you’ve just upped the open interest. If you buy or sell to close, you’ve just decreased it.

Option cycle: Expiration dates available for various classes of options. There are three cycles, offset monthly: January/April/July/October; February/May/August/November; and March/June/September/December.

Out-of-the-money: The opposite condition to being in-the-money. Here, an option has no intrinsic value, only time value. For example, if a stock is trading at $8, its call options with a $10 strike price would be out-of-the-money.

Premium: The total price of an option contract; the sum of an option’s intrinsic value and its time value.

Put option: The right, but not the obligation, to sell a stock at a set price at or before the expiration date. A put’s value increases as a stock’s price falls.

Rho: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this indicates an option’s sensitivity to changes in short-term interest rates. Option premiums get more expensive when interest rates go up.

Rolling forward, up, or down: Follow-up action in which you repurchase or sell an option you already own while changing the strike price, expiration date, or both. “Rolling forward” (also called “rolling out”) involves closing options that expire in the near term and opening options with longer-term expirations. “Rolling up” involves closing options with a lower strike price and simultaneously opening new options at a higher strike price (while maintaining the same expiration). “Rolling down” involves closing options at a higher strike price and simultaneously opening new options at a lower strike price.

Sell to close: The brokerage command to exit an option contract in which you originally bought (“buy to open”) the put or call.

Sell to open: The brokerage command to enter an option contract in which you intend to write (a.k.a. sell) a put or call.

Spread: Any option strategy in which you buy and write (“sell to open”) options of the same type (call or put) on the same underlying stock.

Straddle: A direction-neutral options strategy consisting of a call and a put with the same strike prices and expiration date. It profits from a large move, up or down, in the underlying stock.

Strangle: Similar to a straddle (a strategy consisting of a call and a put with the same expiration) but with different strike prices. It profits from large moves, up or down, in the underlying stock. A strangle is cheaper to set up than a straddle but requires a larger move in the underlying stock to become profitable.

Strike price: Also known as the “exercise price,” this is the price at which the option holder can buy (in the case of a call) or sell (in the case of a put) the underlying stock.

Synthetic: A way of using options, sometimes in conjunction with long or short positions in the underlying stock, to mirror the profit and loss potential of a different position. For example, a synthetic long can be created by buying a call and selling a put with the same expiration dates and strike prices. The profit payoff on such a strategy is identical to that of simply buying the underlying stock at the strike price; however, the cost to establish the position is considerably less.

Theta: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this measures an option’s sensitivity to time, or how much the option price decays per day.

Time decay: The reduction in an options value through the passage of time. See also “Theta.”

Time value: The premium that the market is willing to pay for the potential upside of the option until expiration. Its value accounts for beneficial unknowns and volatility until expiration. For a tradable option, deduct intrinsic value from the trading price to arrive at time value. Options are wasting assets, meaning time value declines as expiration draws closer. See also “time decay.”

Uncovered: See “naked.”

Underlying stock/security: The stock being bought or sold at the expiration of the option contract. Since stocks are pieces of businesses, it makes sense to understand that business, its valuation, and its prospects before overlaying options strategies on them.

Vega: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this indicates an option’s price sensitivity to a change in volatility. Higher volatility makes options premiums more expensive.

Volatility: An estimate of the amount that the underlying stock’s price is expected to fluctuate in a given period of time. Generally, volatility is measured by the standard deviation of the continuously compounded returns of the underlying stock.

Write: To sell an option contract. We prefer to use “write” when referring to selling an option contract in general, but specifically this refers to selling a new option contract. The option seller is referred to as the option writer.

Bookmark and Share


Search