American style: An option that can be exercised at any time until expiration.
Assignment: When an option seller (or “writer”) is obligated to assume a long position (if he or she sold a put) or short position (if he or she sold a call) in the underlying stock or futures contract because an option buyer exercised the same option.
At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price.
Average True range (ATR): A measure of price movement that accounts for the gaps that occur between price bars. This calculation provides a more accurate reflection of the size of a price move over a given period than the standard range calculation, which is
simply the high of a price bar minus the low of a price bar. The true range calculation was developed by Welles Wilder and discussed in his book New Concepts in Technical Trading Systems (Trend Research, 1978). True range can be calculated on any time frame or price bar — five-minute, hourly, daily, weekly, etc. The following discussion uses daily price bars for simplicity. True range is the greatest (absolute) distance of the following:
1. Today’s high and today’s low.
2. Today’s high and yesterday’s close.
3. Today’s low and yesterday’s close
Average true range (ATR) is simply a moving average of the true range over a certain time period. For example, the five-day ATR would be the average of the true range calculations over the last five days.
Variance and standard deviation: Variance measures how spread out a group of values are — in other words, how much they vary. Mathematically, variance is the average squared “deviation” (or difference) of each number in the group from the group’s mean value, divided by the number of elements in the group.
For example, for the numbers 8, 9, and 10, the mean is 9 and the variance is:
{(8-9)2 + (9-9)2 + (10-9)2}/3 =
(1 + 0 + 1)/3 = 0.667
Now look at the variance of a more widely distributed set of numbers: 2, 9 and 16:
{(2-9)2 + (9-9)2 + (16-9)2}/3 =
(49 + 0 + 49)/3 = 32.67
The more varied the prices, the higher their variance — the more widely distributed they will be. The more varied a market’s price changes from day to day (or week to week, etc.), the more volatile that market is. A common application of variance in trading is standard deviation, which is the square root of variance.
The standard deviation of 8, 9, and 10 is:
sq. rt. 0.667 = .82; the standard deviation of 2, 9, and 16 is: sq. rt. 32.67 = 5.72.
Backspreads and ratio spreads:are leveraged positions that involve buying and selling options in different proportions, usually in 1:2 or 2:3 ratios. Backspreads contain more long options than short ones, so the potential profits are unlimited and losses are capped.
Ratio spreads: have more short options than long ones and have the opposite risk profile.
Bear call spread: A vertical credit spread that consists of a short call and a higher-strike, further OTM long call in the same expiration month. The spread’s largest potential
gain is the premium collected, and its maximum loss is limited to the point difference between the strikes minus that premium.
Bear put spread: A bear debit “vertical” spread that contains puts with the same expiration date but different strike prices. You buy the higher-strike put, which costs more, and sell the cheaper, lower-strike put.
Bull call spread: A bull debit “vertical” spread that contains calls with the same expiration date but different strike prices. You buy the lower-strike call, which has more value, and sell the less-expensive, higher-strike call.
Bull put spread (put credit spread): A bull credit spread that contains puts with the same expiration date, but different strike prices. You sell an OTM put and buy a less expensive, lower-strike put.
Calendar spread: A position with one short-term short option and one long same-strike option with more time until expiration. If the spread uses ATM options, it is market-neutral and tries to profit from time decay, when bought. Calendar Spreads can use OTM options can be used to profit from both a directional move and time decay.
Call option: An option that gives the owner the right, but not the obligation, to buy a stock (or futures contract) at a fixed price on or before a specific date.
Covered call: Shorting an at or out-of-the-money call option against a long position in the underlying market. An example would be purchasing a stock for $50 and selling a call option with a strike price of $55. The goal is for the market to move sideways or slightly higher (below call strike) and for the call option to expire worthless, in which case you keep the premium.
Credit spread: A position that collects more premium from short options than you pay for long options. A vertical credit spread using calls is bearish, while a vertical credit spread using puts is bullish.
Debit spread: An options spread that costs money to enter, because the long side is more expensive that the short
The option “Greeks”
Delta: The ratio of the movement in the option price for every point move in the underlying. An option with a delta of 0.5 would move a half-point for every 1-point move in the underlying stock; an option with a delta of 1.00 would move 1 point for every 1-point move in the underlying stock.
Gamma: The change in delta relative to a change in the underlying market. Unlike delta, which is highest for deep ITM options, gamma is highest for ATM options and lowest for deep ITM and OTM options.
Rho: The change in option price relative to the change in the interest rate.
Theta: The rate at which an option loses value each day (the rate of time decay). Theta is relatively larger (percentage basis) for OTM than ITM options, and increases as the option gets closer to its expiration date.
Vega: The rate of change of an option’s price per a one percent absolute change in volatility.
Diagonal spread: A position consisting of options with different expiration dates and different strike prices — e.g., a December 50 call and a January 60 call.
European style option: An option that can only be exercised at expiration, not before.
Exercise: To exchange an option for the underlying Instrument, in other words exercise your right to buy or sell it.
Expiration: The last day on which an option can be exercised and exchanged for the underlying instrument (usually the last trading day or one day after).
Extrinsic or Time value: The difference between an option’s intrinsic value and it’s current price (premium). For example, with the underlying instrument trading at 50, a 45strike call option with a premium of 8.50 has 3.50 of extrinsic value.
Front month: The contract month closest to expiration. All listed options will have options that expire in the first 2 months closet to the current date
In the money (ITM): A call option with a strike price below the price of the underlying instrument, or a put option with a strike price above the underlying instrument’s price.
Intrinsic value: The difference between the strike price of an in-the-money option and the underlying asset price. A call option with a strike price of 22 has 2 points of intrinsic value if the underlying market is trading at 24.
Naked option: A position that involves selling an unprotected call or put without having another position as a hedge against it, such as stock or another options. Naked Options typically have a large or unlimited amount of risk and will require a certain amount of margin. If you sell a call, for example, you are obligated to sell the underlying instrument at the call’s strike price, which might be below the market’s value, triggering a loss. If you sell a put, for example, you are obligated to buy the underlying instrument at the put’s strike price, which may be well above the market, also causing a loss. Given its risk, selling naked options is only for advanced options traders, and newer traders aren’t usually allowed by their brokers to trade such strategies.
Naked (uncovered) puts: Selling put options to collect premium that contains risk. If the market drops below the short put’s strike price, the holder may exercise it, requiring
you to buy stock at the strike price (i.e., above the market). Selling a naked put is similar in risk/reward to a covered call. It is also a method for acquiring stock.
Near the money: An option whose strike price is close to the underlying market’s price.
Open interest: The number of options that have not been exercised in a specific contract that has not yet expired.
Out of the money (OTM): A call option with a strike price above the price of the underlying instrument, or a put option with a strike price below the underlying instrument’s price.
Parity: An option’s intrinsic value or if an option is only trading for its intrinsic value, it is said to be at parity (on expiration).
Premium: The price of an option (bought or sold).
Put option: An option that gives the owner the right, but not the obligation, to sell a stock (or futures contract) at a fixed price on or before a specific date.
Put ratio backspread: A bearish ratio spread that contains more long puts than short ones. The short strikes are closer to the money and the long strikes are further from the money.
For example, if a stock trades at $50, you could sell one $45 put and buy two $40 puts in the same expiration month. If the stock drops, the short $45 put might move into the
money, but the long lower-strike puts will hedge some (or all) of those losses. If the stock drops well below $40, potential gains are limited until it reaches zero.
Put spreads: Vertical spreads with puts sharing the same expiration date but different strike prices. A bull put spread contains short, higher-strike puts and long, lower-strike puts. A bear put spread is structured differently: Its long puts have higher strikes than the short puts.
Simple moving average: A simple moving average (SMA) is the average price of a stock, future, or other market over a certain time period. A five-day SMA is the sum of the five most recent closing prices divided by five, which means each day’s price is equally weighted in the calculation.
Straddle: The purchase of a call and a put with the same expiration price and the same expiration date. It is a non-directional option spread that typically consists of an at-the-money call and at-the-money put with the same expiration. For example, with the underlying instrument trading at 25, a standard long straddle would consist of buying a 25 call and a
25 put. Long straddles are designed to profit from an increase in volatility or a large move in the underlying stock; short straddles are intended to capitalize on declining volatility. The strangle is a related strategy.
Strangle:A non-directional option spread that consists of an out-of-the-money call and out-of-the-money put with the same expiration. For example, with the underlying instrument trading at 25, a long strangle could consist of buying a 27.5 call and a 22.5 put. Long strangles are designed to profit from an increase in volatility and/or a large directional move in the underlier; short strangles are intended to capitalize on declining volatility. A Guts strangle involves the sale or purchase of an in the money call and an in the money put.
Strike (“exercise”) price: The price at which an underlying instrument is exchanged upon exercise of an option.
Time decay: The tendency of time value to decrease at an accelerated rate as an option approaches expiration. All options are ‘wasting’ assets.
Time spread: Any type of spread that contains short near-term options and long options that expire later. Both options can share a strike price (calendar spread) or have different strikes (diagonal spread).
Time value (premium): The amount of an option’s value that is a function of the time remaining until expiration. As expiration approaches, time value decreases at an accelerated rate.
Vertical spread: A position consisting of options with the same expiration date but different strike prices (e.g., a September 40 call option and a September 50 call option).
Volatility: The level of price movement in a market. Historical (“statistical”) volatility measures past price fluctuations (usually calculated as the standard deviation of closing prices) over a certain time period — e.g., the past 20 days.
Implied volatility is the current market estimate of future volatility as reflected in the level of option premiums. The higher the implied volatility, the higher the option premium.
