Options Trading Terminology And Strategies

Calls And Puts

(1) A call gives the buyer the right to buy the underlying at the strike price until expiration; they are not obligated to do so. The seller of a call has the obligation to sell the underlying to the option buyer, if they exercise their right.

(2) A put gives the buyer the right to sell the underlying at the strike price until expiration; they are not obligated to do so. The seller of a put has the obligation to buy the underlying from the option buyer, if they exercise their right.

See call and put profit graphs below.

Underlying:  This is what the option contract is based on, for instance a stock or etf, which would be the most common.

Exercise:  This refers to invoking the right that is inherent in the option contract.  For instance, the buying of a call buys the underlying when they exercise, and the buyer of a put sells the underlying when they exercise

Assignment:  This refers to when an option buyer has exercised their option, and the seller is obligated to sell them the underlying in the case of a call, or buy the underlying from them in the case of a put.

Covered Option:  An option sell is considered to be covered if (1) there is an opposite underlying position – long underlying covers a short call, and short underlying covers a short put (2) the sold option is part of a spread that includes a bought option of the same quantity.

If the option is not covered, then it is referred to as uncovered or naked short.

Strike Price:  This is the price where an option buyer can exercise the option.

Expiration Date:  This is the date when the option contract becomes void.  Technically it is the Saturday after the third Friday of the expiration month, but practically it is that Friday while the market is open.  This is something to absolutely discuss with your broker, and be sure that you know their expiration instruction rules.

Multiplier:  1 option ‘represents’ 100 shares of the option.  So, if you buy 1 call and exercise it, then you will be buying 100 shares.  Also, if you buy 1 call for $1.00, then you will be spending $100 on your purchase.

At The Money:  An option is at the money when the strike price is essentially equal to the underlying price.  For instance, if the option strike price is 25 and the underlying is 25.20, that option is at the money.

In The Money:  Any option that has intrinsic value, which is the amount the option is in the money, is an option that is in the money.  Calls are in the money when the underlying is higher than the strike price, and puts are in the money when the underlying is lower than the strike price.

If the call strike price is 25 and the underlying is 24.00, then the option is in the money and has 1.00 of intrinsic value = call strike price – underlying price.

Credit:  The proceeds received from selling an option.

Premium:  This refers to the price of the option.  If the option is bought, then the premium is what is paid for the option.  If the option is sold, then the premium is what is received for the option.

Out Of The Money:  Any option that has no intrinsic value, or all time value, is an option that is out of the money.  Note:  an at the money option is technically out of the money if the strike price and underlying price is not the same, but buy convention when the prices are essential equal they are still said to be at the money.

Time Decay:  This is a term that refers to the value of the option decreasing as a result of the passing of time.

Intrinsic Value:  The amount that an option is in the money.  For instance, a call with a strike price of 20 and an underlying of 25, may have an option price of 27 – the intrinsic value is 5 = underlying price – strike price.

Time Value:  This refers to the amount of the option price that is not intrinsic value.  For instance, a call with a strike price of 20 and an underlying of 25, may have an option price of 27 – the time value is 2 = option price – strike price.

Option Pricing Model:  The price formula that calculates the theoretical value of an option.  The price is based on the following inputs:  (1) underlying price (2) strike price (3) time to expiration (4) interest rate (5) dividends (6) volatility.

Theoretical Value:  This is the price determined by the option pricing model.

Option Greeks:  Additional calculations from the pricing formula used to determine the change in the price of the option.  Their names are Greek, thus the term.

Delta:  The amount that an option price will change with a 1 point move in the underlying.  Call options have a positive delta, and a put option has a negative delta.  The at the money option will have a delta right around +/- 50.

Gamma:  The amount that the option price will change after a 1 point move in the underlying.  So gamma essentially becomes the change in the option delta.  Gamma is always a positive number.

Rho:  The change in the option price from a 1% change in interest rates.

Theta:  The change in the option price for each day the option becomes closer to expiration.  Theta will always be a negative number.

Vega:  The change in the option price from a change in volatility.  Vega is always a positive number.

Volatility:  A measure of the change in the price of the underlying over time.  This is also referred to as historical volatility.

Implied Volatility:  This is not an option pricing input, but an option pricing output – it is the volatility in the underlying that is implied by the price of the option.  Historical volatility and implied volatility will be compared to determine if the price of the option is relatively cheap or expensive.

Protected Strategy: Any position that has limited risk is a protected strategy. A short underlying can be protected by a long call. A long underlying can be protected by a long put. A short option can be protected by a long option of the same quantity in a spread.

Long Call Spread: The buying of a call with a strike price lower than the short call in the spread. The maximum profit is achieved at or above the short strike, and is equal to the width of the spread minus what the spread was bought for. The maximum risk, which will occur at or below the long strike price, is the cost of the spread.

Short Call Spread: The selling of a call with a strike price lower than the long call in the spread. The maximum profit is achieved at or below the short strike, and is equal to the amount the spread was sold for. The maximum risk is at or above the long strike, and is equal to the width of the spread minus what the spread was sold for.

Long Put Spread: The buying of a put with a strike price higher than the short put in the spread. The maximum profit is achieve at or below the short strike, and is equal to the width of the spread minus what the spread was bought for. The maximum risk, which will occur at or above the long put strike, is the cost of the spread.

Short Put Spread: The selling of a put with a higher strike price than the long put in the spread. The maximum profit is achieved at or above the long put strike, and is equal to the amount the spread was sold for. The maximum risk is at or below long put strike minus what the spread was sold for.

There are a number of additional option trading strategies - straddles, strangles, ratio spreads,calendar spreads. 

As well as synthetic positions, which is the creation of one position profit curvature, from the combination of options or options with the underlying.  For instance, if you buy a put and sell a call with the same strike and expiration, you have created a synthetic short underlying.  This gives tremendous flexibility for the usage of options in trading strategies.

I will discuss these further in another hub.