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In the past 5-6 months, we've learned a lot about option fundamentals. We've dished out a plethora of terms and concepts. It's been a lot of information – especially for beginning option traders.
I know many of you are printing out these columns for future reference. Like Rembrandt, after I'm dead, these columns will be worth a fortune. But, now, if you focus on learning these concepts, and use them properly, they could be worth a fortune to you.
When you open a brokerage account and request a trading level to trade options, you are typically sent (by your broker) a free booklet called the "Characteristics and Risks of Standardized Options." It's standard operating procedure. Brokers want to keep you as a client for a long time. They don't make commissions if you blow up your account right away. Plus, they want to reduce their liability for your losses as much as possible.
This might be a good time to provide you with a quick reference sheet that will help answer some questions and/or help you recall some of things we've discussed thus far. Most of the definitions below come from another handy booklet called, "Understanding Stock Options." This will be a valuable addition to your collection of printed columns.
GLOSSARY OF OPTION TERMINOLOGY
American-Style Options: An option contract that may be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style.
Assignment: The receipt of an exercise notice by an option seller (writer) that obligates him to sell (in the case of a call) or purchase (in the case of a put) the underlying security at the specified strike price.
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At-The-Money: An option is at-the-money if the strike price of the option is equal to the market of the underlying security.
Call: An option contract that gives the holder the right (but not the obligation) to buy the underlying security at a specified price for a certain, fixed period of time.
Closing Purchase: A transaction in which the purchaser's intention is to reduce or eliminate a short position.
Closing Sale: A transaction in which the seller's intention is to reduce or eliminate a long position.
Covered Call: A strategy in which one sells call options while simultaneously owning an equivalent position in the underlying security.
Covered Put: A strategy in which one sells put options and simultaneously is short an equivalent position in the underlying security.
Delta: The change in price of an option given a $1 change in the underlying asset and the mathematical probability that an option will finish in-the-money.
Equity Options: Options on shares of an individual common stock.
European-Style Option: An option contract that may be exercised only during a specified time just prior to its expiration.
Exercise: To implement the right under which the holder of an option is entitled to buy (in the case of a call) or sell (in the case of a put) the underlying security.
Exercise Settlement Amount (Index): The difference between the strike price of the option and the exercise settlement value of the index on the day an exercise notice is tendered, multiplied by the index multiplier.
Expiration Cycle: An expiration cycle relates to the dates on which options on a particular underlying security expire.
Expiration Date: The day in which an option contract becomes void.
Gamma: Measures the change in delta of an option as the price of the underlying asset rises.
Greeks: The different ways risk can be measured as it relates to a particular option or position. (Delta, Gamma, Theta, Rho).
Hedge: A conservative strategy used to limit investment loss by generating a transaction which offsets an existing position.
In-The-Money: A call option is in-the-money if a strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security.
Intrinsic Value: The amount by which an option is in-the-money.
LEAPS: Long term Equity AnticiPation Security. Long term stock or index options.
Long Position: A position in which an investor's interest in a particular series of options is as a net holder.
Margin Requirement: The amount an uncovered (naked) option writer is required to deposit and maintain to cover a position. Also, the amount a trader is required to maintain a credit spread position.
Opening Purchase: A transaction in which the purchaser's intention is to create or increase a long position in a given series of options.
Opening Sale: A transaction in which the seller's intention is to create or increase a short position in a given series of options.
Open Interest: The number of outstanding open option contracts in a particular option's strike price.
Out-Of-The-Money: A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the-money if the strike price is less than the market price of the underlying security.
Premium: The price of an option contract which the buyer of the option pays to the option seller for the rights conveyed by the option contract.
Put: An option contract that gives the holder the right to sell the underlying security at a specified price for a certain fixed period of time.
Rho: Represents the impact of the prevailing interest rate on an option's value.
Short Position: A position wherein a person's interest in a particular series of options is as a net seller.
Spreads: An options position utilizing at least one long option and one short option. There are "credit" spreads and "debit" spreads. Also, horizontal and diagonal spreads.
Strike Price: The stated price per share for which the underlying may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.
Theta: Measures the impact of time on an option's value.
Time Value: The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option has in addition to its intrinsic value.
Type: The classification of an option contract as either a put or a call.
Uncovered Call Option Selling: A short call option position in which the seller (writer) does not own an equivalent position in the underlying security represented by his option contracts.
Uncovered Put Option Selling: A short put option position in which the seller does not have a corresponding short position in the underlying security or has not deposited, in a cash account, the equivalent to the exercise value of the put.
Underlying Security: The security subject to being purchased or sold upon exercise of the option contract.
Volatility: A measure of the fluctuation in the market price of the underlying security. There are two types of volatility – historical and implied.
Writer: The seller of an option contract.
That Should Do It
There are more definitions. Actually, there a lot of other technical things you can learn about options that can scramble your brains. I'm trying to provide you with the information you will need to "profitably" trade options. Trading options is tough enough as it is. We'll try not to clutter your mind with superfluous information.
In upcoming columns we're going to begin our discussion of spreads. We'll discuss how you can further reduce your speculative risk by using spreads. It's not as complicated as some lead you to believe – now that you have a good basic understanding of puts and calls.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. www.tradingacademy.com/newsletters.htm.
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
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