Options Glossary

Here are some terms that are important and helpful for options traders to know: 

 

At-the-money:

This refers to options where the strike price is the closest to the stock's current trading price. Out-of-the-money refers to options whose strike price for calls is above the current trading stock price and for puts is below the current trading stock price. You wouldn't want to pay to buy stock above the currently trading price, nor would you want to pay to sell a stock lower than it is currently trading. Thus, out-of-the-money options have no intrinsic value. Why would we pay to own them and why is the premium for in-the-money options often more than their intrinsic value? This part of the option price is referred to as time value (although I like the term extrinsic value as there is more than time involved) and it is based on a number of factors: time to expiration, implied volatility, dividend, carrying cost and short interest. (Extrinsic value is what makes options fun and scares off the faint of heart.)

 

In-the-money: 

This refers to an option that has intrinsic value. When referring to a call, this means that the strike price is below the currently trading stock price. Therefore, you could exercise your call right now and buy stock below the price of the stock. When referring to a put, this means the strike price is higher than the stock's current trading price. Therefore, you could exercise your put and sell the stock above the current price. Thus, these options are worth something right now -- even if the stock freezes until expiration, they have intrinsic value. If the premium equals the intrinsic value, an option is considered to be trading at parity.

 

Covered Writes/Overwrite:

These allow a trader to generate cash and protect against small contrary moves. Essentially, you might use this strategy if you think that an underlying contract that you are long or short might move only slightly in the near term -- or if you are nearing a point where you've made some gains and were thinking of selling to close or buying back at a certain price point.

 

If we are long a stock, but feel we are entering a time period when it might sit still temporarily, we can generate income by selling upside calls in proportion to the stock we are long (one call for every 100 shares). Our profit-and-loss (P&L) graph until that call's expiration will look like that of a short put:

 

Long underlying contract + short call = synthetic short put

 

If the stock moves down, we are protected up to the price of the call. If the stock moves up but not through the strike or stays still, then we will receive the decay on the call, which will expire worthless. If stock blows through the strike, then the call that we are short will be exercised and our stock will be called away. Our profit will be the premium we received on the option sale.

 

This strategy is very different from a protective option. We are only protected on the short side by the price of the call and our upside profit becomes limited. You have to be willing to sell your stock at that strike price if it reaches that level before your call's expiration. So this can be a nice strategy if you have seen some gains and are approaching a level where you might sell your stock anyway. For example, a stock could be reaching what you see as a resistance point. You can sell a call at that resistance point strike. If it gets close but not through it, you have made the price of the call and are still long the stock if it tries again. If you do have to sell your stock, it is at a point where you were willing to sell anyway.

 

During the lifetime of the call, you can lose money if the implied volatility goes up and you decide you want to buy it back before expiration. This could happen if there were news that was perceived as positive and you decided you weren't willing to sell stock at that price. Then you would have to buy back the call for what might be more than you received for it.

 

Which call to sell depends on what you think the stock will do and where you are willing to sell it. Obviously, the closer it is to at-the-money, the higher the premium and the more downside protection you will have. However, you will not be able to partake in any upside profit. The farther out-of-the-money the option is, the less you will receive for selling it. The covered call is a strategy we would primarily recommend for near-term options as the decay, called theta, is greatest at this point.

 

If a trader buys the stock and sells the call at the same time, it is referred to as a buy/write.

 

Collar:

 

A collar is the combination of a protective option and a covered write that allows you to limit both your profit and your loss.

 

From the long stock perspective, for every 100 shares of stock you are long, you would buy one put and sell one call. This is a nice strategy if you are nervous about a big move down, but don't want to pay a lot for the protection and are willing to lose some upside profit potential. Again, if you've seen some nice gains already in a stock and are approaching an earnings that you think might be questionable, this can be a good strategy.

 

The collar is a good conservative strategy if you think a stock is going up generally, but are anxious about a big move down on an event. The same thing can be done with a short position: buying a call and selling a put. The collar can be put on for a credit, debit or even. Which options to choose depend on how much downside you can take if the price goes against you and how much upside you are willing to lose if the stock goes the way you are long or short. It is important to consider these actual scenarios rather than just the price of the collar. Putting on a collar for credit can be very tempting, but you may not be completely satisfied with the consequences.

 

 

Protection:

 

If you are long or short stock and fear a major event/move, you can simply buy puts or calls, respectively, in proportion to the stock you are long or short and be protected. For the life of the option, this essentially turns the position into a synthetic call or put.

 

long stock + long put = synthetic long call

 

short stock + long call = synthetic long put

 

If you are long a stock and buy an out-of-the-money put, then if it goes up or stays still you make money on your stock and lose the price of the put, which will expire worthless. If stock goes down through the put strike, then your stock will have been called away (as that now in-the-money put will be exercised) and your maximum loss is the price of the put plus -- what you have lost on the stock going down until that strike. A protective put is also referred to as a married put.

 

One might buy a protective option if there is a major bifurcating event upcoming where the underlying might move drastically in either direction, or if implied volatility is trading incredibly low and you perceive the puts or calls to be a very good deal as an insurance policy since the stock historically to be more volatile. Unfortunately, before major bifurcating events, implied volatilities tend to trade high.

 

Which call or put to buy depends on how much pain you are willing to take if stock moves against you. The further out of the money, the cheaper the call or put will be, but the more money you will lose on your stock position before you are protected. A near-term call or put will be cheaper, but your protection lasts only until it expires. These options are insurance policies and the better the insurance, the more you have to pay for it.

 

 

Straddle:

 

A straddle consists of buying or selling both a call and a put of the same strike. Usually, this is done with at-the-money options and therefor is initially a delta neutral strategy as at-the-money calls and puts have around 50 deltas, positive and negative, respectively. For a long straddle, you buy the call and put and a short straddle you sell them.

 

 

Long Straddle:

 

With a long straddle you are long gamma, long vega, and negative theta. By buying both the call and the put, you are spending money -- buying premium. You need the stock to move significantly in either direction and/or for implied volatility to go up, all before too much time passes. Your upside and downside profit potential are unlimited (until stock reaches zero) and your maximum loss is what you paid for the straddle.

 

If you have bought a straddle near expiration, the time decay on the premium of the options will be extreme. Therefore, you will need the stock to move either up or down beyond the price of the straddle to make money. A move up in implied volatility may or may not be enough to make up for the time decay.

 

You might buy a near-term straddle before an event if you think the move in the stock, up or down, will be greater than the price of the straddle. With this strategy, it is important to look at historical moves after events. For example, on an earnings report, you might look at the previous three or more earnings to see if the stock has moved beyond the price of the straddle following the announcement. Many times, the average earnings move is priced already into the options. That's why this strategy takes some conviction and precision in what you are expecting. You also generally would want to sell the straddle quickly after the event as implied volatility will generally come in.

 

If you think a stock will be moving around a lot over the duration of the life of the straddle, you might buy with the expectation of scalping the stock. As the stock goes up, the straddle will become a long delta position (the call goes in-the-money, the put goes out-of-the-money) and you can sell stock to stay delta neutral. As the underlying contract moves down, you become short deltas (the put goes in-the-money and the call out-of-the -money) and you would buy stock to be delta neutral. With moves up and down, you would be scalping the stock for a profit.

 

A long straddle further out will have less negative theta (time decay) and more positive vega. One might buy a long straddle a few months out if you think that volatility is trading especially low and that there could be stock movement or uncertainty occurring down the road that would cause implied volatility to go up.

 

Let's say you are considering a straddle three months out. To make a volatility determination, you might look at 90-day historical volatility. Another consideration might be a year-long graph of 30-day implied volatility. If 30-day implied volatility has not been below 40 (for instance) all year and you are buying lower than that, then you might consider it low. You might look at where earnings and events fall in relation to the straddle and what implied volatility has done historically in relation to earnings and events. You might consider the volatility of the underlying vs. other similar underlying contracts or the market as a whole.

 

Even though a long straddle would seem to be a low-risk strategy, it in fact requires a lot of consideration and precision of expectation in order to be profitable.

 

 

Short Straddle:

 

This a high risk position. Losses are unlimited and profits max at the price received for the sale of the straddle. Profits are only in the span of up or down the price of the straddle from the strike.

 

With a short straddle you are short gamma, short vega and positive theta. You want stock to stay still, implied volatility to come in and the option premium to just decay away. You might sell a straddle if you think that implied volatility is exaggerated compared to the movement you expect in the stock.

 

 

Strangle:

 

Strangles have many of the same characteristics as straddles, but with a larger margin of error. For a strangle, you buy or sell both an out-of-the-money call and an out-of-the-money put of the same expiration. Thus, the premium paid or received is considerably lower than a straddle. On the other hand, with a long strangle you need the stock to move quite a bit farther or volatility to go up quite a bit more (vega being smaller out-of-the-money) for it to be profitable. A short strangle has a larger area of profitability, but the maximum profit is not as great because the premium received for out-of-the-money options is less. The theta is also smaller, so decay will not be as dramatic.

 

Strangles tend to be a lower premium strategy as compared to straddles, but the probability that you will lose all of your premium is also higher. If you think volatility is low, you can buy a straddle that has a higher probability of being profitable if you are correct. However, the strangle has a much higher payout if the stock makes an extreme move. Your decision will depend on your expectations, your risk tolerance and your conviction.

 

Both straddles and strangles are strategies to take advantage of a perceived mispricing of options where the trader thinks that implied volatility or premium does not represent what the underlying contract will do, but where he or she does not have a strong directional opinion. They are often tempting, but should definitely be used with caution. The risks of short straddles and strangles are obvious, but a slow death by decay can be extremely tortuous as well.

 

 

Volatility:

 

The two types of volatility we refer to on this site are historical and implied volatility. Historical volatility is measured from the actual movement of the stock over a time period. So the 20-day historical volatility, or hv20, is measured from how much the stock has actually moved in the previous 20-day period. If the stock moves a lot, the volatility will be higher than if the stock moves very little.

 

Implied volatility is derived from the difference between the market price of an option and what the price would be given just the inputs of stock price, strike price, time to expiration, interest rate, dividend and cost to borrow stock. The implied volatility tells you what the market predicts the volatility of the stock will be going forward. If the implied volatility is higher than historical volatility, then the market is predicting that the stock will move about more going forward than it has in the past.

 

On a practical basis, when people buy options, market makers raise the price and when people sell them, they lower it. Implied volatility is constantly changing. So if implied volatility is high on a particular option or a strike or a month, it usually means people have been buying those options. (Why do people buy particular options in large quantities? They might be buying them because they know something you don't know or because of a rumor or to hedge a large stock position or to balance a portfolio.) What do we mean by high? Generally, we mean higher than historical for the same period, but we may also mean in comparison to other option strikes or expirations or in comparison to implied volatility in a previous period.

 

When implied volatility goes up, the price of the option goes up because there is a greater chance that that option will finish in the money. Ideally, you want to buy low volatility and sell high volatility. With directional trading, volatility may not be your primary consideration, but it must be considered as it should affect your choice of strategy. Volatility helps you assess the relative value of different options.

 

 

For Other Terminology:

 

See TheStreet's full Dictionary of Financial Terms.

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