Options Trading Key Terms
American Option – An American option is an options contract that can be exercised on or before the expiry or maturity date unlike a European option.
Assignment – Assignment refers to when an option seller is designated to buy or sell the underlying asset which typically happens when an option expires in the money.
European Option – A European option is an options contract that can only be exercised on the expiry or maturity date and not before like American options.
Option – An option is a contract that gives a buyer the right to buy or sell shares of the underlying asset at a predetermined price called the strike price within a certain period of time.
Options Chain – A list of options contracts used for quoting the options via a list of the available strike prices and expiration’s for the underlying security.
Option Class – An option class is the set of all call or put options for sale for a given security, including every expiration date and strike price combination.
Option Series – Option series refers to a group of options belonging to the same security and characterized by the same price and maturity month.
Monthly Options – Expire the third Friday of each month. (Not all stocks trade options).
Weekly Options – Typically stop trading at 5:30 pm EST on Friday, except index options which trade until 4:15 when non-expiring and 4 pm on date of expiry. (Not all stocks that trade options, trade weekly options).
Open Interest – The open interest for an option is the total number of outstanding or open, not delivered or closed, options that are in effect on any given day.
Strike Price – The strike price is the price set on a derivative contract that is used to determine where options will be assigned or exercised.
Put/Call Ratio – The put-call ratio is the ratio of total trading volume of put options divided by the total trading volume of call options.
Option Expiration – Option expiration is the day an option contract expires and since they are expiring assets they will experience time decay the closer it gets to expiration.
The Greeks (Delta, Theta, Vega, Gamma, Rho) – Greeks are dimensions of risk involved in taking a position in an option (or other derivative). Each risk variable is a result of an imperfect assumption or relationship of the option with another underlying variable. Various sophisticated hedging strategies are used to neutralize or decrease the effects of each variable of risk.
Intrinsic Value – Intrinsic Value refers to the difference between the exercise price (strike price) and the market value of the underlying security.
Implied Volatility (IV) is the estimated volatility of a security’s price. In general, implied volatility increases when the market is bearish, when investors believe that the asset’s price will decline over time, and decreases when the market is bullish, when investors believe that the price will rise over time. This is due to the common belief that bearish markets are more risky than bullish markets. Implied volatility is a way of estimating the future fluctuations of a security’s worth based on certain predictive factors.
Historical Volatility (HV) is the realized volatility of a financial instrument over a given time period. Generally, this measure is calculated by determining the average deviation from the average price of a financial instrument in the given time period. Standard deviation is the most common but not the only way to calculate historical volatility.
Quadruple Witching – Quadruple witching is a rare derivative expiration event where 4 different derivative types expire on the same day which can lead to volatile price action.
Underlying Asset – Underlying asset is a term that is used in the trading of derivatives that refers to what the derivative is trading on. So if you bought options on Apple stock, then the underlying would be Apple.
When Might Options Trading Be Considered?
When markets are trending up or down, when markets are flat, when volatility is high or low and when we want to manage risk and gain leverage! As you can see, there are many reasons to learn options trading and many scenarios in which traders might trade them.
Credit Spread – An options strategy where a high premium option is sold and a low premium option is bought on the same underlying security.
Debit Spread – Two options with different market prices that an investor trades on the same underlying security. The higher priced option is purchased and the lower premium option is sold – both at the same time. The higher the debit spread, the greater the initial cash outflow the investor will incur on the transaction.
What Are Some Popular Kinds Of Options?
Call Options (Bullish) – Call options trading is an agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period. It may help you to remember that a call option gives you the right to call in, or buy, an asset. You profit on a call when the underlying asset increases in price.
Puts Options(Bearish) – A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares.
Option Strategies
Covered Call – A covered call is a type of options strategy that is used to hedge a long stock position by selling calls against it.
Butterfly Spread – A butterfly spread is defined as a limited risk and non directional options strategy that has a high probability of earning limited profit and is utilized mainly by income traders.
Calendar Spread – A calendar spread is an options spread that requires you to open a spread with each leg having different expiration months.
Collar – Collars are protective strategies involving options that are used after a long position in a security has already achieved a significant increase.
Straddle – A straddle refers to an options strategy where the investor holds a position in both call and puts with the same strike price and expiration. The idea is to capitalize in a strong move in either direction. You can have both a long straddle and a short straddle position.
Strangle – A strangle is an options trading strategy that uses a put and call on the same underlying security with the same expiration date to bet on a substantial price move in either direction.
Protective Put – A protective put is a position that is utilized to reduce losses on a long stock position. So if you have a position that is currently up or profitable and you want to protect it from a down move you would by a put as a hedge.
Bull Call (Bullish, Debit) – Use when IV is low. Seeking an increase in low IV when compared to HV. An example of what a bull call spread alert might look like if the SPY was trading at $200.00: “BOUGHT SPY APR16 201.5/205.5 bull call spread for a debit of 3.00” You can see in the example below, we buy the closest to the money call strike (201.5) and sell the back call strike (205.5) for protection.
Bear Call (Bearish, credit) – Use when IV is high. Seeking a decrease in high IV when compared to HV. An example of what a bear put spread alert might look like if SPY was trading at $200.00: “SOLD SPY APR16 201.5/205.5 bear call spread for a credit of 2.94” You can see in the example below, we sell the closest to the money call strike (201.5) and we buy the back call strike (205.5) for protection.
Bull Put (Bullish, credit) – Use when IV is high. Seeking the decrease of high IV when compared to HV. An example of what a bull put spread alert might look like if the SPY was trading at $206.00 “SOLD SPY APR16 201.5/205.5 bull put spread for a credit of 1.11” You can see in the example below, we sell the closest to the money put strike (205.5) and buy the back put strike (201.5) for protection.
Bear put (Bearish, debit) – Use when IV is low. Seeking the increase of low IV when compared to HV. An example of what a bear put spread alert might look like if the SPY was trading at $206.00: “BOUGHT SPY APR16 201.5/205.5 bear put spread for a debit of 3.00” You can see in the example below, we buy the closest to the money put strike (205.5) and sell the back put strike (201.5) for protection.
Iron Condors (neutral, credit) – Use when IV is high and before a large event like earnings. Seeking the decrease of high IV when compared to HV. When receiving an alert for an iron condor, it might look like “Earnings Iron Condor – ABC Feb20 (weekly) 45/50/60/65 for a credit of $0.50” Breaking that alert down, we see that the Iron Condor is for an earnings play on ABC stock. We know we are using the February 20 WEEKLY expiration.
The strike prices are read from left to right (lowest to highest). The first two represent the put spread and the second two represent the call spread. Since these are both credit spreads (Iron Condor = 1 credit/bull put spread and 1 credit/bear call spread), we know that the order of operations for this alert is long/short/short/long. So, buy to open 45p, sell to open 50p, sell to open 60c, buy to open 65c, for a net credit of $0.50.
What do options chains look like?
Options chains will show you everything from current bid/ask spreads, to the Greeks, to volume and open interest. It is critical that you familiarize yourself with options chains in your broker, if you plan to trade options.
Options Trading Approval Level
To trade options, you will need to seek approval from your broker. The following are options levels that require separate approval:
Level 1: Covered calls, protective puts (Secured with stock you own)
Level 2: Long calls/puts
Level 3: Spreads (bull call, bear put, bull put, bear call, diagonal, vertical, condors)
Level 4: Uncovered or Naked options (risky business and potential for unlimited risk)