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Adjustment An alteration to the terms of an option contract due to certain events such as a stock split or a stock dividend. In a 2-for-1 stock split, an option holder will own twice as many contracts at half the strike price. An adjusted option may cover more than the usual 100 shares. For example, after a 3-for-2 stock split, the adjusted option will represent 150 shares. The OCC publishes Contract Adjustment memos that spell out the specifics of such adjustments.
All-or-none order An order that must be completely filled or not filled at all.
American Stock Exchange (AMEX) One of six U.S. exchanges that trades options.
American-style option An option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American-style. All stock options are American-style.
Arbitrage The process by which professional traders simultaneously buy and sell similar securities for a profit at theoretically zero risk. Risk in arbitrage occurs when historical relationships that were expected to hold no longer apply, or when expected events like an announced takeover fail to materialize.
Asked price The lowest price a seller is willing to accept for a security (also called the "offer price").
Asset A resource that has economic value to its owner. Cash, accounts receivable, inventory, real estate, and securities are examples of assets.
Assignment The receipt of an exercise notice by an option seller (writer) that obligates him or her to sell (in the case of a call) or purchase (in the case of a put) the underlying security at the specified strike price.
At the money An option is "at the money" if its strike price is equal to or very near the market price of the underlying security. Also called "on the money."
Automatic exercise A protection procedure whereby the Options Clearing Corporation (OCC) attempts to protect the holder of an expiring in-the-money option on behalf of the trader by automatically exercising the option.
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Bearish An outlook that anticipates lower prices for a security.
Bearish credit spread An option strategy implemented by selling a lower-strike call and purchasing a higher-strike call. This results in a net credit to the investor's account. The maximum profit is achieved as long as the sold call stays out of the money by expiration.
Bearish debit spread An option strategy implemented by selling a lower-strike put and purchasing a higher-strike put. This results in a net debit to the investor's account. The maximum profit is achieved if the underlying stock closes at or below the strike of the sold put.
Beta A measure of how a stock moves more or less than the movement of a broader market index.
Bid price The highest price a buyer is willing to pay for a security.
Bid/Asked quotation The latest available bid and asked prices for a particular option.
Bid/Asked spread The difference in price between the latest available bid and asked quotations for a particular option contract.
Black Scholes formula This version of the option pricing model is used most often in the standardized pricing on the floors of the various options exchanges. It factors in the current stock price, strike price, time until expiration, level of interest rates, any dividends, and the volatility of the underlying security. The creators of the Black Scholes model won a Nobel Prize in 1997 for its contribution to the financial markets.
Bollinger Bands Well-known analyst John Bollinger developed Bollinger Bands, which are traditionally plotted above and below the 21-day moving average of a stock's price. These upper and lower boundaries factor in two standard deviations (about 95 percent) of the price movement over the previous 21 days.
Boston Options Exchange (BOX) One of six U.S exchanges that trades options. The most-recently introduced exchange, the BOX started trading in February 2004.
Break-even point The stock price at which a particular option strategy neither has a gain nor a loss at option expiration.
Bullish An outlook anticipating higher prices in the underlying security.
Bullish credit spread An option strategy implemented by selling a higher-strike put and purchasing a lower-strike put. This results in a net credit to the investor's account. The maximum profit is achieved as long as the sold put stays out of the money by expiration.
Bullish debit spread An option strategy implemented by selling a higher-strike call and purchasing a lower-strike call. This results in a net debit to the investor's account. The maximum profit is achieved if the underlying stock closes at or above the strike of the sold call.
Butterfly spread A long butterfly spread is established by buying an in-the-money option, selling two at-the-money options, and buying an out-of-the-money option. A butterfly is typically entered anytime a credit can be received (i.e., when the premium received is greater than the premium paid).
Buy to close See Closing purchase.
Buy to open See Opening purchase.
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Calendar spread The sale of an option with a nearby expiration and the purchase of an option with the same strike price, but a more distant expiration. The loss is limited to the net premium paid, while the maximum profit depends on the time value of the distant option when the nearby expires. This strategy takes advantage of time value differentials during periods of relatively flat prices.
Call An option contract that gives the buyer (holder) the right to purchase and gives the seller (the writer) the obligation to sell a specified number of shares (typically 100) of the underlying stock at the given strike price on or before the expiration date of the contract.
Call ratio backspread A directional trade with a hedging component that allows a trader to book a small profit or break even in the event that the trade moves against them. The risk is limited while the reward is unlimited. Call ratio backspreads involve selling a call at one strike and then buying two more calls at a higher strike price (other ratios can be used). The goal is to keep the ratio of calls sold to calls purchased under 0.67, allowing a credit to be received in order to profit from a strong move in either direction by the underlying security. See also Put ratio backspread.
Called away The process by which a call option writer is obligated to surrender the underlying stock to the option buyer at a price equal to the strike price of the written call. Similar to Assignment.
Cash-settlement option An option that is exercised by a cash payment rather than the delivery of the underlying security. The amount of cash settlement is determined by the difference between the option's strike price and the price of the underlying security. Stock index and industry group options are usually cash settled.
CBOE NASDAQ Volatility Index (VXN) VXN is an indicator of investor sentiment toward the future volatility of the Nasdaq 100 Index (NDX). VXN, which is derived from bid/ask quotes of NDX options, measures the implied volatility of a hypothetical NDX option that is always at the money with a constant one-month maturity. VXN is expressed as an annualized standard deviation of returns.
CBOE S&P 100 Volatility Index (VXO) VXO is an indicator of investor sentiment toward the future volatility of the S&P 100 Index (OEX). The VXO gauges expected market volatility over the next 30 calendar days by calculating a weighted average of the implied volatilities of eight OEX calls and puts that have an average time to maturity of 30 days. VXO measures the implied volatility of a hypothetical OEX option that is always at the money with a constant one-month maturity. VXO is expressed as an annualized standard deviation of returns.
CBOE Volatility Index (VIX) The VIX gauges expected market volatility over the next 30 calendar days by calculating a weighted average of S&P 500 Index (SPX) options with a constant maturity of 30 days to expiration. Extreme high and low VIX readings can provide good contrarian signals, though it actually doesn't matter where the reading lies on an absolute basis if it is at an extreme relative to its recent readings. Buy signals often occur as the VIX reverses lower after an extreme peak, while sell signals occur as the VIX moves higher off an extreme bottom.
Chicago Board of Trade (CBOT) Established in 1848, the CBOT is the world's oldest derivatives (futures and futures-options) exchange. Futures and options on agricultural (wheat, corn, oats, etc.), financial (U.S. Treasury bonds and notes, etc.), and index (Dow Jones Industrial Average) instruments trade on the CBOT.
Chicago Board Options Exchange (CBOE) The CBOE is one of six U.S. options exchanges. In 1973, the CBOE created "listed options" that became the standard, and option prices were set in an auction market nearly identical to the stock exchanges.
Chicago Mercantile Exchange (CME) CME is the largest futures exchange in the U.S. and the second-largest exchange in the world for the trading of futures and options on futures. The exchange offers futures and options on futures in four basic product areas: interest rates, stock indexes, foreign exchange, and commodities. Founded as a not-for-profit corporation in 1898, CME became the first publicly traded U.S. financial exchange in December 2002.
Class of options Options contracts of the same type (call or put) and style (American or European) that cover the same underlying security.
Clearinghouse An agency associated with an exchange that guarantees all trades, thus assuring contract delivery and/or financial settlement. The clearinghouse becomes the buyer for every seller and the seller for every buyer. In the case of listed equity option, the clearinghouse is the Options Clearing Corporation (OCC).
Closeout date The predetermined date an options trader chooses to close a position if it hasn't achieved its target profit. Using such "time stops" is a key component of The Option Advisor's overall risk/reward management strategy.
Closing price The price of a stock (or option) at the last transaction of the day.
Closing purchase (buy to close) A transaction in which an investor who initially sold an option intends to liquidate his or her written position by buying, in a closing purchase transaction, an option having the same terms as the option he or she wrote.
Closing sale (sell to close) A transaction in which an investor who initially bought an option intends to liquidate his or her purchased position by selling, in a closing sale transaction, an option having the same terms as the one he or she purchased. This transaction will reduce the open interest for that option.
Collar A collar is an options strategy that involves the purchase of a put option and the sale of a call option on the same pre-owned underlying stock. The call and put do not have the same strike price (the call is always at a higher strike than the put), nor must they necessarily have the same expiration date.
Combination (position) A combination involves two different option positions and can take a variety of forms. This could involve buying both a call and a put on a given stock, e.g., a straddle (both options have the same strike price) or a strangle (options have different strike prices). Options can also be used in conjunction with stock. A covered combination, for example, involves selling a covered call against stock already owned and selling a put below the current stock price. This strategy enhances total returns in flat-to-rising markets, allowing one to buy more stock at lower prices and effectively lowering the net cost to acquire the stock.
Commission One of the costs associated with trading. This is a fee paid to a brokerage firm when entering or exiting a position. Commissions vary widely, so we suggest searching for those with reasonable rates.
Confirmation statement After an option position has been initiated or closed, a statement must be issued to the customer by the brokerage firm. The statement contains the number of contracts bought or sold and the prices at which the transactions occurred. It is sometimes combined with a purchase and sale statement.
Consensus estimate When a stock reports earnings each quarter, the analysts who follow that stock will each have their own earnings estimate for the company's quarterly results. The average of all these forecasts is known as the consensus estimate. Actual earnings that come in above the consensus estimate are considered a positive earnings surprise. Earnings that are below the estimate are considered negative surprises. The stock's reaction to these earnings announcements typically confirms whether expectations were high or low heading into the earnings report.
Contingency order A type of order that specifies some parameters that must be met before an order is filled. For example, stock traders betting on a breakout may want to buy only if a stock trades above a certain level and would place a "buy-stop" order to get in immediately after the stock trades at a defined price. Options traders wanting to enter an option trade immediately may place a "fill or kill" order. This means the order is either executed at the specified price as soon as it hits the trading floor or is immediately canceled. Another type is an "all or none" order, which is filled only if all of the contracts requested are received.
Contract A call or put option issued by The Options Clearing Corporation.
Contract size The number of shares of the underlying asset covered by an options contract. This size is usually 100 shares for one stock option contract unless otherwise adjusted for a special event (such as a stock split or stock dividend).
Contrarian theory Schaeffer's contrarian philosophy, which is based on Humphrey Neill's The Art of Contrary Thinking, is that the crowd is most likely to be right when it is supportive of the current price trend and is most likely to be wrong when it rejects the current price trend. Contrarian theory is not about buying low prices or cheap stocks, i.e., value investing. True contrary opinion is about buying low expectations. Low expectations often accompany strong technicals and strong fundamentals. Contrarians tend to be attracted to stocks with low expectations that are generally avoided by the crowd. Similarly, they also look to avoid (or short) stocks or sectors that are overly loved by the crowd. Fundamentals and technicals are key to supporting these contrarian conclusions.
Convexity One of the benefits of buying options is convexity. When a stock drops one point, a call option with an initial delta of 50 percent will lose a half-point. But the option will now have a lower delta, such that the next point drop in the stock will result in a smaller loss for the option. This "positive curvature" helps reduce an option's price risk on each successive decline in the underlying shares, while the stockholder continues to lose the same one point on each successive drop in the stock. This positive curvature also works in the same manner as the stock moves up. A call option's delta will increase on each successive gain in the stock, allowing the call holder greater upside participation with each successive gain in the underlying share price.
Convexity also refers to playing more dollars on successive trades during a winning streak and fewer dollars on successive trades in a losing streak (although the percentage allocated remains constant). This preserves capital during a string a losses and provides greater participation during a hot streak.
Cover Indicates the repurchase of previously sold contracts or shares, known as "covering" a short position. Short covering is synonymous with liquidating a short position.
Covered call writing A short option position in which the seller (writer) owns the number of shares of underlying stock represented by the sold options. This strategy is less risky than outright long stock positions and is equivalent in its profit/loss profile to naked put writing.
Credit spread See Bearish credit spread or Bullish credit spread.
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Day order An order that automatically expires at the end of the session if not executed during the day it's entered. All orders are assumed to be day orders unless otherwise specified.
Day trader Stock or options traders (often active on the trading floor) who usually initiate and offset a position during a single trading session.
Debit spread See Bearish debit spread or Bullish debit spread.
Deep in the money An arbitrary term that describes an option that is so far in the money that it's unlikely to move out of the money prior to expiration.
Deep out of the money An arbitrary term that describes an option that is so far out of the money that it's unlikely to move in the money prior to expiration.
Deep-discount broker A broker offering stripped-down services in exchange for very low commission rates.
Delta (also neutral hedge ratio) The percentage of price movement in the underlying stock that will be translated into the price movement in a particular option. For example, a delta of 50 percent indicates that the option will move up (or down) by one-half point for each one-point rise (or decline) in the underlying stock. Call options have positive delta and put options have negative delta. Delta increases as the stock price rises and decreases as the stock price declines. It's also commonly used to approximate the probability that an option will finish in the money.
Delta hedging The process of buying an increasing quantity of stock as it moves closer to the money relative to a sold call position in order to remain delta neutral. Like short covering, this can result in delta hedging rallies that drive a stock price higher.
Derivative security A financial security whose value is derived in part from the value and characteristics of another security, known as the underlying security. Options are a derivative securities.
Diagonal spread A strategy that utilizes options with different expiration dates and strike prices.
Discount broker A broker whose commission rates are lower than typical full-service brokers. Discount brokers usually provide a few additional services such as investment research and/or advice.
Diversification An investing or trading strategy in which positions are maintained in a variety of underlying stocks or stock options for the purpose of reducing risk and increasing bottom-line profits. For options traders, diversification also refers to being invested in both calls and puts.
Dividend Compensation paid by a company on a regular basis to existing shareholders. Dividends usually take the form of quarterly cash payments, which attract investors seeking regular income. Dividends can also be paid in the form of additional stock or spin-offs of existing subsidiaries.
Double Top A double top is a technical formation in which a stock makes two sets of significant highs at a similar price level. Double tops are used for forecasting potential downside risk until their highs are taken out. Once that occurs, all downside forecasts are negated and significant rallies can follow with overhead resistance no longer in place.
Downtrend A process of successive downward price movements in a security over time.
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Efficient Market Hypothesis The EMH view of the markets believes that information is priced instantaneously into stock prices as soon as it is released to the public. The weak form of EMH suggests that technical analysis adds no value to the markets since all past market prices and data are fully reflected in securities prices. The semi-strong form of EMH suggests that all publicly available information is fully reflected in securities prices; thus, fundamental analysis cannot provide an edge in investment selection. The strong form of EMH suggests that even insiders cannot make an above-average profit from their knowledge since all information is fully reflected into the share price. EMH assumes the markets are efficient and thus random in the direction of future prices.
Equity option See Stock option.
European-style option An option contract that can be exercised only during a specified period just prior to the expiration date.
Exchange An association of persons who participate in the business of buying or selling securities. A forum or place where traders (members) gather to buy or sell economic goods.
Exchange-Traded Funds (ETFs) ETFs are investments that contain a pool of securities representing a sector or specific index such as the Dow Jones Industrial Average or the S&P 500. Essentially, ETFs are built like mutual funds but trade like stocks. They are priced continually and can be bought or sold throughout the trading day. ETFs are attractive to both individual and institutional investors because they provide liquid, cost-efficient exposure to a broad range of asset classes. They can be shorted or purchased on margin and many of them are even optionable, such as the Nasdaq-100 Trust (QQQQ).
Execution The actual completion of a buy or sell order on the exchange floor.
Exercise The process by which an option holder/owner invokes the terms of the option contract. To exercise, call owners will buy the underlying stock, while put owners will sell the underlying stock under the terms set by the option contract. Option sellers must be aware of this exercise risk when the option they sold goes deep into the money, and they must make sure they have the capital available to cover any such potential
