Option Terminology – Avoiding Confusion

Among the terms most often misused is the way traders describe closing a short position. Anyone belonging to a covered call group online can find this every day. A trader describes closing a trade for a covered call, saying, “It became profitable and I bought it back.” This idea – “buying it back” is very confusing. The correct terminology is “I bought to close.”

Why is this important? Imagine how confusing options are when first introduced to them. It is a struggle just to master the methods and terminology involved. A novice might ask, “If you bought it back, when did you own it? I thought selling a call meant you opened with a sale.” This is a valid point. Kin order to maintain clarity in describing the steps involved, traders may focus on the correct terminology:

• Opening a short position = sell to open
• Closing a short position = buy to close
• Opening a long position = buy to open
• Closing a long position = sell to close

The habit of accuracy avoids confusion in placing trades as well. Many traders (perhaps most) have at one time or another entered a buy order when they meant to sell, or vice versa. And there is more to this. The proper terminology extends to how specific options are expressed:

• Use dollar signs for underlying values = $6 per share or $6.50 per share ($600 or $650 for 100 shares of the underlying).
   
• Do not use dollar signs for option values = premium of 2 or 1 ½  (these are per-option values, so they represent $200 of $150 for options trades on underlying 100 shares.
   
• Expiration month is usually expressed as an abbreviated 3-letter version: Jan, Feb, Mar, Apr, May, Jun, Jul, Aug, Sep, Oct, Nov, and Dec. In most applications, the current year applies. For longer-term options, the year is added in two digits: Jan 21 or 21 Jan, for example.
   
• Calls and puts are distinguished by single letters – c and p.
   
• The strike is always given in whole numbers, and decimals are used only when the strike is not a whole number: Strike is 4 or 4.50, for example, not 4.0 or 4 ½.
   
• The full listing includes the underlying symbol, call or put, expiration, strike, and premium. For example, an IBM call expiring December 11 and with premium of 4, is written as: IBM Dec 11 c, 4.                
   
• Pay attention to decimal places = use two places when one or two partial dollar values are involved, such as 6.50 or 1.25 (options). Use no decimal places when no partial values are involved, such as 6 or 1 ($600 or $100 premium). The same rule applies to values per share of the underlying (for 100 shares, $650 and $125, or $600 or $100).
   
• Dividends are normally expressed on a per-share basis and without dollar signs, but always to two decimal places. A current dividend of 1.25 equals $125 for 100 shares held, and a current dividend of 2.00 equals $200 for 100 shares held.

These are among the descriptions that traders see and use every day. There are, without doubt, many more of these terminology and usage “rules” or conventions. The purpose to each is to clarify and accurately describe how it all works, not just to expect traders to adhere or conform to what someone else has decided. However, it is also important to realize that these forms of expression are not arbitrary. They add clarity and avoid misunderstands and inaccuracy. Even the simple use or exclusion of a dollar sign makes a clear distinction between the underlying value per share, and the premium value of an option.
 

Options terminology is made even more confusing because some issues are described with different terminology. For example, a “ratio backspread” is used in some cases, and in others simply called a “backspread.” A calendar spread is also described as a horizontal spread or a time spread. All three describe the same trade, but for those new to options terminology, this is very confusing and at times, misleading.
 

Another potentially confusing matter relates to dividends and when they are earned (version record date or pay date). The term ex-dividend means “without” the dividends, meaning that the ex-dividend date (ex-date) is the first date when the current option will not be earned if a trader buys the underling on that day. To earn the dividend, the stock must be traded the day before. This is made more confusing because the record date is based on settlement, and payment date takes place later, often several weeks later. However, when looking online, either in groups or chat rooms, ex-dividend date often is referred to as the last day to buy stock to earn the dividend. This is inaccurate.
 

Even traders who thoroughly know these guidelines can easily fall into the habit of poor expression or inaccuracy. Traders using the incorrect term or expressing what they are describing incorrectly, should not assume that other traders know what they mean. You do not “buy back” an option by closing the short position, you buy to close, which is a vastly different expression of what took place.

Similarly, when someone reports that 75% of all options expire worthless, this is false. In fact, 75% of options held to expiration expire worthless, but the majority are closed or exercised before expiration date. Only about 15% to 25% of options are held to expiration, far fewer than the often reported 75%.

In any field, not only options and stocks, accuracy matters. If traders consider one of their roles to help novices master terminology and the mechanics of trading, part of that role should also be to help with the struggle to master terminology.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
 

Related articles

• Understanding Option Trading
• Options Strategies: An Introduction
• How To Start: Options Basics
• Top 10 Options Trading Strategies
• 10 Basic Facts About Options Trading
• Beginner's Guide To Options Trading
• More Options With Options Trading
• What Can You Do With An Option?
• Options Terms: The Glossary
• The Life Of An Options Contract
• How To Start: Options Basics