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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
American style option – An option that may be exercised at any time before the option expires. Assigned (an exercise notice) – Notification that the recipient is obligated to fulfill the conditions of the contract because the owner exercised his/her rights. At-the-money – An option whose strike price equals (or is near) the price of the underlying asset. Bear spread – A position consisting of two or more options on the same underlying asset, designed to earn a profit when the underlying stock declines. Bull spread – A position consisting of two or more options on the same underlying, designed to earn a profit when the underlying stock rallies. Butterfly spread – A position consisting of three different options (all calls or all puts) on the same underlying with the same expiration date. You construct a butterfly spread by buying one option, selling two options at a lower strike price and buying one option at a still lower strike price. The options sold are equidistant from the options bought. Example: buy one Oct 50 call, sell two Oct 55 calls, buy one Oct 60 call. Buy-Write Transaction – The simultaneous purchase of 100 shares of stock and sale of one call option. Call – An option contract giving its owner the right to buy the underlying asset at the strike price for a limited time. Cash settled – An option whose owner receives (and whose seller pays) the intrinsic value of the option – at expiration. Covered Call – A short (i.e., sold) call option backed by an equivalent number of shares. Long 100 shares, short one call. Credit spread – A position consisting of two calls or two puts on the same underlying and with the same expiration date in which the option with a higher premium is sold and the option with a lower premium is bought, resulting in the trader collecting a cash credit. Debit spread – A position consisting of two calls or two puts on the same underlying and with the same expiration date in which an option with a higher premium is bought and an option with a lower premium is sold, resulting in the trader paying a debit. European style option – An option that may be exercised at expiration (also referred to as “settlement”), and not earlier. It is cash-settled and no shares are exchanged. Exercise – The election by the owner of an option to do what the option contract allows: either buy or sell the underlying at the strike price. Exercise Notice – The means by which an investor is notified that the option owner has exercised the contract. Also known as an assignment. Expiration – The time, after which, the option is no longer a valid contract. For most stock options, it is the 3rd Friday of the specified month. However, many options expire on a weekly basis (i.e., expiration is the specified Friday. Some index options expire on Wednesday. Be aware that some options expire at the close of business (PM settled) while others have an expiration time that coincides with the morning opening prices (AM settled). Expire Worthless – When an option is not exercised by the time that expiration arrives. Hedge – An investment made to reduce the risk of holding another investment. Historical Volatility – The past volatility of a stock over a specified period of time. HV is a property of the underlying stock and not of the option. Implied Volatility – The volatility that, when inserted into the equation for calculating the theoretical value of an option, makes the theoretical value equal to the market price of the option. Implied volatility is a property of the option, not the stock. In-the-money – A call option with a strike price lower than the underlying price, or a put option with a strike price higher than the underlying price. An option with an intrinsic value greater than zero. Intrinsic Value – The amount by which the stock price exceeds the strike price of a call option, or is below the strike price of a put option. If you are not a member yet, you can join our forum discussions for answers to all your options questions. Iron Condor – A combination built by selling one call credit spread and one put credit spread on the same underlying. All options expire at the same time. In addition, the distance between the two calls equals the distance between the two puts. Example: Buy Nov60 call, sell Nov 50 call. Also sell Nov55 put and buy Nov45 put. LEAPS – Acronym for Long Term Equity AnticiPation Series. These are Puts and calls with a January expiration. The expirate more than eight, and less than 36, months in the future. NOTE: the acronym is always capitalized and the singular form is LEAPS, not LEAP or leap. Leg – One part of a spread position Long – A position resulting from ownership. Margin – The amount that must be deposited into an account in the form of cash or eligible securities. The deposit is required to protect the broker against the risk of loss. NOTE: This limits the broker’s exposure to a loss; not your exposure. Margin Account – An account in which an investor can (but is not required to) buy securities on credit, using other securities held in the account as collateral. The needed cash is borrowed from the broker and interest is charged. A margin account is required for all options trades. Obligations – Attributes forced upon the seller of an option. Offsetting – Moving in the opposite direction. A position acting as a hedge. Option – A legal contract that gives its owner the right, but not the obligation, to buy or sell a specified asset at a specified price (strike price) for a specified time (until expiration). Options Clearing Corporation (OCC) – an organization that keeps records for every outstanding option contract. When someone exercises an option, the OCC verifies that the person has the right to exercise. The OCC then randomly assigns an exercise notice to a broker who then assigns (randomly) it to one of the accounts that is currently short the option. Optionspeak – My term for the language of options. Out-of-the-money – A call option with a strike price higher than the price of the underlying, or a put option with a strike price lower than that of the underlying asset. An option with no intrinsic value. Premium – The price of an option. It is the sum of the intrinsic value (if any) and the time value. Put – An option contract giving its owner the right to sell the underlying asset at the strike price for a specified time. Rights – Attributes given to the owner of an option. Rolling a Position – The process of buying to cover a previously sold option, and selling a different option with a more distant expiration. It is often done near expiration as a method for reducing current risk. Series – a specific option, with a specific strike and expiration. ex: JNJ OCT70 put Short – The position resulting from selling an asset that is not owned. There is a future obligation to repurchase — unless it is an option that expires worthless. Spread – Two simultaneous trades in which you buy one option and sell another. The underlying is the same for both options, but the expiration may vary. Spread Transaction – A simultaneous options trade consisting of 2 (or more) legs. The legs are such they partially offset each other. A hedged position. Standard Deviation – A statistic describing how closely data points are distributed around the average of those data points Straddle – A position consisting of one call and one put on the same underlying stock or index. Both options have the same strike price and expiration.The straddle is long when the options are bought and short when the options are sold. Strangle – Similar to a straddle, but the call and put options have different strike prices. Strike Price – The price at which an option owner can buy or sell the underlying asset. Theoretical Value (Fair value) – The price an option is worth, based on a mathematical calculation and some assumptions. In the real world, the actual price usually differs from the fair price. Time Spread (Calendar spread) – A position in which one option is bought and another sold – both with the same strike price and underlying, but with a different expiration. Time Value – The part of the option premium derived from the volatility and the time remaining until expiration. It is the part of the option premium that is NOT intrinsic value. Uncovered Call – A call option that is sold when the trader does not own the underlying. Also called a naked call. Underlying – The asset from which the option derives its value and which the call owner may buy, or the put owner may sell. Volatility – A measure of the price change of a stock over time. Write – Sell. Related articles 10 Basic Facts About Options Trading Beginner's Guide To Options Trading More Options With Options Trading Trading An Iron Condor: The Basics What Can You Do With An Option? Want to join our winning team? Start Your Free Trial
In short, options trading and investing has come to the masses; and at times it causes mass confusion. Before you jump in, you should have a strong grasp on the basics. This article is obviously geared towards new options traders but if you’re already swimming, a refresher from time-to-time can be quite useful. WHAT ARE OPTIONS? Equity options are contracts whose value is derived from the value of a specific (called underlying) stock trading in the market. These contracts can be used to profit, leverage, and hedge your position in its underlying stock, based on your belief in the direction of the market and/or how market volatility will behave. An option establishes a right to buy or sell the underlying property. A standard equity option establishes the right to buy or sell 100 shares of the underlying stock at a fixed price before a specific date in the future, known as the expiration date. The expiration date for an option usually occurs in three, six, or nine months. In the United States, options are traded on the Chicago Board Options Exchange, over-the-counter, and on several other exchanges. Don’t worry about using a specific exchange, your broker will take care of that for you. Now that you have a basic definition of what an options contract is, the rest of this article will focus on the difference between calls vs. puts; buying and holding vs. selling and writing; pricing and premiums; type, class, and series of options; opening and closing positions; and, European versus American-style options. Wow, that was a mouthful! THE BASICS OF OPTIONS Calls vs. Puts The right to buy the underlying stock at a fixed price (strike price)before expiration is a call option; the right to sell the underlying stock is a put option. Call options only make financial sense to exercise (i.e., exercise the call buyer's right to purchase the shares) when the price of the stock goes above the strike price of the call while the put options would only be exercised if the price of the stock goes below the strike price. Buying and Holding vs. Selling and Writing The purchaser of an option contract is known as the holder. The holder pays the seller (writer) of the option a premium (at the time of the options trade), which isalso the price for the option. The price, like stock, is what is reported by the exchange as the last price and will vary throughout the day and remaining life of the contract. The buyer, (holder) exercises the option by informing broker, who then informs the writer that she wishes to buy (for a call option) or sell (for a put option) shares of the underlying security at a specified price (strike or exercise price). Options are always described from the standpoint of the holder. The holder has a right to exercise the option while the writer has an obligation to deliver the underlying stock at the specified price, or strike price. A call holder would have a bullish outlook for the market or shares upon which the option was purchased, believing prices are generally going to rise. A put holder has a bearish or contrary outlook of the market. The seller, or writer, of the contract (should) have the opposite view. Pricing and Premiums The exercise price is the set price at which the 100 shares of stock trade will be executed. Exercise (strike) prices are determined by the exchange(s) where the options trade. These strike prices are set at certain standard increments depending on the current price of the underlying stock. Often beginning options traders get confused with the strike price. It’s important to note that the strike prices are not arbitrary and are set for the life of the contract. If the underlying stock is trading at less than $200 per share, the strike prices on the options contract will be set at 5-point intervals. For example, if the stock for FB (Facebook, Inc.) has been trading around $140 to $160/share, there will be puts and calls set at strike price intervals of 140, 145, 150, 155, 160, etc. If the underlying stock is trading over $200 per share, the strike prices of the options contracts will generally be set at 10-point (dollar) intervals. For example, if GOOGL (Alphabet Inc, the parent company of Google) stock has been trading in a range from $1,300 to $1,000 over the past few months, there will be puts and calls on GOOGL at 1030, 1040, 1050, and so on and so forth. The premium is the price buyers pay and sellers receive for the options contracts. Premiums are determined, largely, by supply and demand in an auction market (on the respective exchange) in the same way a stock’s price will fluctuate based on supply and demand in the market.The relationship between the strike price of the option and the market price of the underlying stock is a major one. If the market price is above the strike price, calls at that strike price will have a greater premium than puts at that strike price (this is because the call is considered in-the-money while the put would be out-the-money). Type, Class, and Series of Options There are two types of options; puts are one type and calls are the other type. All calls are one type of option, and all puts are another type. By adding the underlying stock to the type, we get the class of options. All IBM calls are one class; all IBM puts constitute another options class. Once the expiration month added to the class then this establishes the maturity class of an option. All GM JAN(January) calls are one maturity class; all GM JAN puts are another maturity class. Adding the strike (exercise) price to the maturity class gives the series of an option. All XOM (Exxon Mobil Corporation) JAN 75 calls are one series; all XOM JAN75 puts are another series. Once the series is defined, this is the final level of granularity in defining the contract to be traded. Opening and Closing Positions Every beginning options contract position begins with an opening transaction. Whether you write (sell) or hold (buy) the option, you are executing a corresponding ‘opening’. Ex. Buy 1 JAN IBM 120 Call @4.00 = opening buy ($400 + commission paid = total transaction cost) Sell 5 APR MSFT 100 Puts @4.25 = opening sale ($2,125 - commission paid = net proceeds received) A closing transaction takes place when you purchase the same contract at or near expiration to close out your position before an exercise occurs. Ex. Buy 1 JAN IBM 120 Call @ 4.00 = opening buy; Sell 1 JAN IBM 120 Call @8.00 = closing sale Sell 5 APR MSFT 100 Puts @4.25 = opening sale; Buy 5 NOV MSFT 125 Puts @2.00 = closing buy How Many Options Contracts Are There? Unlike stock, the company does not “issue” its options contracts as it would its shares. Rather, the exchange standardizes the classes of options available and the market creates the supply. How, you might ask? The exchange standardizes the series of options available for each class. A new contract is created when a seller initiates an opening transaction. Did you notice that I used the term “write” synonymously with “sell” above? When a contract is “Sold to Open” it creates a contract that can be bought on the exchange. Once the buyer and seller make the deal (via the efficiency of the exchange) a new contract is born and the “Open Interest” of the series will increment by 1 contract. Open interest shows how many contracts are still “active” in the market. Remember, the seller (who has the obligation of the contract) must hold up the terms of the contract or execute a closing transaction to cancel out their obligation. Why bring this up again? Let’s take our initial example and say the series only has an open interest of only 1. In this case, the seller could only close the position if the buyer would sell the contract back. The series is said to be very illiquid in this case. The seller would likely be forced to maintain the obligation throughout the contracts life. On the contrary, if the series had 10,000 open interest then the seller would easily be able to find another seller in order to purchase the closing order and exit the trade. European versus American-style Options Most exchange-listed options in the United States are classified as American-style options, meaning that the contracts may be exercised at any time up to their expiration date. This differs from European-style options, which may only be exercised at expiration. Certain ETFs and index options trade European-style despite being listed on American Exchanges. Understand that the style is very important, especially when writing options contracts. In general, American-style options tend to have higher premiums than European-style because there is more flexibility to exercise the rights of the contract (for the holder) and more risk to be exercised against (for the seller). Remember, it is the seller’s obligation to either deliver 100 shares at the strike price or buy 100 shares from the holder at the strike price depending on the contract type. Have I said this enough times? It’s a very important point. BASIC OPTIONS TRADING SETUPS** or ‘STRATEGIES’ The most basic options strategies involve buying and selling single contracts. For some, this is fine way to trade options. Buying and selling calls and selling puts meets the basic requirements when looking to take advantage of movements in the market. Buying calls or selling puts are a position taken when your outlook is bullish on the market. In the other hand, selling a call or buying a put creates a bearish position. Establishing these positions as a holder gives you a right to purchase the stock at a price lower than what it is currently trading. Writing calls and puts provides premium as income, however, it also inherits an obligation (risk) to deliver (or buy) the stock at a price that is reserved by the holder (repeated once again!). Buying and selling a single contract is the most basic ‘options strategy’ and far from ideal in many circumstances. Most of the trades we use are known as “spreads”, or combinations of puts and calls within the same class. Spreads allow us to control our trading risk and be more strategic; this is why the various spread type is often referred to as the ‘Options Strategy’. I have to note. I’ve never liked the term ‘Options Strategy’ to refer to a spread. A spread can be used strategically, but purchase or sale of a spread does not constitute an options strategy in my book. A strategy must holistically evaluate multiple criteria and be rule-based for entry and exit…but I digress…. For sake of simplicity, and to get your feet wet. Let’s take a closer look at these three ‘strategies’: Example 1: Buy 1 AAPL JAN 170 CALL (Market Price of AAPL $165) @ about $5 In this example, you are bullish on AAPL stock and believe that the market price is going to rise well above the strike price of $170. Currently, the market price of AAPL is $165, meaning that the call is considered out-of-the-money (OTM)by $5. If you were to exercise the option, you would be able to buy the stock for $170 per share. So this trade will only become profitable for you if AAPL rises in prices to above $175/share.At this price the option is now in-the-money(ITM). Why $175/share, you might ask? Above we discussed that it makes financial sense to exercise the call option if the stock is above the strike price? The reason for this, is that you also need to recoup the cost of the premium you paid to the option writer. Here’s an example: Exercise the call at the strike price (170): $170 × 100 = $17,000 Sell the stock in the market at its current price (let’s assume AAPL appreciates to $176 per share prior to January expiration): $176 × 100 = $17,600Difference: $17,600 - $17,000 = $600 Net Profit/Loss (based on $500 in premiums paid): $600 - $500 = $100 Note: You don’t actually need to exercise the stock to profit $100. One of the beautiful features of options is that you would stand to profit about the same if you simply sold the call to someone else. This closes your position and allows you to book your profits. Example 2: Sell 1 AAPL JAN 170 CALL (Market Price of AAPL is $165) @ 5.00 This time, instead of a bullish outlook for AAPL, you feel that the market price is going to drop. You decide that you want to collect premium income by selling a call when the market price is below the strike price. If the market price stays below $170 by January expiration, the call will expire worthless and you as the writer will pocket the $500 in premiums collected. Should the price of the stock go up, you have a $5 cushion to breakeven (exercise price + premium = breakeven) before you lose in this strategy. Notice this is the opposite risk profile of the buyer. Except in this case, your obligation is unlimited. The buyer can only lose the premium paid. The seller is on the hook for much more. Therefore, it’s very important to note that, in theory, AAPL could continue to increase in value endlessly within the expiration period, therefore, this type of trade is not suitable for beginner options traders. In fact, most brokers will not give you permission to execute this type of trade without demonstrating that you have adequate experience and capital. Example 3: Sell 1 AAPL 160 PUT (Market Price of AAPL is $165) @$4.25 Another basic position to take is to sell a put. Where selling a call is bearish, writing puts are considered a bullish strategy as well. If the price remains above the exercise price (165), you will pocket the $425 in premiums received. In a falling market, the holder will ‘put’ the stock to you at $165 as prices fall; your breakeven in this position is the exercise price less the premium you received ($165 - $4.25 = $160.75 breakeven). Other more intermediate/advanced options strategies include covered call writing, vertical spreads, and calendar (time) spreads. This is where we really get to harness the power of options trading. WRAPPING UP Options trading involves risks. You must take on risk to make a profit. However, after reading this article, I hope you have less risk tied to “beginner mistakes” in your initial trading. A sound understand of the mechanics and basics will help you avoid a sticky situation. Your next step is to understand the effects of implied and historical volatility on options pricing before getting your feet wet with very small, risk-defined trades. Happy to answer any questions you have in the comment section below. Drew Hilleshiem is the Co-Founder and CEO of OptionAutomator, an options trading technology startup offering a free options screener that leverages Multi-Criteria Decision Making (MCDM) algorithms to force-rank relevancy of daily options opportunities against user’s individual trading criteria. He is passionate to help close the gap between Wall Street and Main Street with both technology and blogging. You can follow Drew via @OptionAutomator on Twitter. 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