The Options Playbook

Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between TradeKing

Glossary

(AKA Definitely-boring-definitions)

Sometimes when defining terms throughout the playbook, we simplified things a little so they’d be easier to understand. But here we present the standard textbook definitions for a whole slew of options terminology without any jokes, interjections or unnecessary asides.

If your friends like to refer to you as “Poindexter” and that is not your real name, we’re sure you’ll enjoy these definitions much more than the ones in Key Options Terms.

Assignment

The receipt of an exercise notice by an equity option seller (writer) that obligates him/her to sell (in the case of a short call) or buy (in the case of a short put) 100 shares of underlying stock at the strike price per share.

At-the-money

An equity call or put option is at-the-money when its strike price is the same as the current underlying stock price.

Back month

For an option spread involving two expiration months, the month that is farther away in time.

Break-even point

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An underlying stock price at which an option strategy will realize neither a profit nor a loss, generally at option expiration.

Call option

An equity option that gives its buyer the right to buy 100 shares of the underlying stock at the strike price per share at any time before it expires. The call seller (or writer), on the other hand, has the obligation to sell 100 shares at the strike price if called upon to do so.

Cash settlement

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A settlement style that is generally characteristic of index options. Instead of stock changing hands after a call or put is exercised (physical settlement), cash changes hands. When an in-the-money contract is exercised, a cash equivalent of the option’s intrinsic value is paid to the option holder by the option seller (writer) who is assigned.

Closing transaction

A transaction that eliminates (or reduces) an open option position. A closing sell transaction eliminates or reduces a long position. A closing buy transaction eliminates or reduces a short position.

Commission

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The fee charged by a brokerage firm for its services in the execution of a stock or option order on a securities exchange.

Cost-to-carry

The total costs involved with establishing and maintaining an option and/or stock position, such as interest paid on a margined long stock position or dividends owed for a short stock position.

Credit (transaction)

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Any cash received in an account from the sale of an option or stock position. With a complex strategy involving multiple parts (legs), a net credit transaction is one in which the total cash amount received is greater than the total cash amount paid.

Debit (transaction)

Any cash paid out of an account for the purchase of an option or stock position. With a complex strategy involving multiple parts (legs), a net debit transaction is one in which the total cash amount paid is greater than the total cash amount received.

Delta

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The amount a theoretical option’s price will change for a corresponding one-unit (point) change in the price of the underlying security.

Early exercise / assignment

The exercise or assignment of an option contract before its expiration. This is a feature of American-style options that may be exercised or assigned at any time before they expire.

Equity option

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A contract that gives its buyer (owner) the right, but not the obligation, to either buy or sell 100 shares of a specific underlying stock or exchange-traded fund (ETF) at a specific price (strike or exercise price) per share, at any time before the contract expires.

Even money (transaction)

With a complex strategy involving multiple parts (legs), an even money transaction results when the total cash amount received is the same as the total cash amount paid.

Exchange traded fund (ETF)

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A security that represents shares of ownership in a fund or investment trust that holds a basket (collection) of specific component stocks. ETF shares are listed and traded on securities exchanges just like stock, and so may be bought and sold throughout the trading day.

Ex-dividend date

When a corporation declares a dividend, it will simultaneously declare a “record date” on which an investor must be recorded into the company’s books as a shareholder to receive that dividend. Also included in the declaration is the “payable date,” which comes after the record date, and is the actual date dividend payments are made. Once these dates are established, the exchanges will then set the “ex-dividend” date (“ex-date”) for two business days prior to the record date. If you buy stock before the ex-dividend date, you will be eligible to receive the upcoming dividend payment. If you buy stock on the ex-date or afterwards, you will not receive the dividend.

Exercise

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To employ the rights an equity option contract conveys to its buyer to either buy (in the case of a call) or sell (in the case of a put) 100 shares of the underlying security at the strike price per share at any time before the contract expires.

Exercise price

A term of any equity option contract, it is the price per share at which shares of stock will change hands after an option is exercised or assigned. Also referred to as the “strike price,” or simply the “strike.”

Expiration date

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The day on which an option contract literally expires and ceases to exist. For equity options, this is the Saturday following the third Friday of the expiration month. The last day on which expiring equity options trade and may be exercised is the business day prior to the expiration date, or generally the third Friday of the month.

Expiration month

The calendar month during which a specific expiration date occurs.

Extrinsic value

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The portion of an option’s premium (price) that exceeds its intrinsic value, if it is in-the-money. If the option is out-of-the-money, the extrinsic value is equal to the entire premium. Also known as “time value.”

Front month

For an option spread involving two expiration months, the month that is nearer in time.

Gamma

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The amount a theoretical option’s delta will change for a corresponding one-unit (point) change in the price of the underlying security.

Historical volatility

A measurement of the actual observed volatility of a specific stock over a given period of time in the past, such as a month, quarter or year.

Implied volatility

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An estimate of an underlying stock’s future volatility as predicted or implied by an option’s current market price. Implied volatility for any option can only be determined via an option pricing model.

Index option

An option contract whose underlying security is an index (like the NASDAQ), not shares of any particular stock.

In-the-money

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An equity call contract is in-the-money when its strike price is less than the current underlying stock price. An equity put contract is in-the-money when its strike price is greater than the current underlying stock price.

Intrinsic value

The in-the-money portion (if any) of a call or put contract’s current market price.

LEAPS

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Long-term Equity AnticiPation Securities, or LEAPS, are long-term option contracts. Equity LEAPS calls and puts can have expirations up to three years into the future and expire in January of their expiration years.

Leg

1: One part of a complex position composed of two or more different options and/or a position in the underlying stock.

2: Instead of entering one order to establish all parts of a complex position simultaneously, one part is executed with the hope of establishing the other part(s) later at a better price.

Lognormal distribution

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With respect to stock prices over a period of time, a lognormal distribution of daily price changes represents not the actual dollar amount of each change, but instead the logarithms of each change. Mathematically, this type of distribution implies that a stock’s price can only range between 0 and infinity, which in the real world is the case. So in a sense a lognormal distribution could be considered to have a bullish bias. A stock can only drop 100% in value but can increase by more than 100%. In general, assumptions made by option pricing models about a stock’s future volatility are based on a lognormal distribution of future price changes.

Long option

A position resulting from the opening purchase of a call or put contract and held (owned) in a brokerage account.

Long stock

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Shares of stock that are purchased and held in a brokerage account and which represent an equity interest in the company that issued the shares.

Margin requirement

The amount of cash and/or securities an option writer is required to deposit and maintain in a brokerage account to cover an uncovered (naked) short option position. This cash can be seen as collateral pledged to the brokerage firm for the writer’s obligation to buy (in the case of a put) or sell (in the case of a call) shares of underlying stock in case of assignment.

MEAN

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For a data set, the mean is the sum of the observations divided by the number of observations. The mean is often quoted along with the standard deviation: the mean describes the central location of the data, and the standard deviation describes the range of possible occurrences.

Normal distribution

One of the most familiar mathematical distributions, it is a set of random observed numbers (or closing stock prices) whose distribution is symmetrical around the mean or average number. A graph of the distribution is the familiar “bell curve,” with the most frequently occurring numbers clustered around the mean, or the middle of the bell. Since this a symmetrical distribution, when the numbers represent daily stock price changes, for every possible change to the upside there must be an equal price change to the downside. The result is that a normal distribution would theoretically allow negative stock prices. Stock prices are unlimited to the upside, but in the real world a stock can only decline to zero. See “lognormal distribution.”

Opening transaction

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A transaction that creates (or increases) an open option position. An opening buy transaction creates or increases a long position; an opening sell transaction creates or increases a short position (also known as writing).

Option pricing model

A mathematical formula used to calculate an option’s theoretical value using as input its strike price, the underlying stock’s price, volatility and dividend amount, as well as time until expiration and risk-free interest rate. Generated by an option pricing model are the option Greeks: delta, gamma, theta, vega and rho. Well-known and widely used pricing models include the Black-Scholes, Cox-Ross-Rubinstein and Roll-Geske-Whaley.

Out-of-the-money

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An equity call option is out-of-the-money when its strike price is greater than the current underlying stock price. An equity put option is out-of-the-money when its strike price is less than the current underlying stock price.

Physical settlement

The settlement style of all equity options in which shares of underlying stock change hands when an option is exercised.

Premium

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The price paid or received for an option in the marketplace. Equity option premiums are quoted on a price-per-share basis, so the total premium amount paid by the buyer to the seller in any option transaction is equal to the quoted amount times 100 (underlying shares). Option premium consists of intrinsic value (if any) plus time value.

Profit + loss graph

A representation in graph format of the possible profit and loss outcomes of an equity option strategy over a range of underlying stock prices at a given point in the future, most commonly at option expiration.

Put option

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An equity option that gives its buyer the right to sell 100 shares of the underlying stock at the strike price per share at any time before it expires. The put seller (or writer), on the other hand, has the obligation to buy 100 shares at the strike price if called upon to do so.

Rho

The amount a theoretical option’s price will change for a corresponding one-unit (percentage-point) change in the interest rate used to price the option contract.

Roll

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To simultaneously close one option position and open another with the same underlying stock but a different strike price and/or expiration month. Rolling a long position involves selling those options and buying others. Rolling a short position involves buying the existing position and selling (writing) other options to create a new short position.

Short option

A position resulting from making the opening sale (or writing) of a call or put contract, which is then maintained in a brokerage account.

Short stock

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A short position that is opened by selling shares in the marketplace that are not currently owned (short sale), but instead borrowed from a broker/dealer. At a later date, shares must be purchased and returned to the lending broker/dealer to close the short position. If the shares can be purchased at a price lower than their initial sale, a profit will result. If the shares are purchased at a higher price, a loss will be incurred. Unlimited losses are possible when taking a short stock position.

Spread

A complex option position established by the purchase of one option and the sale of another option with the same underlying security. The two options may be of the same or different types (calls/puts), and may have the same or different strike prices and/or expiration months. A spread order is executed as a package, with both parts (legs) traded simultaneously, at a net debit, net credit, or for even money.

Strike price

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A term of any equity option contract, it is the price per share at which shares of stock will change hands after an option is exercised or assigned. Also referred to as the “exercise price,” or simply the “strike.”

Theta

The amount a theoretical option’s price will change for a corresponding one-unit (day) change in the days to expiration of the option contract.

Time decay (erosion)

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A regular phenomenon in which the time value portion of an option’s price decays (decreases) with the passage of time. The rate of this decay increases as expiration gets closer, with the theoretical rate quantified by “theta,” one of the Greeks.

Time value

For a call or put, it is the portion of the option’s premium (price) that exceeds its intrinsic value (in-the-money amount), if it has any. By definition, the premium of at- and out-of-the-money options consists only of time value. It is time value that is affected by time decay as well as changing volatility, interest rates and dividends.

Underlying stock

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The stock on which a specific equity option’s value is based, which changes hands when the option is exercised or assigned.

Vega

The amount a theoretical option’s price will change for a corresponding one-unit (point) change in the implied volatility of the option contract.

Volatility

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The fluctuation, up or down, in the price of a stock. It is measured mathematically as the annualized standard deviation of that stock’s daily price changes.

Write

To sell a call or put option contract that has not already been purchased (owned). This is known as an opening sale transaction and results in a short position in that option. The seller (writer) of an equity option is subject to assignment at any time before expiration and takes on an obligation to sell (in the case of a short call) or buy (in the case of a short put) underlying stock if assignment does occur.