is purchasedat one strike price and expiration, and another option of the same type is sold at amore in-the-money strike price and a different expiration. It is usually a net credittransaction. It is called diagonal because the options have different strike pricesand different expiration dates.diagonal debit spread A type of calendar spread where an option is purchased atone strike price and expiration, and another option of the same type is sold at amore out-of-the-money strike price and a different expiration. It is usually a netdebit transaction. It is called diagonal because the options have different strikeprices and different expiration dates.directional trade A trade designed to take advantage of an expected price movement.early exercise A feature of American-style options, allowing the owner to exercise an option at any time prior to its expiration date.equity This term has three separate but widely used deﬁnitions related to ﬁnance:• The residual dollar value of a trading account, assuming the liquidation of allopen positions at the current market price.• The net worth of a company—the amount by which assets exceed liabilities.• A term synonymous with common stock.equity option An option on shares of an individual common stock. Also knownas a stock option.European-style option An option that can only be exercised on the expirationdate of the contract.exchange traded The generic term used to describe securities, futures, options,and other instruments that are traded on an organized exchange.exercise The act by which the holder of an option takes up his rights to buy orsell the underlying at the strike price. For instance, a call option holder’s demandthat the number of units of the underlying speciﬁed in the contract be delivered to
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him at the speciﬁed price; or a put option holder’s demand that the number of unitsof the underlying asset speciﬁed be bought from him at the speciﬁed price.exercise price See strike price.expected return The return expected on an investment or position, consideringall possible outcomes and the probability of each outcome.expiration, expiration date, expiration month The date by which an optioncontract must be exercised or it becomes void and the holder of the optionceases to have any rights under the contract. In the United States, all stock andindex option contracts expire on the Saturday following the third Friday of thespeciﬁed month.expiration cycle Traditionally, there were three cycles of expiration dates used inoptions trading:January Cycle (1):
January/April/July/October
February Cycle (2):
February/May/August/November
March Cycle (3):
March/June/September/December
Each stock was assigned one of these three traditional cycles. Today, equity options expire on a hybrid cycle which involves a total of four or ﬁve option series:the two nearest-term calendar months and the next two or three months from itstraditional cycle.fair value
See theoretical value, theoretical price.
far month, far term See back month.ﬁll
When an order has been completely executed, it is described as ﬁlled.
ﬁll or kill (FOK) order A type of order where the trader stipulates that a trade beﬁlled immediately and entirely, if possible, or else canceled. This is like the all-ornone (AON) order in that the entire order must be ﬁlled at once. However, the FOKorder has a time constraint while the AON order does not.ﬂoor broker An exchange member who is paid a fee for executing orders forclearing members or their customers.ﬂoor trader An exchange member who generally trades only for his own accountor an account controlled by him. Also known as a local.follow-up action The trades an investor makes subsequent to implementing astrategy. Through adjustments, the investor transforms one strategy into a different one in response to price changes in the underlying or other factors, in order tobetter position the strategy going forward.front month The ﬁrst month of all available contracts listed on an exchange. Thisis usually the most actively traded contract, but volume gradually shifts from thisto the second month contract as the front month nears expiration. Also known asnear month.
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fundamental analysis The study of basic underlying factors to forecast futureprices, including economic and industry analysis. For commodities, it includes factors affecting supply and demand. For stocks, it includes examining the company’sﬁnancials and operations, especially sales, earnings, growth potential, assets, debt,products, and competition.future The term used to designate all contracts covering the sale of ﬁnancial instruments or physical commodities for future delivery on an exchange.futures contract A standardized, transferable legal agreement to make or takedelivery of a speciﬁc amount of a commodity of a certain grade or type at a predetermined date in the future. The price is determined at the time the agreement ismade. Futures contracts are traded on organized futures exchanges, and deliveryand physical possession take place on the contract date unless the contract hasbeen closed out by an offsetting transaction. Futures are also available on variousﬁnancial products and indexes.futures option An option on a futures contract.gamma A measure of the amount by which delta changes with a one-point increase in the price of the underlying. Gamma is positive for all options. If a call option has a delta of 45 and a gamma of 10, then the option’s expected delta will be 55if the underlying goes up one point. If we consider delta to be the velocity of an option, then gamma is the acceleration.good ’til canceled (GTC) order An order that is effective until it is either ﬁlled bythe broker or canceled by the investor. This order is automatically canceled at theoption’s expiration.greeks The Greek letters used to describe various measures of the sensitivity ofthe value of an option with respect to different factors. They include delta, gamma,theta, vega, and rho.hedging Taking a position opposite to a position held to minimize the risk of ﬁnancial loss from an adverse price change.historic volatility See statistical volatility.holder The purchaser of an option. Also known as the option buyer.horizontal credit spread A type of calendar spread. It is a credit transaction inwhich the investor buys an option in a nearer expiration month and sells an optionof the same type in a farther expiration month with the same strike price.horizontal debit spread A type of calendar spread. It is a debit transaction inwhich the investor sells an option in a nearer expiration month and buys an optionof the same type in a farther expiration month with the same strike price.immediate-or-cancel (IOC) order An option order that gives the trading ﬂoor anopportunity to partially or totally ﬁll an order, with any unﬁlled balance immediately canceled.
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illiquid An illiquid market has a low volume of transactions and/or a smallnumber of participants. In an illiquid market, a security or an option is usuallypriced with a wide bid/asked gap, resulting in the trader paying more in transaction costs.implied volatility (IV) The volatility that the underlying would need to have forthe pricing model to produce the same theoretical option price as the actual option price. The term implied volatility comes from the fact that options implythe volatility of their underlying, just by their price. A computer model startswith the actual market price of an option, and measures IV by working the optionfair value model backward, solving for volatility (normally an input) as if it werethe unknown.In actuality, the fair value model cannot be worked backward. However, options analysis software can compute IV by working forward repeatedly through aseries of intelligent guesses until the volatility is found that makes the fair valueequal to the actual market price of the option.index A compilation of several stock prices into a single number (e.g., the S&P 500).index option An option contract with an index as the underlying asset. These areusually cash-settled.initial margin The proportion of a security’s market value an investor mustpay when buying securities on margin, or the total amount of margin requiredwhen a futures or short option position is opened. The Securities Exchange Actof 1934 gives the board of governors of the Federal Reserve the responsibility toset initial margin requirements: initial margin requirements for futures contractsare set by the futures exchanges. Individual brokerage ﬁrms are free to sethigher requirements.in-the-money (ITM) The term used when the strike price of an option is lessthan the price of the underlying for a call option, or greater than the price of theunderlying for a put option. In other words, the option has an intrinsic valuegreater than zero.intrinsic value The amount of any favorable difference between the strike priceof an option and the current price of the underlying (i.e., the amount by which it isin-the-money). The intrinsic value of an out-of-the-money option is zero.joint clearing members Firms that clear on more than one exchange.last trading day The last business day prior to the option’s expiration when theoption may be traded. For equity options, this is generally the third Friday of theexpiration month.LEAPS Long-term Equity Anticipation Securities are calls and puts with expirations as long as two to ﬁve years. Currently, equity LEAPS have two series in existence at a time, always with January expirations, and only about 10 percent ofequities have LEAPS. Some indexes also have LEAPS.
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leg A term describing one component of a spread position. For example, a calendar spread has two legs; a butterﬂy spread has three.legging A risky method of implementing or closing out a spread strategy one legat a time. Instead of utilizing a spread order to insure that both the written and thepurchased option orders are ﬁlled simultaneously, an investor gambles that a better deal can be obtained overall by entering two or more separate orders.leverage A means of increasing potential return without increasing investment, such as using borrowed funds to buy stocks on margin. Option contractsare leveraged, because they allow you to control a greater amount of the underlying asset with fewer dollars, providing the possibility of higher returns on yourinvestment.limit order An order placed with a brokerage to buy or sell a predeterminednumber of contracts (or shares of stock) at or better than the speciﬁed price. Limitorders can be placed as day or GTC orders (day is the default). Limit orders maycost slightly higher commissions than market orders but are often better to use, especially with options, because the price you’ll pay is strictly limited.liquid A liquid market has a high volume of transactions and many participants.In a liquid market, a security or an option is usually priced with a narrow bid/askedgap, resulting in the trader being able to trade greater quantities while paying lessin transaction costs.listed options Options that are traded on an exchange.long You are long if you have bought more than you have sold in any particularmarket, commodity, instrument, or contract. Also known as having a long position, you have purchased an asset with the intention of selling it at a higher pricesometime in the future. Thus when you are long you expect the asset to increasein price.long backspread This strategy involves selling one option near the money andbuying two (or more) options of the same type farther out-of-the-money, with thesame expiration. Requires margin.long option Buying an option. See also long.long straddle See straddle.long strangle See strangle.long synthetic See synthetic.long underlying Buying the underlying (i.e., stock). See also long.maintenance margin The amount that must be maintained on deposit at all timesin a margin account to cover a position. If the equity in an account drops to or below this level due to adverse price movement, the broker issues a margin call, requiring the investor to either deposit more funds or securities, or close positions toreduce the requirements.
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margin The legally required amount of cash or securities deposited with a brokerage to insure that an investor can meet all potential obligations. Margin (orcollateral) is required on futures contracts and investments with open-endedloss potential, such as writing naked options. See also initial margin; maintenance margin.mark to market The revaluation of a position using current market prices,usually for the recalculation of margin requirements or for accounting or taxpurposes.market maker A trader or institution that plays a leading role in a market by being prepared to quote a two-way price (bid and ask) on request—or constantly, inthe case of some screen-based markets—during normal market hours.market order An order to buy or sell a security immediately at the best available current price; sometimes referred to as an unrestricted order. A market order is the only type of order that has guaranteed execution. It should be usedwith caution in placing option trades, because you can end up paying more thanyou anticipated (when buying) or selling for less than you anticipated (whenselling).market-if-touched (MIT) order An order that is placed with a price, below market if buying or above market if selling, that automatically becomes a market orderif the speciﬁed price is reached.market-not-held order A type of market order in which the investor gives discretion to the broker regarding the price and/or time that a trade is executed. It iscalled “not held” because the broker is not held to the usual requirement of ﬁllingthe order as quickly as possible.market-on-close (MOC) order A type of day order in which the investor speciﬁesthat the order be delayed until right before the market closes, at which time it becomes an active market order. Thus the order is executed at or near the closingprice of the day on which the order is entered.maximum price ﬂuctuation The maximum amount a contract price is allowed tochange, up or down, during one trading session, as ﬁxed by exchange rules.minimum price ﬂuctuation
See tick.
naked A position where options are sold short and are not matched with either acovering position in the underlying or a long position in another option of the sametype expiring at the same time or later than the options sold.near term, near month See front month.normal distribution A statistical distribution based on a random process whereobservations are evenly distributed around the mean; also called the bell curve.not-held order See market-not-held order.offer See ask.
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offset Closing an outstanding long or short position by making an oppositetransaction.one-cancels-the-other (OCO) order A type of order that treats two or more option orders as a package, whereby the execution of any one of the orders causesall the other orders to be reduced by the same amount. Can be placed as a day orGTC order.open interest The cumulative total of all option contracts of a particular seriessold but not yet repurchased or exercised.open order An order that has been placed with the broker and is still active or“working.” It remains open until it is either ﬁlled or canceled.opening transaction The creation of, or addition to, a trading position.option A contract that conveys the right to buy or sell a speciﬁed quantity ofan asset at a speciﬁc price within a speciﬁed period of time. See also call option,put option.option chain A list of all the options available for a given underlying asset.out-of-the-money (OTM) An out-of-the-money option is one whose strike price isunfavorable compared to the current price of the underlying. For a call option, thisis when the strike price is greater than the price of the underlying. For a put option,this is when the strike price is less than the price of the underlying. An out-of-themoney option has no intrinsic value, only time value.over the counter (OTC) market A decentralized market (as opposed to an exchange), where geographically dispersed dealers are linked together by telephonesand computer screens.position The number of contracts bought or sold for which no offsetting transaction has been entered into. An opening transaction to buy places the investor in along position. An opening transaction to sell places the investor in a short position.premium
The price of an option contract.
protective put A strategy that involves buying a put option in conjunction with along position on the underlying, in order to hedge.put option An option contract that conveys the right to sell a standard quantityof a speciﬁed asset at a ﬁxed price per unit (the strike price) for a limited length oftime (until expiration).put/call ratio A ratio is used by many traders as a leading indicator, computed bydividing the total put volume by the total call volume.put/call parity The relationship between the price of a put and the price of a callwith the same strike price and expiration date, where the two options are at thesame level of implied volatility. If the two options have different implied volatilities, it creates an arbitrage opportunity for professional traders to buy the lower
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207
implied volatility option and sell the higher implied volatility option, driving thetwo options back into parity.put ratio backspread A long backspread using puts. See long backspread.realized gain (loss) The difference between the original cost of a position andthe proceeds received when it is closed. A positive difference is a gain and a negative difference is a loss.reversal A short position in the underlying combined with a long synthetic. Alsoknown as a reverse conversion.rho An indication of an option’s sensitivity to changes in interest rates. Rho measures the change in an option’s theoretical value with respect to a unit change inthe risk-free interest rate.risk-free rate The prevailing rate of interest for securities issued by the government of the country of the currency concerned (i.e., U.S. Treasury securities).rolling A trading action in which the trader simultaneously closes an open position and creates a new position. As the front month expiration date approaches,traders who want to maintain their positions often roll them over into the next contract month.round turn When an option contract is bought and then sold (or sold and thenbought). The second trade closes the position, completing the round turn. Futuresbrokerage commissions are usually quoted on this basis.short You are short if you have sold more than you have bought in any particularmarket, commodity, instrument, or contract. Also known as having a short position, you have sold an asset with the intention of buying it at a lower price sometime in the future. Thus, when you are short you expect the asset to fall in price.short backspread A strategy that involves buying one option nearer the moneyand selling two (or more) options of the same type, farther out-of-the-money, withthe same expiration. Requires margin.short option Selling an option. See also short.short selling A trade where the investor (through a broker) borrows a securityand sells it with the expectation the price will fall. When it is repurchased later, thesecurity is returned to the party who initially loaned it. If repurchased at a lowerprice, the short seller proﬁts. Requires margin.short straddle See straddle.short strangle See strangle.short synthetic See synthetic.short underlying Selling an asset short. See also short selling.slippage The portion of transaction costs associated with the bid/ask spread,arising from the fact that you usually buy at the ask price and sell at the bid price,and ask price is usually higher than bid price.
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GLOSSARY
spread A strategy involving positions in two or more different options on thesame underlying, in which the investor is long in one or more options and short inone or more other options, usually of the same type (calls or puts). The investorusually enters into a spread with the expectation of beneﬁting from a favorablechange in the price relationship between the two (or more) options.spread order An order for the simultaneous purchase and sale of two (or more)options of the same type. If placed with a limit, the two options must be ﬁlled for aspeciﬁed price difference, or better.standard deviation From statistics, the square root of the sum of the squares ofthe deviations of each member of a population (in ﬁnancial terms, a group ofprices) from their mean. In a normal distribution, one standard deviation encompasses 68 percent of all possible outcomes.statistical volatility (SV) A measure of the actual price ﬂuctuations of an assetover a speciﬁc period of time on a percentage basis. It can be measured using anyrecent sample period, but regardless of the length of the sample period, SV is always normalized to represent a one-year, single standard deviation price move ofthe underlying.stock option See equity option.stop order A “stop” or “stop-limit” order is an order to sell when the asset pricefalls to a particular point, or to buy when the asset price rises to a particular point.Sent to the exchange ﬂoor, these orders remain inactive until there is a trade at thespeciﬁed stop price on the exchange where the order was sent. At this time a stoporder becomes an active market order, and a stop-limit order becomes an activelimit order. Stop and stop-limit orders are often used to limit an investor’s losses,but they can also be used to open a new position. It can be a good idea to use stoporders if you will be unable to watch your positions for an extended period.straddle A strategy involving the simultaneous purchase (or sale) of call and putoptions with the same strike price and expiration date. In a short straddle, both thecalls and puts are sold short, for a credit. In a long straddle, both the calls and putsare bought long, for a debit.strangle A strategy involving the simultaneous purchase (or sale) of call and putoptions with different strike prices but the same expiration date. Strangles are usually constructed using out-of-the-money options. In a short strangle, both the callsand puts are sold short, for a credit. In a long strangle, both the calls and puts arebought long, for a debit.strategy An option strategy is any one of a variety of option investments. It includes using options individually or in combination with the underlying and/orother options to create positions that possess desired risk/reward characteristics.strike price The price at which the owner of a call option contract can buy theunderlying asset, or the price at which the owner of a put option contract can sell
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the underlying asset. This is a ﬁxed price per unit and is speciﬁed in the option contract. Also known as striking price or exercise price.synthetic A strategy that uses options to mimic the underlying asset. A long synthetic uses a long call combined with a short put to mimic a long position in the underlying. A short synthetic uses a short call and a long put to mimic a shortposition in the underlying. In both cases, the call and put have the same strikeprice and expiration date.technical analysis Any number of methods where future price movements arepredicted based on historical data such as prices, trading volume, open interest,numbers of advancing issues and declining issues, short selling volume, and so on.Many traders use this type of analysis to make trading decisions, especially shortterm trading decisions.theoretical value, theoretical price The mathematically calculated value of anoption. It is determined by using a pricing model and inputting (1) the strike priceof the option, (2) the current price of the underlying, (3) the amount of time untilexpiration, (4) the volatility of the underlying, (5) the current interest rate, (6) dividend ﬂow information (if stock or index option), and (7) the style of the option(American or European). Also known as fair value.theta An indication of an option’s sensitivity to the passing of time. Theta measures the theoretical change in an option’s value over the next 24 hours. Long option positions have negative theta. Short option positions have positive theta.tick The smallest unit price change allowed in trading a speciﬁc security, future,or option.time decay A term used to describe how the value of an option declines overtime. Time decay is quantiﬁed by theta.time spread Another name for a calendar spread. See calendar spread.time premium The amount by which the value of an option exceeds its intrinsicvalue. It reﬂects the statistical possibility that an option will have intrinsic value atexpiration rather than ﬁnishing worthless. If an option is out-of-the-money then itsentire value consists of time premium. Also known as time value.trading halt A temporary suspension of trading in a particular issue due to an order imbalance, or in anticipation of a major news announcement. An industrywidetrading halt can occur if the Dow Jones Industrial Average falls below parametersset by the New York Stock Exchange.trading ﬂoor The physical place on an exchange where trading occurs. Not allexchanges have trading ﬂoors. Some rely entirely on computerized trading systemsthat enable dealers to place bids and offers and trade from many locations.trading pit A speciﬁc location on the trading ﬂoor of an exchange designated forthe trading of a speciﬁc asset or options.
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GLOSSARY
trailing stop A trailing stop is a stop order that is adjusted by the investor periodically as the price of the security continues to move favorably.transaction costs All charges associated with trading, including brokerage commissions, slippage, and fees for exercise and/or assignment. See also slippage.true delta, true gamma More accurate than standard delta and gamma, true deltaand true gamma are computed using a method that takes into account a projectedchange in volatility along with the usual projected change in underlying price.type
Refers to the type of option, as either a call or a put.
uncovered See naked.underlying The asset speciﬁed in an option contract that is transferred when theoption contract is exercised, unless the option is cash-settled. With cash-settled options, only cash changes hands at exercise, based on the current price of the underlying relative to the strike price of the option.unrealized gain (loss) The difference between the original cost of an open position and its current market price. A negative difference indicates a loss; a positivedifference indicates a gain. Once the position is closed, it becomes a realized gainor loss.vega The measure of an option’s sensitivity to changes in volatility. It is theamount of gain or loss you should theoretically experience if implied volatilitygoes up one percentage point.vertical credit spread A strategy that involves the simultaneous purchase andsale for a net credit of two options of the same type with different strike prices butthe same expiration date. See also bull put spread, bear call spread.vertical debit spread A strategy that involves the simultaneous purchase andsale for a net debit of two options of the same type with different strike prices butthe same expiration date. See also bull call spread, bear put spread.volatility Volatility measures the amount by which an asset has ﬂuctuated, or isexpected to ﬂuctuate, in a given period of time. Assets with greater volatility exhibit wider price swings, and their options are more expensive than those of lessvolatile assets. (Volatility is not equivalent to beta.)volatility trade A trade designed to proﬁt from an expected change in volatility.volume The quantity traded in any market or security. It can be measured in dollars or in the number of units traded (i.e., number of contracts for options, or number of shares for stocks).warrant A long-term call option often provided with a new issue of a security, asan enticement. For instance, corporate bonds may be sold with warrants to buycommon stock of that corporation. Warrants are generally detachable.wash sale When an investor repurchases the same or substantially similar assetwithin 30 days of the sale date and reports the original sale as a tax loss. The In-
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211
ternal Revenue Service prohibits wash sales since no real change in ownershiptakes place.write To sell an option in an opening transaction. While this position remainsopen, the writer is obligated to fulﬁll the terms of that option contract if the optionis assigned.writer A trader who sells an option is called the writer, whether the option is covered or uncovered.Yates model A reﬁned version of the Black-Scholes pricing model that takes intoaccount dividends and the possibility of early exercise.
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ccc_yates_indx_213-218.qxd 6/4/03 1:37 PM Page 213
Index
Account, establishing, 1–2, 151Achelis, Steve, 190American style, 11–12AOL, 162Assigned, 4Assignment, early, 79At the money, 8Backspread, 40, 88–92Bad quote, 146Balancing factors, 139Bank of New York, 163Bearish backspread, 90–91Bell-shaved curve, 128Binomial model, 129–130Black model, 133Black-Scholes model, 130–132Bottom, VIX as indicator of, 170–171,175–176Breakdown:deﬁnition of, 161indexes and, 166, 168–169individual stocks and, 168recognizing, 165–166signals of, 65–66trading and, 161, 165Broker:placing spread orders with,80–82selecting, 151Bull call spread, 74Business:philosophy of, 191–193starting, 186–187, 188Butterﬂy spread, 100–101
Buying, reasons for, 3Buy write, 27–28Calculators:fair value, 133probability, 86, 87Calendar spread, see Horizontal spreadCall backspread, 89–90Called away, 27Call option:description of, 6in the money, 8out of the money, 8purchase of, 71Capital, 151CEV (constant elasticity of volatility),72, 136–137Charles Schwab, 96Choosing strategy, 101–104Clearing agency, 5Closed-form solution, 130Closing transaction, 4, 10–11Commodities market, 62–63Compartmentalizing trading, 158–159Condor, 85–88Constant basis model, 146Constant elasticity of volatility (CEV),72, 136–137Conversion, 140Convertible securities:Millennium Pharmaceuticals,112–114overview of, 111–112possible pitfalls of strategy, 117–118Wendy’s International, 115–116
213
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INDEX
Corn, 55–59Covered combo, 66Covered combo strategy, 119–122