Options Terminology

Assignment - the receipt of an exercise notice by an option writer (seller) that obligates him to sell (in the case of a call) or purchase (in the case of a put) the underlying at the specified strike price.  Note:  this assumes the exercise settles in the underlying - see cash settlement.

At The Money - an option is at-the-money if the strike price of the option is ‘equal’ to the market price of the underlying security.

Bear Call Spread - this strategy involves selling a call with a lower strike and buying a call with a higher strike. The maximum profit is achieved when the underlying trades at or below the lower strike and is equal to the credit that the spread was sold for - the maximum risk is equal to the width of the spread minus the credit the spread was sold for.

Bear Put Spread - this strategy involves buying a put with a higher strike price and selling a put with a lower strike price. The maximum profit is achieved at or below the lower strike price and is equal to the width of the spread minus the debit that the spread was purchased for - the maximum risk is equal to the debit that the spread was purchased for.

Bull Call Spread - this strategy involves buying a call with a lower strike and selling a call with a higher strike. The maximum profit is achieved at or above the higher strike and is equal to the width of the spread minus the debit that the spread was purchased for - the maximum risk is equal to the debit that the spread was purchased for.

Bull Put Spread - selling a put with a higher strike and buying a put with a lower strike. The maximum profit is achieved at or above the higher strike price strike and is equal to the credit that the spread was sold for - the maximum risk is equal to the width of the spread minus the credit the spread was sold for.

Call - a call option gives the buyer the right, but not the obligation, to buy the underlying at a specific price for a specified time. The seller of a call option has the obligation to sell the underlying should the buyer exercise his option to buy.

Cash Settlement - the process by which the terms of an option contract are fulfilled through the payment or receipt in dollars of the amount by which the option is in-the-money as opposed to delivering or receiving the underlying.

Combination Option Spread – a spread that includes both call and put options.

Condor - a limited risk, limited reward strategy with 4 options at 4 strike prices.  The outer strike prices make the "wings" - the "body" consists of one option at each of two middle strikes.

Covered - a written option is considered to be covered if the writer also has an opposing market position on a 1:1 basis in the underlying. That is, a short call is covered if the underlying is long, and a short put is covered (for margin purposes) if the underlying is also short in the account.  In addition, a short call is covered if the account is also long another call on the same underlying.  A short put is covered if the account is also long another put on the same underlying.

Credit – the proceeds received from writing an option.

Credit Spread - the difference in value between two options, where the value of the short position exceeds the value of the long position.  Bear call spreads and bull put spreads are examples of credit spreads.

Debit – the amount spent to purchase an option.

Debit Spread - the difference in value between two options, where the value of the long position exceeds the value of the short position.  Bull call spreads and bear put spreads are examples of debit spreads.

Delta - the amount by which an option's price will change for a one-point change in price by the underlying entity. Call options have positive deltas, while put options have negative deltas. Technically, the delta is an instantaneous measure of the option's price change, so that the delta will be altered for even fractional changes by the underlying entity.  In general, at-the-money options have deltas of 50.

Equivalent position - this is also referred to as a synthetic position.  By using a combination of options or options and underlying, traders can create positions that have the same risk/reward characteristics of option only or underlying only positions.

Exercise - to invoke the right associated with a particular option contract. When exercising a call option, the holder buys the underlying at a predetermined price (strike) from the option seller. In the case of a put, the holder of the option sells the underlying to the option seller at the strike price.

Exercise Price - the price at which the option holder may buy or sell the underlying, as defined in the terms of his option contract.  It is the price at which the call holder may exercise to buy the underlying or the put holder may exercise to sell the underlying.  The exercise price is the strike price.

Expiration Date - the day on which an option contract becomes void.  The expiration date for listed stock options is the Saturday after the third Friday of the expiration month. Holders of options should indicate their desire to exercise, if they wish to do so, by this date.

Expiration Time - the time of day by which all exercise notices must be received on the expiration date. Technically, the expiration time is currently 5:00PM on the expiration date, but public holders of option contracts must indicate their desire to exercise no later than 5:30PM on the business day preceding the expiration date. The times are Eastern Time.

Fair Value - a term used to describe the worth of an option or futures contract as determined by a mathematical model.  This term is also used to indicate intrinsic value. 

Gamma - used to represent the rate of change of an option delta as the underlying price changes.

Hedge - limit loss by effecting a transaction which offsets an existing position.

Hedge Ratio - the mathematical quantity that is equal to the delta of an option. It is useful in that a theoretically neutral hedge can be established by taking offsetting positions in the underlying and its options.

Historical Volatility - a measurement of the actual movement of the underlying’s price over a specific period of time. This number can be ‘plugged’ into an option pricing model as an input to determine the theoretical price of the option.

Implied Volatility - the amount of movement expected in the underlying given the current price of the options as opposed to using historical volatility in a pricing model to determine the value of the option. This level of volatility is then compared to the historical volatility for the same underlying to determine if the options are relatively cheap, relatively expensive or in-line with expectations.

In The Money - any option that has intrinsic value.  A call option is in-the-money if the underlying is higher than the striking price of the call. A put option is in-the-money if the underlying is below the striking price

Intrinsic Value - the amount an option is in-the-money.  

Legging - by legging into a spread, a trader does part of the spread at one price and hopes the market will move so the rest of the spread can be completed at a better price.  The risk in this strategy comes from the fact that a better price may never be available, and a worse price must eventually be accepted.

Lock – a management strategy where a short option is turned into a long spread where the cost of the spread is a credit, or turned into a short spread where the credit of the spread is larger then the width of the spread strikes.  For instance, a 25 call is sold for 2.00 and then at a later date a 22.5 call is bought for 1.50 - the risk of the short option has been eliminated, and a minimum profit of .50 has been ‘locked’ into the spread. 

Long Position - a position is long if the position is a purchase of the underlying or its options.  A position is also long if the holder benefits from an increase in the price of the underlying.

Math To Expiration - a graphical representation of the potential outcomes of a strategy if it is held until the expiration date.  Profit or loss is graphed on the vertical axis, and underlying prices are graphed on the horizontal axis.

Naked Option - a written option is considered to be naked or uncovered if the trader does not have an offsetting position in the underlying or from a purchased option as part of a debit or credit spread.

Option Pricing Model - pricing formula using six inputs:  underlying price, strike price, time to expiration, interest rates, dividends and volatility – in order to determine the theoretical value of an option.  Option prices do not predict the direction of the price of the underlying instrument.

Option Type - American options are contracts that may be exercised at any time between the date of purchase and the expiration date.  Most exchange-traded options are American-style.  European options are contracts that stipulate that the option may only be exercised at expiration - there can be no early assignment with this type of option.

Option Write - the sell of an option as the opening transaction thereby creating the obligation to meet the terms of the contract in the event of assignment.

Out Of The Money - a call option is out-of-the-money if the strike price is greater than the market price of the underlying, and a put option is out-of-the-money if the strike price is less than the market price of the underlying.

Position Curvature - this is a graphical representation of the projected price of an option at a fixed point in time. It reflects the amount of time value premium in the option for various underlying prices, as well. The curve is generated by using a mathematical model.

Premium - the premium is the price of the option and is paid by the buyer to the writer, or seller, of the option. In return, the writer of the call option is obligated to deliver the underlying to an option buyer if the call is exercised or buy the underlying if the put is exercised. The writer keeps the premium whether or not the option is exercised.  Premium is a term also used to define the extent to which an option price exceeds its intrinsic value.

Protected Strategy - this is a position that has limited risk, for instance a protected short sale (short underlying, long call) has limited risk, as does a protected straddle write (short straddle, long out-of-the-money combination).

Put - a put option gives the buyer the right, but not the obligation, to sell an underlying at a specific price for a specified time. The seller of a put option has the obligation to buy the underlying should the buyer choose to exercise his option to sell.

Ratio Spread - any option strategy in which the number of contracts purchased is greater or less than the number sold.

Ratio Write - a partially covered position in which the options sold represent more shares than are covered by the corresponding underlying position For instance, long 100 shares of stock - short 2 out-of-the-money calls, is a ration write.  If the underlying price rises and the options are assigned, this person will have to turn over 200 shares at the strike price. However, since the person only has 100 shares, the potential loss on the position is unlimited because one of the calls is uncovered.

Rho - the expected change in an option's price given a 1% move in interest rates.

Short Position - a position is short if the position is a sell of the underlying or its options.  A position is also short if the holder benefits from a decrease in the price of the underlying.

Spread - any option position having both long options and short options of the same type on the same underlying.

Standard Deviation - a measure of the volatility of an underlying. It is a statistical quantity measuring the magnitude of the daily price changes of that stock.

Straddle – the purchase (long straddle) or sell (short straddle) of an at-the-money call and put with the same expiration.  A long straddle has unlimited profit potential - a short straddle has limited profit equal to the size of the credit and unlimited risk.

Strangle – the purchase (long strangle) or sell (short strangle) of an out-of-the money call and put with the same expiration.  A long strangle has unlimited profit potential - a short strangle has limited profit equal to the size of the credit and unlimited risk.

Strike Price – this is also the exercise price, and is the price specified by the option contract, at which the holder can buy or sell the underlying.

Synthetic long underlying - a short put option and a long call option with the same strike and expiration

Synthetic short underlying - a long put option and a short call option with the same strike and expiration

Synthetic long call - a long put and a long underlying

Synthetic short call - a short put and a short underlying

Synthetic long put - a long call and a short position underlying

Synthetic short put - a short call and a long underlying

Theoretical Value - this is the fair value of an option as determined by a mathematical pricing model. This takes into account the following factors: strike price, the current price of the underlying, interest rates, time remaining until expiration, dividends (if any), and volatility.

Theta - a measure of the rate of change in an option's theoretical value for a one-unit change in time to the option's expiration date.

Time decay - a term used to describe how the theoretical value of an option "erodes" or reduces with the passage of time.

Time Value - the amount by which the current price of an option exceeds its intrinsic value. The price of out-of-the-money option is made up exclusively time value.  In contrast, the price of an in-the-money option can consist of both time value and intrinsic value. For example, with a stock trading at $52, the 50 call has $2 of intrinsic value.  If the 50 call is currently selling for 3 ¼, the price is made up of $2 of intrinsic value and 1 ¼ of time value.

Uncovered - a written option is considered to be uncovered if the holder does not have an offsetting position in the underlying security, or a long option as part of a spread.

Underlying - the stock, commodity, or other financial instrument on which an option contract is based.

Vega - a measure of the rate of change in an option's theoretical value for a one-unit change in the volatility assumption.

Vertical spread - used to describe the purchase of one option and sale of another where both are of the same type and same expiration, but have different strike prices.

Volatility - a measure of the fluctuation in the market price of the underlying security.