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American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date exercise date. Exercising means utilizing the right to buy or the sell the underlying security. Option on stocks typically represent shares. In terms of speculation, option buyers and writers have conflicting views regarding the outlook on the performance of an underlying security.
An option writer who sells a call option believes that the underlying stock's price will drop or stay the same relative to the option's strike price during the life of the option, as that is how they will reap maximum profit. The writer's maximum profit is the premium received when selling the option. If the buyer is right, and the stock rises above the strike price, the buyer will be able to acquire the stock for a lower price strike price and then sell it for a profit at the current market price.
Risk to the call buyer is limited to the premium paid for the option, no matter how much the underlying stock moves. The profit at expiration, if applicable, is: This will give the total profit or loss to the trader in dollars. The risk to the call writer is much greater. Their maximum profit is the premium received, but they face infinite risk because the stock price could continue to rise against them. To offset this risk, many option writers use covered calls.
The opposite is true for a put option writer. For example, a put option buyer is bearish on the underlying stock and believes its market price will fall below the specified strike price on or before a specified date. If the underlying stock's price closes above the specified strike price on the expiration date, the put option writer's maximum profit is achieved. They get to keep the entire premium received.
Conversely, a put option holder benefits from a fall in the underlying stock's price below the strike price. If the underlying stock's price falls below the strike price, the put option writer is obligated to purchase shares of the underlying stock at the strike price.
This is then multiplied by if each contract is shares and the number of contracts bought. The risk to the option writer if the stock price falls is that they have to buy the stock at the strike price.
An order to buy or sell at a specific price. A limit buy order is placed below the current market price; a limit sell order is placed above the current market price. The investment required by a brokerage firm. Long options must be paid for in full. Futures contracts and naked options are margined. In this sense, one is not borrowing money from the broker.
Rather the margin is a deposit of collateral against potential losses from the position. An average of closing prices over a specific time period, which could be hourly, daily, weekly, or even monthly. A day moving average of a stock price is sometimes considered to be significant support or resistance. A written option is considered to be naked, or uncovered, if the investor does not have an offsetting position in the underlying stock or futures.
Describing a position that does not have exposure to a certain factor of the marketplace. For example, delta neutral means that the position is not affected by short-term market movements; gamma neutral means that the position will not be affected by even larger market movements; vega neutral means the position is not affected by changes in implied volatility.
A trade which adds to the net position of an investor; an opening buy adds more long options or futures, while an opening sell adds more short stock or futures.
The net total of outstanding open futures or options contracts that have been purchased. Note that for every opening buy, there is an opening sell as well, but the open interest only counts one side, not both.
Describing an option with no current intrinsic value. For calls, when the stock or future is below the strike; for puts when the stock or future is above the strike. Describing an in-the-money option trading for its intrinsic value.
Also used as a point of reference -- an option is sometimes said to be trading at a specific distance "over parity" or "under parity". An option trading under parity is trading at a discount. A graphical representation of the profit potential of a position. Usually, the stock or future price is plotted on the horizontal axis, while the dollars of profit or loss are plotted on the vertical axis. Results may be plotted at any point in time. Generally, in The Option Strategist, profit graphs will show results projected two weeks hence, as well as projected results at expiration of the nearest-term option in the position.
A measure of the exposure of an entire option position to market movement. A measure of option trading volume that is sometimes used as a contrarian technical indicator to predict forthcoming market movements. The ratio is computed by dividing trading volume of puts by the trading volume of calls.
It may be used in a specific case, such as options on gold futures, for example. It may also be used in a broader sense by dividing the total volume of all puts trading on equities on all exchanges by all calls traded. If the ratio gets too high, that indicates too many people are buying puts. Since this is a contrarian indicator, that would be a buy signal. Conversely, if too many calls are being bought, the ratio will be too low, and that is generally a sell signal.
A spread in which the number of options sold is larger than the number purchased. Hence the strategy involves naked options.
A term in technical analysis indicating a price area higher that the current stock price where an abundance of supply exists. Therefore the stock or future may have trouble rising through the resistance price. To close an option and re-establish a similar position in another option on the same underlying security.
To roll a long call, one would sell the call he owns, and buy another call, generally with either a higher strike or a longer time to expiration, or both. A term referring to volatilities of options at different striking prices on the same underlying security. If the implied volatilities are different at each strike, there is said to be volatility skewing.
For options, any option position having both long options and short options of the same type put or call on the same underlying stock or futures contract. For futures, any position involving both long and short futures either with different months on the same commodity, or on two related commodities.
An order which becomes a market order when the stock or future trades at the price specified on the stop order. Buy stop orders are placed above the current market price; sell stop orders are placed below the current market price. Any position involving both puts and calls on the same side of the market, with the same striking price.
For example, a long straddle involves buying both puts and calls with the same striking price. A term in technical analysis indicating a price area lower than the current price of the stock or future, where demand is thought to exist.
Thus a stock or futures contract would stop declining when it reached a support area. The method of predicting future price movements based on observations of historical price movements; applies to either stocks or futures. A broad term used to denote the stock, index, or futures contract which underlies a particular series of options.
A term to describe the amount by which an option's price will change for a 1 percent change in the volatility of the underlying security. A measure of the amount by which an underlying security is expected to fluctuate in a given period of time. The amount of trading of a stock, option, or future.
Excessive trading volume in an equity option may portend a move in price by the underlying stock. If one can spot unusually heavy trading in calls, that may be a buy signal for the underlying stock. Trading or investing whether on margin or otherwise carries a high level of risk, and may not be suitable for all persons.
Leverage can work against you as well as for you. Before deciding to trade or invest you should carefully consider your investment objectives, level of experience, and ability to tolerate risk. The possibility exists that you could sustain a loss of some or all of your initial investment or even more than your initial investment and therefore you should not invest money that you cannot afford to lose.
You should be aware of all the risks associated with trading and investing, and seek advice from an independent financial advisor if you have any doubts. Past performance is not necessarily indicative of future results. Testimonials are believed to be true based on the representations of the persons providing the testimonials, but facts stated in testimonials have not been independently audited or verified.
Nor has there been any attempt to determine whether any testimonials are representative of the experiences of all persons using the methods described herein or to compare the experiences of the persons giving the testimonials after the testimonials were given. You should not necessarily expect the same or similar results. Past performance results for advisory services and educational products are shown for illustration and example only, and are hypothetical. A comprehensive list of option-oriented terms and their definitions These option trading terms are used with some frequency throughout our website and in our various publications Assignment The process by which a seller or writer of an option is notified that he is being required to fulfill his obligation to sell stock call assignment or buy stock put assignment.
Backspread Any spread in which in-the-money options are sold and a greater quantity of out-of-the-money options are bought. Bear spread A spread which makes money if the underlying stock or future declines in price.
Break-even Point The point at which a strategy or position would neither make nor lose money generally, at the option's expiration date. Bull spread A spread which makes money if the underlying stock or future rises in price.
Calendar spread A spread in which one sells options at one strike and buys options at a longer maturity with the same striking price. Cash-based An option or future that settles for cash at its expiration date, rather than being converted into stock or a physical commodity.
Closing transaction A trade that reduces an investor's position. Collateral The loan value of marginable securities; generally used to finance the writing of naked options. Contrarian One who thinks that the popular opinion of the masses is wrong, and will therefore go against that opinion.
Cover 1 to buy back an option that was written; 2 to sell an option against an existing position in the underlying stock or futures. Covered option A written option is considered covered if the investor has an offsetting position in the underlying security.
Covered write Typically meant to denote the strategy in which one is long the stock or future and is short an equal number of calls. Credit Money received in an account. Debit Money expended from an account.
A debit spread requires an outlay of dollars to establish. Delta The amount by which an option's price will change if the underlying security moves one point in price. Discount An option is trading at a discount if it is selling for less than its intrinsic value.
Early exercise or assignment The exercise or assignment of an option before its expiration date. Equity options Options which have common stock as their underlying security. Equivalent positions Two strategies are equivalent if they have the same profit picture at expiration. European exercise A feature of some options which means that they are only allowed to be exercised at expiration, but not before.
Exercise To invoke the holder's right to buy stock calls or sell stock puts. Expected return A mathematical estimate of the return that can be made from a position. Expiration date The date on which an option contract becomes void. Fair Value A term used to describe the theoretical worth of an option or futures contract; determined generally by a mathematical model, with volatility sometimes being a subjective variable.
Futures A standardized contract calling for the delivery of a specified quantity of a commodity at a specified date in the future. Futures options Options which have futures contracts as their underlying security. Gamma The amount by which the delta will change when the underlying stock moves by one point.