Defining Options Flashcards
Learn about the options trading instrument, option terms and option chains.
Options are purchased in:
Contracts
1 contract equals ___ shares of a stock
100
The options buyer has the _____ to buy or sell
right
The options seller (writer) has an _________ to buy or sell
obligation
The Call option: Provides the options buyer the _____ __ ___ an equity at a fixed priced within a set time frame.
right to buy
The Call option: _________ the options writer (seller) __ ____ an equity at a fixed price within a set time frame.
Obligates to sell
The Put option: Provides the options buyer the _____ __ ____ an equity at a fixed price within a set time frame.
right to sell
The Put option: ________ the Put options writer (seller) __ ___ an equity at a fixed price within a set time frame.
Obligates to buy
Options allow you to benefit from equity movements without ______ _________.
equity ownership
Options allow you to ________ trading capital.
leverage
Options can generate a greater ___
ROI
Options are ____ risky since less capital is used to benefit from ______ _________.
less equity movements
(When you compare the capital required to own 1,000 shares of an equity versus buying 10 option contracts that represent the same 1,000 shares).
By combining option trading instruments, we can create a _______ _____ that significantly reduces risk and improves results.
spread trade
A fixed price at which the option can be exercised. It is also known as the exercise price.
Strike price
The date on which the option expires. For stock options this is always a Saturday following the third Friday of the expiration month.
Expiration date
The value at which we sell an option — wholesale.
Bid
The value at which we buy an option — retail.
Ask
A Call Option is “ITM” if the current market value of the equity is above the strike price of the option.
“In the Money” - (Financial advantage - intrinsic value)
A ___ _______ is “ITM” if the current market value of the equity is below the strike price of the option.
Put Option - For example: If the current market price of xyz stock is $50, an xyz 45 call would be “in the money” by $5.
When the current market value of the stock is the same as the strike price of the option.
“At the Money”
When the strike price of a call is above the current market value of the equity, or if the strike price of a put is below the current market value of the equity
“Out of the Money” - For example: The current market price of xyz stock is at $50, a call with a strike price of $55 would be “out of the money” by $5 and a put would be “out of the money” by $5 with a strike price of $45.
The number of contracts that have exchanged hands for the day. This value is generated by option activity at each of the member exchanges (CBOE, etc).
Volume — (opened or closed - buy or sell unknown)
The total number or outstanding contracts for a particular equity, month and strike price. This value is maintained by the Options Clearing Corporation (0CC) and does NOT change during the trading day. It is recalculated before Market Open and reflects the NET changes from the day before.
Open Interest — (for long term expectation (LEAPs)
The actual value. It reflects the amount, if any, by which an option is “in the money”.
Intrinsic Value — For example: xyz stock is currently at $45 dollars a share, an xyz 40 call would have an intrinsic value of $5 per share. If the market price of the stock were to decline to $40 or lower, the call would no longer have any intrinsic value. (Stock Price - Strike Price) No time element
Any other value above the intrinsic value. Extrinsic value can be thought of as the probability of the equity finishing ATM.
Extrinsic Value - “Wild Card” - Expectation (risk) of movement of underlying security from current price.
Value based on the current market sentiment of the future fluctuations of the underlying equity.
Implied Volatility - Markets expectation of future movement of underlying equity during life of the option (explains price of option)
The time value of an option erodes as the option approaches the expiration date.
Time Decay (rent) - Time decay is not linear, it accelerates and becomes more noticeable during the last month prior to expiration.
One of “The Greeks”. It is the rate of change in an option’s price relative to a one dollar change in the price of the stock.
Delta — For example, if a Call Option has a delta of .50 and the price of the equity increases by one dollar, the option’s price increases by 50 cents.
Equity price — strike price =
Call intrinsic value
Any value in EXCESS of the intrinsic value of the option’s price is the options ______ _____
extrinsic value.
OTM Calls and Puts have ________ ______ only.
extrinsic value
For a given strike price, an option’s ________ _____ is the same amount regardless of expiration month
intrinsic value
The strike price is LESS than the equity’s price.
ITM Calls and OTM Puts
The Strike Price is GREATER than the equity’s price.
OTM Calls and ITM Puts
Strike price — Equity Price =
Put intrinsic value
Typically, there are more calls than puts. However, when a bearish sentiment is present, there may be more puts than calls.
Put/Call Ratio
Option contracts are ______ ________. They are not “Traded” between parties.
“Opened” and “Closed”
“Long” options are …
Bought To Open (BTO), and Sold To Close (STC).
“Short” options are …
Sold To Open (STO) and Bought To Close (BTC).
Long options have _______, short options carry _____________
rights obligations
The ____ ____ provides the buyer the RIGHT to buy the equity at the strike of the option for the life of the option
Long Call
The ______ ____is OBLIGATED to sell the equity at the strike of the option sold for the life of that option.
Short Call
The ____ ___ provides the buyer the RIGHT to sell the equity at the strike of the option for the life of that option
Long Put
The ______ ___ is OBLIGATED to buy the equity at the strike of the option sold for the life of the option
Short Put
Long Options
Buy to Open — Sell to Close
Short Options
Sell to Open — Buy to Close
Debit Trade
This is your risk - Spending money, like a debit card
Credit Trade
This is your reward - The most you can make ~ reward significantly less than risk
LONG PUT Application:
At The Money (ATM), 45 Days Of Time Value (Minimum).
SHORT PUT Application:
Near Term Option — Out Of The Money (OTM) Below Support.
LONG CALL Application:
At The Money (ATM), 45 days of time value - minimum.
SHORT CALL Application:
Near Term Option — At or Above Levels of Resistance.
Open long option contracts can be …
exercised, resold to close, or allowed to expire.
Open short option contracts can be …
bought to close, allowed to expire, or assigned (obligation realized).
Bullish options include ….
Long Calls and Short Puts (both involve BUYING the equity).
Bearish options include ….
Long Puts and Short Calls (both involve SELLING the equity).
Long options MUST have …
directional movement, an increase in Implied Volatility or both by the underlying equity to become profitable.
Short options can be profitable due to ….
directional movement of the underlying equity, but they can also be profitable in a stagnant trend as long as the short option remains out of the money.
Only _____ options can be assigned.
Short
At options expiration, all options that are in the money WILL be _________________
exercised/assigned
__________ ______Reflects the amount, if any, by which an option is “in the money” (ITM).
Intrinsic Value
To determine the amount of intrinsic value for a Call option we would ________ the strike price of the Call option from the current equity market price.
subtract
Call Intrinsic Value =
Equity Price — Call Strike Price (if zero or less, there is no intrinsic value)
To determine the amount of intrinsic value for a Put option we would subtract the current ______ market price from the Put option ______ price.
equity strike
Extrinsic Value =
Option Price — Intrinsic Value
What makes up an option’s extrinsic value?
- Stock price
- Strike price
- Time
- Dividends (if any)
- The “Risk Free Interest Rate”
- Implied Volatility
The mathematical measure of stock price fluctuation over a period of time. Also known as Standard Deviation.
Volatility
Based on equity (stock) prices.— The volatility that did occur.
Historical Volatility
Based on options prices. — The volatility that will occur.
Implied Volatility
The market’s expectation of the future price behavior of the stock for the life of the option being considered.
Implied Volatility (IV)
- Based on Stock Prices.
- Can be calculated over a variety of time periods.
- Basis for Bollinger Bands.
Historical Volatility (HV)
Implied Volatility can only impact the __________ value portion of an option’s price — NOT the __________ value.
EXTRINSIC INTRINSIC
If ________ ___________ increases it indicates that the market expects the equity to become more volatile. This causes the value of both calls and puts to _________.
Implied Volatility increase
Implied Volatility is _______ to each option in each option series.
UNIQUE
What affects Implied Volatility?
— Earnings announcements. — Takeover rumors. — Brokerage downgrades/upgrades. — Increased uncertainty. — NEWS!
Strategies for Low IV Markets
- Any Debit Trade: Directional option purchases or Spread Trades.
- Positions buying more options than selling (including just long options).
- Particularly good for Straddles/Strangles.
Strategies for High IV Markets
- Credit Trades: Selling options.
- Positions selling more options than buying (including just short options).
- Particularly good for Calendar spreads, Collar trades, and Butterflies.
Intrinsic Value is the ___ portion of an option’s price.
ITM
Historic volatility is the equity’s ____ behavior over a specified time period
PAST
Implied Volatility is the market’s expectation of the _______ behavior of an equity during the lifetime of the option in question.
FUTURE
The amount that an option’s value will increase or decrease based on a $1.00 move in the underlying equity
Delta: • Long call deltas are positive values. • Short call deltas are negative values. • Long put deltas are negative values. • Short put deltas are positive values.
At options expiration, all options will have a delta of …..
1.0, 0.0 or -1.0 — no exceptions.
The rate of change of delta with respect to the underlying equity.
Gamma:
• Gamma is greatest for the strike price that is At The Money (ATM) for a given expiration series.
• For a given strike price, Gamma decreases as you go further out in time.
• Gamma reaches it’s maximum at options expiration for the At The Money option.
• Mathematically it is the first derivative of Delta.
• Gamma can give you an idea of the sensitivity of Delta and how ¡t can change.
The amount that an option’s delta will change based on a $1.00 move by the underlying equity.
Gamma:
• Gamma is at a maximum when the option ¡s the ATM option. Gamma gets very large for the ATM option as expiration nears
Measures the extrinsic value decay of a position.
Theta:
• If Theta is a negative number e.g. -0.08 that means that the option will lose 8 cents per day on the value of that trade.
• If Theta is a positive value, that means that the position will be GAINING on a daily basis.
The amount that an option’s value will change per day due to the erosion of extrinsic value.
Theta:
• Long options have a negative theta.
• Short options have a positive theta.
• Theta decays the EXTRINSIC value of an option’s price.
• Short term ATM options have the largest theta values.
• The difference between theta values of shorter term options near the money can be significant.
• Long term options have relatively smaller theta values.
• The difference between theta values of longer term options near the money ¡s not as significant as for shorter term
• options. Theta of options on high volatility stocks will be higher than the theta of options on low volatility stocks.
• Options on higher volatility stocks have more extrinsic value and therefore have more premium to lose on a daily basis.
Quantifies the ¡mpact of implied volatility changes on the price of an option.
Vega - is the amount by which an option’s price changes when implied volatility changes by one percentage point.
The amount that an option’s value will change based on a 1% change in the option’s implied volatility.
Vega can only affect the extrinsic value portion of an option. Vega is higher for options that are further out in time. An increase in implied volatility can overcome days or weeks of time decay.
The amount that an option’s value will change based on a change in the risk free interest rate.
Rho is positive for long calls and negative for long puts. The value of an option is least sensitive to changes in the risk-free interest rates. For this reason, rho is the least used of the primary Greeks.
