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Options and Derivatives Glossary

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Important Terms for Physician-Executives and Investors

[By Staff Writers}

Text BooksAmerican-style option: An option that can be exercised at any time prior to expiration.

Ask price: The price at which a seller is offering to sell an option or stock.

Assignment:  Notification by the Options Clearing Corporation to the writer (seller) of an option that the holder has exercised the option and the terms of the settlement must now be met. The Options Clearing Corporation makes assignments on a random basis.

At-the-money: A term that describes an option with an exercise price that is equal to the current market price of the underlying stock.

Bearish: An adjective describing the belief that a stock (or the market in general) will decline in price.

Bid price: The price at which a buyer is willing to buy an option or stock.

Break-even point: A stock price at option expiration at which an option strategy results in neither a profit nor a loss.

Bullish: An adjective describing the belief that a stock (or the market in general) will rise in price.

Call option: A contract that gives the physician investor or holder the right (but not the obligation) to purchase the underlying stock at some predetermined price. In the case of American-style call options, this right can be exercised at any time until the expiration date. In the case of European-style call options, this right can only be exercised on the expiration date. For the writer (or grantor) of a call option, the contract represents an obligation to sell stock to the holder if the option is exercised.

Carrying cost: The interest expense on money borrowed to finance a stock or option position.

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

Closing price: The final price at which a transaction was made, but not necessarily the settlement price.

Closing transaction: A reduction or an elimination of an open position by the appropriate offsetting purchase or sale. An existing long option position is closed out by a selling transaction. An existing short option position is closed out by a purchase transaction.

Collateral: Securities or cash against which loans are made.

Contract size: The amount of the underlying asset covered by an options contract. This is 100 shares for one equity option, unless adjusted for a special event such as a stock split or a stock dividend. For index options, the contract size is the index level times the index multiplier.

Cover: To close out an open position. This term is used most frequently to describe the purchase of an option to close out an existing short position for either a profit or a loss.

Covered call: An option strategy in which a call option is written against a long stock (stock held in a client’s portfolio).

Covered option: An open short option position that is fully collateralized. If the holder of the option exercises, the writer of the option will not have a problem fulfilling the delivery requirements.

Covered put: An option strategy in which a put option is written against a sufficient amount of cash (or T-bills) to pay for the stock purchase if the short position is assigned.

Credit: Money received in an account from either a deposit or a transaction that results in increasing the account’s cash balance.

Cycle: The expiration dates applicable to the different series of options. Traditionally, there were three cycles:

• January/April/July/October

• February/May/August/November

• March/June/September/December

Today, equity options expire on a sequential cycle that involves a total of four option series: two near-term months and two far-term months. For example, on January 1, a stock traditionally in the January cycle will be trading options expiring in January, February, April, and July. Index options, however, expire on a consecutive cycle that involves the four near-term months. For example, on January 1, index options will be trading options expiring in January, February, March, and April.

Delivery: The process of meeting the terms of a written option when notification of assignment has been received. In the case of a short call, the writer must deliver stock and in return receives cash for the stock sold. In the case of a short put, the writer pays cash and in return receives the stock purchased.

Early exercise: A feature of American-style options that allows the holder to exercise an option at any time prior to the expiration date.

Equity: In a margin account, this is the difference between the securities owned and the margin loans owed. It is the amount the investor would keep after all positions have closed out and all margin loans are paid off.

Equity option: An option on a common stock.

European option: An option that can be exercised only on the expiration date.

Exercise: To invoke the rights granted to the holder of an option contract. In the case of a call, the option holder buys the underlying stock from the option writer. In the case of a put, the option holder sells the underlying stock to the option writer.

Exercise price: The price at which the holder of an option can either purchase (call) the underlying stock from or sell (put) it to the option writer.

Expiration date: The date on which an option and the right to exercise cease to exist.

Futures contract: A contract calling for the delivery of a specific quantity of a physical good or a financial instrument (or the cash value) at some specific date in the future. There are exchange-traded futures contracts with standardized terms, and there are over-the-counter futures contracts with negotiated terms.

Hedge: A position established with the specific intent of protecting an existing position.

Hypothecation agreement: A document giving a broker the right to pledge securities to a bank in order to provide for lending capacity.

Index: A compilation of several stock prices into a single number. Example: the S&P Index.

Index option: An option whose underlying entity is an index. Generally, index options are cash-settled.

In-the-money:  A term used to describe an option with intrinsic value. A call option is “in-the-money” if the stock price is above the strike price. A put option is “in-the-money” if the stock price is below the strike price.

Intrinsic value: The in-the-money portion of an option’s price.

Leg: A term describing one side of a position that has two or more sides.

Leverage: The ability to borrow against a position to increase the investor’s purchasing power. A term describing the greater percentage of profit or loss potential when a given amount of money controls a security with a much larger face value. For example, a call option enables the physician investor or holder to assume the upside potential of 100 shares of stock by investing a much smaller amount than required to buy the stock. If, for example, the stock increases by 10%, the option can double in value. Conversely, a 10% stock price decline can result in the total loss of the purchase price of the option.

Limit order: A trading order placed with a broker to buy or sell a security at a specific price.

Listed option: A put or call traded on a national option exchange with standardized terms. In contrast, over-the-counter options usually have non-standard or negotiated terms.

Long position: A term used to describe either an open position that is expected to benefit from a rise in the price of the underlying stock (such as long call, short put, or long stock) or an open position resulting from an opening purchase transaction such as long call, long put, or long stock.

Margin: The minimum equity required to support an investment position. To buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm.

Market maker: An exchange member on the trading floor who buys and sells for his own account and who is responsible for making bids and offers and maintaining a fair and orderly market.

Market order: A trading instruction from an investor to a broker to immediately buy or sell a security at the best available price.

Mark to market: An accounting process by which the price of securities held in an account is valued each day to reflect the last sale price or market quote if the last sale is outside of the market quote. The result of this process is that the equity in an account is updated daily to properly reflect current security prices.

Married put strategy: The simultaneous purchase of stock and the corresponding number of put options. This is a limited-risk strategy during the life of the puts, because the stock can be sold at the strike price of the puts.

Monetization: A strategy that allows an investor to generate cash from a position without realizing a sale of the underlying position.

Non-equity options: Any option that does not have common stock as its underlying asset. Non-equity options include options on futures, indexes, interest rate composites, and physicals.

Opening transaction: An addition to or creation of a trading position. An opening purchase transaction adds long options (or long securities) to an investor’s total position, and an opening sell transaction adds short options (or short securities).

Option writer: The seller of an option contract who is obligated to meet the terms of delivery if the option holder exercises his or her right.

Out-of-the-money: A term used to describe an option that has no intrinsic value, i.e., all of its value consists of time value. A call option is “out-of-the-money” if the stock price is below the strike price. A put option is “out-of-the-money” if the stock price is above the strike price.

Over-the-counter (OTC) option: An option that is traded in the over-the-counter market. OTC options are not usually listed on an options exchange and generally do not have standardized terms.

Parity: The difference between the stock price and the strike price of an in-the-money option. When an option is trading at its intrinsic value, it is said to be trading at parity.

Position limits: The maximum number of open option contracts that an investor can hold in one account or in a group of related accounts. Some exchanges express the limit in terms of option contracts on the same side of the market, and others express it in terms of total long or short delta.

Premium: The total price of an option, which equals its intrinsic value plus its time value. Often this word is used to mean the same as time value.

Put option: A contract that gives the buyer the right (but not the obligation) to sell the underlying stock at some predetermined price. For the writer (or grantor) of a put option, the contract represents an obligation to buy stock from the buyer if the option is assigned.

Settlement price: The official price at the end of a trading session. This price is established by the Option Clearing Corporation, and it is used to determine changes in account equity or margin requirements, and for other purposes.

Short option position: The position of an option writer that represents an obligation to meet the terms of the option if it is assigned.

Short position: Any open position that is expected to benefit from a decline in the price of the underlying stock such as long put, short call, or short stock.

Short sale: The sale of a security (i.e., stocks and bonds) before it has been acquired.

Spread: A position consisting of two parts, each of which alone would profit from opposite directional price moves. These opposite parts are entered simultaneously in the hope of limiting risk or benefiting from change or price relationship between the two.

Stock index futures: A futures contract that has as its underlying entity a stock market index. Such futures contracts are generally subject to cash settlement.

Stop limit order: A type of contingency order, placed with a broker that becomes a limit order when the security trades, is bid, or is offered at a specific price.

Straddle: A trading position involving puts and calls on a one-to-one basis in which the puts and calls have the same strike price, expiration, and underlying entity. A long straddle is when both options are owned and a short straddle is when both options are written.

Street name: Securities held in a street name are simply held for a customer’s account in the name of the brokerage house.

Synthetic position: A strategy involving two or more instruments that has the same risk/reward profile as a strategy involving only one instrument. The following list summarizes the six primary synthetic positions.

• Synthetic long call—A long stock position combined with a long put.

• Synthetic long put—A short stock position combined with a long call.

• Synthetic long stock—A long call position combined with a short put.

• Synthetic short call—A short stock position combined with a short put.

• Synthetic short put—A long stock position combined with a short call.

• Synthetic short stock—A short call position combined with a long put.

Tick: The smallest unit price change allowed in trading a security. For a common stock, this is generally 1/8 point. For an option under $3 in price, this is generally 1/16 point. For an option over $3, this is generally 1/8 point.

Time value: The difference between the call price and the intrinsic value.  It reflects what traders are willing to pay for the uncertainty (volatility) of a stock.

Uncovered option: A short option position that is not fully collateralized if notification of assignment should be received. A short call position is uncovered if the writer does not have a long stock position to deliver. A short put position is uncovered if the writer does not have the financial resources available in his or her account to buy the stock.

Volatility: The volatility of an asset is a measure of the variability of its returns. Conventionally, volatility is defined as the annualized standard deviation of the logarithms of the asset’s returns. An important aspect of volatility is that it measures the variability of returns and not the deviation.

Write: To sell an option. A physician-investor who sells an option is called the writer, regardless of whether the option is covered or uncovered.

 

MORE: Glossary Terms Ap 3

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