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Risk Graphs, also known as a risk/reward diagrams, payoff diagrams or profit/loss diagrams, are charts that represent the profit or loss of an option across a spectrum of prices. Risk Profiles allow option traders to evaluate the risk/reward characteristics of an option trading strategy. Risk Profiles display at a glance where are the areas of the highest gains and losses occur. This enables option traders to make more educated decisions without complex calculations. Risk profiles also allow option traders to identify option trading strategies with similar risk/reward profiles, making synthetic positions easier to create and manage. Risk Profiles are simple diagrams made up of 2 axis and a line representing option price at various prices of the underlying security. The horizontal axis or X-Axis represents stock price and the vertical axis or Y-Axis represents option profit or loss.
Is Risk/Reward Limited Or Unlimited
To find out if the risk/reward of an option trading strategy is limited or unlimited through a Risk Profile Graph, a Trader would look at the top end and bottom end of the graph line. If the top end of the graph line is pointing upwards, it is an option trading strategy with unlimited profit potential. If the top end of the graph line is pointing horizontally, it means that it is an option trading strategy with limited profit potential and will rise in price no further when a certain stock price has been reached.
In Addition, if the bottom end of the profile risk graph line is pointing downwards, it is an option trading strategy with unlimited loss potential. If the bottom end of the profile risk graph line is pointing sideways, horizontally, it means that it is an option trading strategy with limited loss potential and will lose no more money beyond a certain stock price has been reached.
Direction of Profit
An option trading strategy turns a profit when the Risk Profile Graph line crosses above the X-Axis (horizontal axis). Remember, the center of a risk graph is the prevailing stock price when the chart is built and that stock price increases to the right and decreases to the left. If the Risk Profile Graph line crosses above the X-Axis to the right, it means that the stock price needs to increase in order to turn a profit. If the profile risk graph line crosses above the X-Axis to the left, it means that the stock price needs to decrease in order to turn a profit.
Where is Breakeven on an Option Trade
The Breakeven Point of an option trade is presented on the Risk Profile Graph as the point where the graph line touches the X-Axis (horizontal axis). This is the point where the option position neither gains nor losses money. In more complex strategies, there could be more than one breakeven point. Where the breakeven points are in relation to the center of the profile risk graph, it tells you which direction the stock price must go in order for the position to breakeven.
Option Strategy Risk Profiles
The following charts illustrate the profit and loss profiles for many popular option strategies.The profit and loss profiles simply show what your option trade profit or loss will be for various stock prices at expiration. It is important to understand that all profit and loss diagrams shown in this reference guide are drawn at expiration of the options. Please note that prior to expiration the diagrams can look very different. Just because a diagram shows a profit at a particular stock price at expiration does not mean that same strategy will be profitable at that same point prior to expiration. Still, the charts are important to understand because they help you get a feel for each strategy and what it is trying to accomplish.
Listed for each strategy:
Outlook: Tells whether the strategy is bullish, bearish or neutral. Bullish strategies make money when the underlying stock rises while bearish strategies make money when it falls and neutral strategies make money when the stock does not move.
Directional Risk: Describes what the risks are for each individual strategy. For example, if a strategy has unlimited risk if the underlying stock rises, this field will say “unlimited upside.” On many positions you may see “unlimited downside risk” meaning there is potential for unlimited losses if the stock falls. To be exact, this is not unlimited risk since a stock cannot fall below zero. However, since it is extremely rare to see a stock down to a price of zero, this risk is still considered to be unlimited.
Max gain: Shows the maximum amount of profit that could be made.
Max loss: Shows the maximum amount of loss that could be occur.
Breakeven: Shows the stock price (or prices) where the strategy breaks even; that is the point where the trader neither makes nor loses money.
Covered Call (Buy-Write)
Covered Put (Sell-Write)
Long Butterfly Spread
Short Butterfly Spread
Long Condor Spread
Short Condor Spread
Long Albatross Spread
Short Alabatross Spread
Call Backspread (Long Call Ratio Spread)
Short Call Ratio Spread
Put Backspread (Long Put Ratio Spread)
Short Put Ratio Spread
Long Call Christmas Tree
Short Call Christmas Tree
Long Put Christmas Tree
Short Put Christmas Tree
Long Calendar Spread
Short Calendar Spread
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CNBC is a recognized world leader in business news, providing real-time financial market coverage and business information to more than 340 million homes worldwide. Since 2009, Andrew Keene has appeared frequently on the network, generally just before the markets open on Squawk on the Street.
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CBOE Chicago Board of Options Exchange
Andrew just recently received his own show on CBOETv, “Unusual Options Activity Report.” Andrew is fortunate to have had a great working relationship with CBOE for over a decade. He continues to be one of the most frequent guests on CBOEtv’s In the Money and recently filled in as a guest host on the networks’s Premarket Pluse. In late summer 2011, Andrew was asked to offer his insights to the highly anticipated new blog, CBOE Community.
Andrew Keene began working with nationally syndicated First Business in early 2011 and enjoys being interviewed weekly on the network’s chart Talk and Trader Talk. While he currently shoots his appearances live from the CBOE, he looks forward to spending some time in their studio.
Andrew is proud to provide Minyanville with Earnings articles and videos twice a week on Tuesday and Thursday. He is the only contributor that includes videos with this highly reputable website.
Andrew does articles and for the OptionsProfit.com section of TheStreet.com. TheStreet is a leading digital financial media company whose network of digital services provides users, subscribers and advertisers with a variety of content and tools through a range of online, social media, tablet and mobile channels. He writes twice a week usually unusual options activity and also provides them with daily Video Recaps in Futures, AAPL, Goog, and all Earnings stocks.
What Are The Option Greeks?
The Mathematical characteristics of the Black-Scholes Model are named after the greek letters used to represent them in the equations. The 5 Option Greeks measure the sensitivity of the price of stock options in relation to 4 different factors; Changes in the underlying stock price, interest rate, volatility and time decay.
The movement of the option position relative to the movement of the underlying stock position. Measures the speed at which the option position is moving relative to the underlying stock position. Therefore, a Delta of 1 means the option position is moving 1 point for every point the stock moves. A Delta of –1 means the option position ismoving –1 point for every point the underlying stock moves. Delta is another way of expressing the probability of an option expiringin-the-money.
Formula for calculating option Delta:
C = Value of the Call Option
S(t) = Current value of the underlying asset
N(d1) = Rate of change of the option price with respect to the price of the underlying asset
T = Option life as a percentage of the year
ln = Natural log
Rf = Risk free rate of return
Gamma is mathematically the second derivative of Delta and can be viewed in two ways: the acceleration of the option position relative to the underlying stock price, or the odds of a change in the probability of the position expiring ITM (in other words, the odds of a change in Delta). Gamma is effectively an early warning to the fact that Delta could be about to change.Both calls and puts have positive Gammas. Typically, deep OTM and deep ITM options have near zero Gamma because the odds of a change in Delta are very low. Logically, Gamma tends to peak around the strike price. Gamma is important because it shows us how fast our position delta changes in relation to the market price of the underlying asset.
Formula for calculation option Gamma:
d1 = Refer to Delta Calculation
S = Current value of underlying asset
T = Option life as a percentage of a year
Theta stands for the option position’s sensitivity to time decay. Long options have negative Theta, meaning that everyday you own that option, time decay is eroding the Time Value portion of the option’s value. In other words, time decay is hurting the position of a Long option position. When you short options, Theta is positive, indicating that time decay is helping the option writer’s position. The closer to the expiration date, the higher the theta and the father away the expiration date, the lower the theta.
The below graphs show the effect of Theta on options during the last 30 days to expiration. ITM and ATM options decay fastest during the last 30 days to expiration. OTM options decay the least during the final 30 days.
Formula for Calculating Theta
d1 = Refer to Delta Calculation
T = Option life as a percentage of year
C = Value of Call Option
St = Current price of underlying asset
X = Strike Price
Rf = Risk free rate of return
N(d2) = Probability of option being in the money
Vega stands for the option position’s sensitivity to volatility. Options tend toincrease in value when the underlying stock’s volatility increases. So, volatility helps the owner of an option and hurts the writer of an option. Vega is positivefor long option positions and negative for short option positions.
Formula for Calculating Vega:
d1 = Refer to Delta Caculation above
S = Current Value of underlying asset
T = Option life as percentage of year
C = Value of Call Option
Rho stands for the option position’s sensitivity to interest rates. A positive Rho means that higher interest rates are helping the position, and a negative Rho means that higher interest rates are hurting the position. Rho is the least important of all the Greeks as far as stock options are concerned.
Rho Charateristics – Options Rho come in positive or negative polarity. Long call options produces positive options Rho and Long put options produces negative options rho. This means that call options rise in value and put options drop in value with a rise in interest rates. Options Rho increases as time to expiration becomes longer. Options Rho is almost equal for all ITM and decreases for OTM options.
d1 = Refer to Delta calculation
T = Option life as a percentage of year
C = Value of Call Option
X = Strike Price
N(d2) = Probabilty of option being in the money
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Day trading, short term trading, options trading, and futures trading are extremely risky undertakings. They generally are not appropriate for someone with limited capital, little or no trading experience, and/ or a low tolerance for risk. Never execute a trade unless you can afford to and are prepared to lose your entire investment. All trading operations involve serious risks, and you can lose your entire investment.
In addition, certain trades may result in a loss greater than your entire investment. Always perform your own due diligence and, as appropriate, make informed decisions with the help of a licensed financial professional. KOTM makes no warranties or guarantees as to our accuracy, the profitability of any trades which are discussed, or any other guarantees or warranties of any kind. You should make your own independent investigation and evaluation of any possible investment or investment advice being considered.
Commissions, fees and other costs associated with investing or trading may vary from broker to broker. You should speak with your broker about these costs. Be aware that certain trades that may be profitable for some may not be profitable for you, after taking into account these costs. You should also be aware that, in certain markets, you may not always be able to buy or sell a position at the price I discuss. Thus, you may not be able to take advantage of certain trades discussed herein.
American Stock Exchange – (AMEX) Securities Exchange that handles approximately 20% of all securities trades within the U.S.
American-Style Option – An option contract that can be exercised at any time before the expiration date. Stock options are American style.
Arbitrage – Where the simultaneous purchase and disposal of a combination of financial instruments is such that a guaranteed profit is made automatically.
Ask – The price that you buy at and the price that market makers and floor brokers are willing to sell at. The Ask stands for what the market makers and floor traders ask you to pay for the stock (or options or other instrument).
At the Opening Order – An order that specifies execution at the market opening or else it is cancelled.
ATM (At the Money) – Where the option exercise price is the same as the asset price.
Automatic Exercise – The automatic exercise of an ITM (In the Money) option by the clearing firm at expiration.
Backspread – A spread where more options (calls or puts) are bought than sold (the opposite of a Ratio Spread).
Bear Call Ladder – A strategy using calls where the trader sells a lower strike call and buys a higher strike call and another higher strike call.
Bear Call Spread – A bearish net credit strategy using calls where the trader buys a higher strike call and sells a lower strike call. The higher strike call will be cheaper, hence the net credit. Bear Call spreads have limited risk and reward, and are more profitable as the underlying asset price falls.
Bear Put Ladder – A spread using puts where the trader sells a lower strike put and buys a higher strike put and another higher strike put.
Bear Put Spread – A net debit spread using only puts where the trader buys a higher strike put and sells a lower strike put. The higher strike put will be more expensive, hence the net debit. Bear Put spreads have limited risk and reward, and are more profitable as the underlying asset falls.
Bid – The price the trader sells at and the price that market makers and floor traders are willing to buy at. The Bid stands for the price at which the market maker will bid for your stock (or options or other instrument).
Bid Ask Spread – The difference between the bid and asked prices. Generally you will buy at the Ask and sell at the Bid. The Ask is always higher than the Bid.
Breakeven – The point(s) at which a risk profile of a trade equals zero.
Breakout – Where a price chart emerges upwards beyond previous price resistance.
Broker – A person who charges commission for executing a transaction (buy or sell) order.
Bull – Someone who expects the market to rise.
Bull Call Ladder – A spread using only calls where the trader buys a lower strike call and sells a higher strike call and another higher strike call.
Bull Call Spread – Long-term bullish strategy involving buying low strike calls and selling the same number of higher strike calls with the same expiration date.
Bull Market – A rising market over a period of time (usually a few years).
Bull Put Ladder – A spread using puts where the trader buys a lower strike put and sells a higher strike put and another higher strike put.
Bull Put Spread – Short-term bullish strategy involving buying lower strike puts and selling higher strike puts with the same expiration date.
Butterfly Spread – Three-legged direction neutral low volatility strategies involving either all call legs or all put legs. Suitable for rangebound stocks.
Buy on Close – An order stipulating to buy the security at the close of the trading session.
Buy on Open – An order stipulating to buy the security at the opening of the trading session.
Buy Stop – A buy order where the price stipulated is higher than the current price.The rationale here is that the buyer believes that if the security breaks a certain resistance then the security will continue to rise.
Buy-Write – A bullish strategy involving buying a stock and selling near term ATM or OTM call options to generate regular income. See “Covered Call.”
Calendar Spread – Two-legged option trade involving buying a long-term option and selling a shorter-term option with the same strike price. A Calendar Spread must involve either all call or all put legs; you cannot mix calls and puts together for this strategy.
Call Option – The right, not the obligation, to buy an underlying security at a fixed price before a predetermined date.
Call Premium – The price of a call option.
Call Ratio Backspread – Bullish strategy involving selling one or two lower strike calls and buying two or three higher strike calls.
Capital Gain – The profit realized from buying and selling an asset.
Capital Loss – The loss taken from buying and selling an asset unprofitably.
Chicago Board Options Exchange (CBOE) – The largest equity options exchange in the world.
Chicago Board of Trade (CBOT) – The oldest commodity exchange in the U.S. Known for listings in T-bonds, notes, and a variety of commodities.
Chicago Mercantile Exchange (CME) – An exchange in which many types of futures contracts are traded in an open outcry system.
Class of Options – Options of the same type, style, and underlying security.
Clearing House – A separate institution to establish timely payment and delivery of securities.
Close – The last price quoted for the day.
Closing Purchase – A transaction that closes an open short position.
Collar – A low-risk bullish strategy involving buying a stock, buying near the money puts, and selling out of the money calls.
Closing Sale – A transaction that closes an open long position.
Commission – A charge made by the broker for arranging the transaction.
Commodity – A tangible good that is traded on an exchange—for example, oil, grains, metals.
Commodity Futures Trading Commission (CFTC) – An institution charged with ensuring the efficient operation of the futures markets.
Condor Spread – Four-legged direction neutral low volatility strategy involving either all call legs or all put legs. Suitable for rangebound stocks.
Contract – A unit of trading for an option or future.
Correction – A post-rise decline in a stock price or market.
Covered Call – A bullish strategy involving buying or owning a stock and selling near term ATM or OTM calls to generate regular income. See “Buy-Write.”
Covered Put – A bearish strategy involving shorting stock and shorting a near term put option to create regular income. Considered a high-risk strategy.
Covered Short Straddle – A bullish strategy involving buying (or owning) a stock and selling near term puts and calls at the same strike price and expiration date. This is a risky strategy, involving almost certain exercise of the put or call and a significant downside risk if the stock price falls.
Covered Short Strangle – A bullish strategy involving buying (or owning) a stock and selling near-term OTM puts and OTM calls at the same expiration date. This is a risky strategy, involving significant downside risk if the stock price falls.
Credit Spread – Where the simultaneous buying and selling of options creates a net credit into your account (i.e., you receive more for the ones you sell than those you buy).
Day Order – An order good for the day only.
Day Trade – The acquisition and disposal of an asset in the same day.
Day Trading – A trading style where positions are closed by the end of every day.
Debit Spread – Where the simultaneous buying and selling of options creates a net debit from your account (i.e., you pay more for the ones you buy than those you sell).
Deep In the Money (DITM) – calls Where the price of the underlying security is far greater than the Call Strike Price.
Deep In the Money (DITM) – puts Where the price of the underlying security is far less than the Put Strike Price.
Delayed Time Quotes – Quotes that are delayed from real time.
Delta – The amount by which an option premium moves divided by the dollar-fordollar movement in the underlying asset.
Delta Hedge – A strategy designed to protect the investor against directional price changes in the underlying asset by engineering the overall position Delta to zero.
Delta Neutral – Where a spread position is engineered so that the overall position Delta is zero.
Derivative – A financial instrument whose value is “derived” in some way from the value of an underlying asset source.
Diagonal Spread – Two-legged option trade involving buying a long-term option and selling a shorter-term option with a higher strike price. ACalendar Spread must involve either all call or all put legs; you cannot mix calls and puts together for this strategy.
Discount Brokers – Low commission brokers who simply place orders and do not provide advisory services.
Dividend – A payment made by an organization to its owners (shareholders), hopefully from profits.
Dow Jones Industrial Average (DJIA) – An index of 30 blue chip stocks traded on the New York Stock Exchange (NYSE). This index is often considered a bellwether of overall market sentiment.
Downside Risk – The potential risk of a trade if prices decline.
End of Day – The close of the trading day when prices settle.
EPS – Earnings per share. The amount of profits of an organization divided by the number of outstanding shares.
Equity Options – Same as Stock Options.
European Style Option – An option that cannot be exercised before the expiration date.
Exchange – Where an asset or derivative is traded.
Exchange Rate – The price at which one currency can be converted into another currency.
Execution – The process of completing an order to trade a security.
Exercise – The activation of the right to buy or sell the underlying security.
Exercise (Strike) Price – The price at which an asset can be bought or sold by the buyer of a call or put option.
Expiration – The date at which the option’s ability to be exercised ceases.
Expiration Date – The last day on which an option can be exercised.
Extrinsic Value (Time Value) – The price of an option less its intrinsic value. Out of the Money Options are entirely made up of Extrinsic (or Time) Value.
Fair Market Value – An asset’s value under normal circumstances.
Fair Value – The theoretical value calculation of an option using a pricing technique such as Black-Scholes options pricing formula.
Fill – An order that has been executed.
Fill Order – An order that must be filled immediately or cancelled.
Fill or Kill – An order where a precise number of contracts must be filled or the order is cancelled.
Floor Broker – A member of an exchange who is paid to execute orders.
Floor Trader – An exchange member who trades on the floor of the exchange for his or her own account.
Fundamental Analysis – Analysis of a stock security that is based on the ability of the organization to generate profits for its shareholders. Such analysis embraces earnings, PE Ratios, EPS, Net Assets, Liabilities, customers, etc.
Futures Contracts Agreement – to buy or sell an underlying security at a predetermined date at an agreed price. The difference between futures and options is that with options, the buyer has the right, not the obligation. With futures, both parties are obliged to fulfill their part of the bargain.
Gamma – The speed by which Delta changes compared with the speed by which the underlying asset is moving.
Good till Cancelled Order (GTC) – An order that continues until either it is filled or cancelled specifically by the trader.
Guts – A volatility strategy involving buying In the Money (ITM) calls and ITM puts. High volatility is required after the position is opened to make this a profitable strategy.
Hedge – A term for reducing the risk of one position by taking other positions with options, futures, or other derivatives.
Historical Volatility – A measure of the price fluctuation of an asset averaged out over a period of time. A typical and popular period would be 21–23 trading days.
Index – A group of assets (often in a similar class of sector or market capitalization) that can be traded as a single security.
Index Options – Options on the indexes of stocks or other securities.
Interest Rates – The rate at which borrowed money is charged by the lender, usually annualized into a percentage figure.
In the Money (ITM) – Where you can exercise an option for a profit. In the Money (ITM) calls ITM calls are where the current stock price is greater than the Call Strike Price. In the Money (ITM) puts ITM puts are where the current stock price is less than the Put Strike Price.
Intrinsic Value – The amount by which an option is in the money.
Iron Butterfly – See “Long Iron Butterfly” or “Short Iron Butterfly.”
LEAPs – Long-term Equity AnticiPation Securities. These are long-term stock options with expirations up to three years in the future. LEAPs are available in callsand puts and are American-style traded options.
Leg – One side or component of a spread.
Leg In/Leg Out – Legging into a spread entails the completion of just one part of a spread with the intention of completing the other parts at more favorable prices later on. Legging out of a spread entails the opposite, whereby you exit your spread one part at a time with the intention of doing so at more favorable prices as the underlying security moves in the anticipated direction.
LIFFE – London International Financial Futures and Options Exchange. Now known as Euronext.liffe.
Limit Order – An order to buy at a set price that is at or below the current price of the security. An order to sell at a set price that is at or above the current price of the security.
Liquidity – The speed and ease with which an asset can be traded. Cash has the most liquidity of all assets, whereas property (real estate) is one of the most illiquid assets. Volume is the measure of liquidity for stocks, and Open Interest is the me
asure of liquidity for options. See Open Interest.
Long – Being long means that you are a buyer of a security.
Long Call – Buying a call option.
Long Call Butterfly – A three-leg direction neutral strategy requiring low volatility,involving buying a low strike call, selling two middle strike calls with the same strike price, and buying a higher strike call.
Long Call Condor – A four-leg direction neutral strategy requiring low volatility, involving buying a low strike call, selling two middle strike calls with different strike prices, and buying a higher strike call.
Long Call Synthetic Straddle – A two-leg direction neutral strategy requiring high volatility, involving buying two ATM calls for every 100 shares (U.S. stock options) sold, thereby replicating the risk profile of a Long Straddle.
Long Combo – A bullish strategy involving selling OTM puts and buying OTM calls in order to partially replicate a long stock position.
Long Iron Butterfly – A direction neutral strategy constructed by combining a Bull Put Spread with a Bear Call Spread or by combining a narrow Short Strangle with a wider Long Strangle.
Long Put – A bearish strategy, buying put options.
Long Put Butterfly – A three-leg direction neutral strategy requiring low volatility,involving buying a low strike put, selling two middle strike puts with the same strike price, and buying a higher strike put.
Long Put Condor – A four-leg direction neutral strategy requiring low volatility,involving buying a low strike put, selling two middle strike puts with different strike prices, and buying a higher strike put.
Long Put Synthetic Straddle – A two-leg direction neutral strategy requiring high volatility, involving buying two ATM puts for every 100 shares (U.S. stock options) bought, thereby replicating the risk profile of a Long Straddle.
Long Stock – Buying shares.
Long Synthetic Future – Buying calls and selling the same amount of puts with the same strike and expiration date, effectively forming the same risk profile of buying a stock but with almost no cost.
Margin – An amount paid by the account holder (either in cash or “marginable securities”)that is held by the brokerage against non-cash or high-risk investments, or where the brokerage has lent the account holder the means to undertake a particular trade.
Market Capitalization – The number of outstanding shares multiplied by the value per share.
Market if Touched (MIT) Order – An order that becomes a market order if the price specified is reached.
Market Maker – A trader or trading firm that buys and sells securities in a market in order to facilitate trading. Market makers make a two-sided (bid and ask) market.
Market on Close – Order An order that requires the broker to achieve the best price at the close or in the last five minutes of trading.
Market on Open – Order An order that must be executed at the opening of trading.
Market Order – Trading securities immediately at the best market prices in order to guarantee execution.
Market Price – The most recent transaction price.
Married Put – See “Covered Put.”
Modified Call Butterfly – A neutral to bullish strategy similar to a Long Call Butterfly, except that the OTM bought calls have a strike price nearer to the central strike price of the sold calls.
Modified Put Butterfly – A neutral to bullish strategy similar to a Long Put Butterfly, except that the ITM bought puts have a strike price nearer to the central strike price of the sold puts.
Naked Selling – Naked options refers to a sold options contract with no hedge position in place. Such a position leaves the option seller (writer) exposed to unlimited risk.
NASDAQ – National Association of Securities Dealers Automated Quotations system.This is a computerized system providing brokers and dealers with securities price quotes.
Near the Money (NTM) – Where the underlying asset price is close to the Strike Price of an option.
New York Stock Exchange (NYSE) – The largest stock exchange in the U.S.
OEX – Standard & Poor’s 100 Stock Index.
Offer – The lowest price at which someone is willing to sell. You also can refer to the “Ask” of a Bid-Ask Spread. See “Ask.”
On the Money (At the Money) – See “ATM (At the Money).”
Open Interest – The total number of options or futures contracts that are not closed or delivered on a particular day. This is a measure of an option’s liquidity. A higher number of “open” contracts indicates greater liquidity. Greater liquidity affords us greater efficiency in closing our open positions.
Open Outcry – Verbal system of floor trading still used at many exchanges (e.g., the CME and CBOT).
Opening – The beginning of the trading session at an exchange.
Opportunity Cost – The risk of an investment expressed as a comparison with another competing investment.
Option – A security that gives the buyer the right, not the obligation, to buy (call) or sell (put) an underlying asset at a fixed price before a predetermined date.
Option Premium – The price of an option.
Option Writer – The seller of an option (usually naked).
Out of the Money (OTM) – Where the option has no intrinsic value and where you cannot exercise an option for a profit. Out of the Money (OTM) calls OTM calls are where the current stock price is less than the Call Strike Price. Out of the Money (OTM) puts OTM puts are where the current stock price is greater than the Put Strike Price.
Position Delta – The sum of all positive and negative Deltas within a hedged trade position.
Premium – The price of an option.
Price Bar – The visual representation of a securities price fluctuation for a set period of time. Price bars can be for as little as one minute (or less) and as much as one year(or more).
Put Calendar – A neutral to bullish strategy involving buying longer expiration puts and selling shorter expiration puts with the same strike price.
Put Diagonal – A neutral to bullish strategy involving buying longer expiration puts and selling shorter expiration puts with a higher strike price.
Put Option – The right, not the obligation, to sell an underlying security at a fixed price before a predetermined date.
Put Ratio Backspread – Bearish strategy involving selling one or two higher strike puts and buying two or three lower strike puts.
Quote – The price being bid or offered by a market maker for a security.
Ratio Backspread – A strategy using all puts or all calls, whereby the trader buys OTM options in a ratio of 3:2 or 2:1 to the ITM options he sells. In this way, the trader is always long in more options than those he is short in.
Ratio Call Spread – A bearish strategy that involves the trader being short in more options than those he is long in, at a ratio of 3:2 or 2:1. In this way, the trader will have an unlimited risk profile with only limited profit potential.
Ratio Put Spread – A bullish strategy that involves the trader being short in more options than those he is long in, at a ratio of 3:2 or 2:1. In this way, the trader will have an unlimited risk profile with only limited profit potential.
Real Time – Data that is updated and received tick by tick.
Resistance – A price threshold on a price chart that is thought to be difficult for the price to burst up through because of past price movements.
Return – The income profit on an investment, often expressed as a percentage.
Rho – The sensitivity of an option price to interest rates. Typically, call options increase in value as interest rates rise, and puts decrease in value as interest rates rise.
Risk – The potential loss of a trade.
Risk-Free Rate – The interest chargeable on Treasury Bills (T-Bills) is generally known as the Risk-Free Rate; this rate is used as a component part of the theoretical valuation of options model.
Risk Profile – The graphic depiction of a trade, showing the potential risk, reward, and breakeven points as the underlying security price deviates within a range of prices.
Securities and Exchange Commission (SEC) – Organization that regulates the securities markets in order to protect investors.
Security – An instrument that can be traded—e.g., stocks, bonds, etc.
Selling Short – Selling a security that you don’t actually own beforehand. You will eventually have to buy it back, hopefully at a reduced price, thus making profit.
Series (Options) – Option contracts of the same class (underlying asset), same strike price, and same expiration date.
Shares – Units of ownership in a company or organization.
Short Selling – a security that you don’t actually own.
Short Call – A bearish strategy involving the short selling of call options.
Short Call Butterfly – A three-leg direction neutral strategy requiring high volatility, involving selling a low strike call, buying two middle strike calls with the same strike price, and buying a higher strike call.
Short Call Condor – A four-leg direction neutral strategy requiring high volatility, involving selling a low strike call, buying two middle strike calls with different strike prices, and buying a higher strike call.
Short Call Synthetic Straddle – A two-leg direction neutral strategy requiring low volatility, involving selling two ATM calls for every 100 shares (U.S. stock options) bought, thereby replicating the risk profile of a Short Straddle.
Short Combo – A bearish strategy involving buying OTM puts and selling OTM calls in order to partially replicate a short stock position.
Short Guts – Alow volatility strategy involving selling In the Money (ITM) calls and ITM puts. Low volatility is required after the position is opened to make this a profitable strategy.
Short Iron Butterfly – A direction neutral strategy constructed by combining a Bull Call Spread with a Bear Put Spread or by combining a narrow Long Strangle with a wider Short Strangle.
Short Put – A bullish strategy, selling put options usually OTM (with a strike price below the current stock price).
Short Put Butterfly – A three-leg direction neutral strategy requiring high volatility, involving selling a low strike put, buying two middle strike puts with the same strike price, and selling a higher strike put.
Short Put Condor – A four-leg direction neutral strategy requiring high volatility, involving selling a low strike put, buying two middle strike puts with different strike prices, and selling a higher strike put.
Short Put Synthetic Straddle – A two-leg direction neutral strategy requiring low volatility, involving selling two ATM puts for every 100 shares (U.S. stock options) sold, thereby replicating the risk profile of a Short Straddle.
Short Stock – Selling shares short.
Short Straddle – A low volatility direction neutral trade that involves simultaneously selling a call and put at the same strike price and with the same expiration date. Requires the underlying asset to be rangebound to make the trade profitable.
Short Strangle – A low volatility direction neutral trade that involves simultaneously selling a call and put at different strike prices (the put strike being lower than the call strike—i.e., both OTM) and with the same expiration date. Requires the underlying asset to be rangebound in order to make the trade profitable.
Short Synthetic Future – Selling calls and buying the same amount of puts with the same strike and expiration date, effectively forming the same risk profile of shorting a stock but with no net credit.
Short Selling – Selling a security that you don’t actually own beforehand. You will eventually have to buy it back, hopefully at a reduced price, thus making profit.
Sigma – Generally a term used to represent volatility. It is generally represented as a percentage. The term “one sigma level” refers to the actual change in the underlying asset price.
Small-Cap Stocks – Smaller (and sometimes newer) companies that are associated with high risk and high potential rewards. Can be illiquid to trade with large bid-ask spreads.
Speculator – A trader who aims to make profit by correctly assessing the direction of price movement of the security. Generally distinguished from investors in that speculators are associated with short-term directional trading.
Spread – The difference between the bid and ask of a traded security. Also, a trading strategy that involves more than one leg to create a (hedged) position. Aprice spread is the difference between the high and the low of a price bar.
Stock – A share of a company’s stock is a unit of ownership in that company.
Stock Exchange or Stock Market – An organized market where buyers and sellers are brought together to trade stocks.
Stock Split – Where a company increases the amount of outstanding stock, thus increasing the number of shares, reducing the value per share. Generally a sign that the stock has been rising and management’s way of assisting the liquidity in the stock.
Stop Orders – Buy Stops: where the order price is specified above the current value of the security. Sell Stops: where the order price is specified below the current value of the security.
Straddle – A neutral trade that involves simultaneously buying a call and put at the same strike price and with the same expiration date. Requires the underlying asset to move in an explosive nature (in either direction) in order to make the trade profitable.
Strangle – A neutral trade that involves simultaneously buying a call and put at different strike prices (the Put Strike being lower than the Call Strike—i.e., both OTM) and with the same expiration date. Requires the underlying asset to move in an explosive nature (in either direction) in order to make the trade profitable.
Strap – A neutral to bullish trade that involves simultaneously buying two calls and a put with the same strike price and expiration date. Requires the underlying asset to move in an explosive nature (preferably upwards) in order to make the trade profitable.
Strike Price (Exercise Price) – The price at which an asset can be bought or sold by the buyer of a call or put option.
Strip – A neutral to bearish trade that involves simultaneously buying two puts and a call with the same strike price and expiration date. Requires the underlying asset to move in an explosive nature (preferably downwards) in order to make the trade profitable.
Support – A price threshold on a price chart that is thought to be difficult for the price to fall through because of past price movements.
Synthetic Call – Buying a share and a put, or going long a future and a put, replicating the risk profile shape of a Long Call.
Synthetic Put – Buying a call and shorting a stock or future, replicating the risk profile shape of a Long Put.
Synthetic Long Stock – Buying a call and shorting a put with the same strike and expiration date.
Synthetic Short Call – Shorting a put and shorting a stock or future.
Synthetic Short Put – Shorting a call and buying a stock or future.
Synthetic Short Stock – Shorting a call and buying a put with the same strike and expiration date.
Synthetic Straddle – Combining stocks (or futures) with options to create a delta neutral trade.
Technical Analysis – Using charts, charting techniques, and indicators
(such as prices, volume, moving averages, stochastics, etc.) to evaluate likely future price movement.
Theoretical Value (Options) – The fair value calculation of an option using a pricing technique such as Black-Scholes options pricing formula.
Theta (Decay) – The sensitivity of an option price to the variable of time. Remember that options only have a finite life (until expiration), so Theta is an extremely important sensitivity to consider.
Tick – The least amount of price movement recorded in a security. Before decimalization, the lowest was 1/32 of a dollar.
Time Premium – The non-intrinsic component of the price of an option.
Time Value (Extrinsic Value) – The price of an option less its intrinsic value. Out of the Money and At the Money options are entirely made up of Extrinsic (or Time) Value.
Trading Plan – The step-by-step process in which you select your chosen securities, define your entry and exit points, and execute your strategy. No trade should ever be made without a proper trading plan in place. Your trading plan is like a business plan for each trading decision.
Triple Witching Day – The third Friday in March, June, September, and December when U.S. stock options, index options, and futures contracts all expire at the same time. The effect of this is often increased volume and volatility as traders look to close short and long positions.
Type – The classification of an option—either a call or a put.
Uncovered Option – A short position where the writer does not have the underlying security (or call option) to hedge the unlimited risk position of his naked position.
Underlying Asset/Instrument/Security – An asset that is subject to purchase or disposal upon exercise.
Upside – The potential for a price to increase.
Vega – The sensitivity of an option price to volatility. Typically, options increase in value during periods of high volatility.
Volatility – The measure of the fluctuation in the price movement in a security over a period of time. Volatility is one of the most important components in the theoretical valuation of an option price. Historical Volatility: the standard deviation of the underlying security (closing) price movement over a period of time (typically 21–23 days). Implied Volatility: the calculated component derived from the option price when using the Black-Scholes Option Pricing model. If there is a significant discrepancy between Implied and Historical Volatility, then there is the opportunity for the trader to take advantage of it.
Volatility Skew – Whereby deep OTM options tend to have higher Implied Volatilities than ATM options. When there are discrepancies, the trader can make trades whose profits are determined by volatility action as opposed to directional price action.
Volume – The number of underlying securities traded on their particular part of the exchange. Where price direction and volume bars are aligned in the same direction, then this is a bullish sign (i.e., it means that prices are rising with increased volume or that prices are falling with decreased volume). Where price direction diverges from volume bars, then this is a bearish sign (i.e., prices rising with falling volume or prices falling with rising volume).
Whipsaw – Where a price swing ensures a losing scenario for both sides of a position.
Witching Day – When two or more classes of options and futures contracts expire.
Writer – Someone who sells an option.
Yield – The rate of return of an investment, expressed as a percentage.
Zeta – An option price’s sensitivity to Implied Volatility.
Top 10 Trading Rules:
1. Always trade with the trend; get long strong stocks & short weak stocks.
2. Always follow your own plan and never veer from it.
3. Never take trades or ideas from others; as Cramer says, “tips are for waiters”.
4. Do not over-trade; commissions can kill your P & L.
5. Don’t be afraid to be ‘flat’ if news or market is uncertain.
6. Don’t be an emotional trader; if you have been in a fight, are hungover, or are extremely tired, DO NOT TRADE!
7. Do keep a journal of trades that have been a. Profitable, b. Unprofitable and, c. Commission Killers.
8. Never add to a losing trade.
9. Always know the levels where you will take your profits or trash a trade.
10. Always know your max loss or gain for any given trade; risk vs reward.
Top 10 Trading Rules for Equity Options
1. Never sell an option naked; always have protection somewhere.
2. Don’t trade merger or acquisition deals.
3. Don’t trade against trend, if so make positions small & tight. Trade risk $0.80 to make $1 but the other way is fine.
4. Always use previous highs, lows, resistance, and support levels to find levels to get long/short.
5. Never have positions so big that you can’t sleep at night. Traders need sleep!
6. Sell weak stocks on strength and buy strong stocks on weakness.
7. Never risk more than 3% of your total capital on any single position.
8. Never be one-sided, too long, too short, long too much premium, or short too much premium.
9. Never lose more than 2% of your total portfolio in one day.
10. Always define risk vs. reward levels. Exit on profitable/unprofitable trades.
Top 10 Reasons to Trade Equity Options
1. Hedge a stock position (buy puts for protection, sell calls to create dividend yield)
2. Be your own boss (make money from comfort of own home)
3. Make your own schedule (choose hours, vacation time, when to work)
4. Massive leverage (Make huge profits in small movements in options and stocks)
5. Tons of cash to be made (Make more money in an hour, day, or year than most people will make in their lifetime)
6. Limiting Risk (Less gap risk and can always limit risk)
7. See results (Unlike other jobs actually see results and performance)
8. Reward uncapped (Risk a little to make a lot)
9. Make money in any market condition (Different option strategy can be profitable in any stock direction or lack of direction)
10. Low margin (Trade a big position on little amount of cash)
Top 10 Pitfalls of Options Trading
1.Always define risk vs reward
2.Follow BIG Money (Be on the trades with big money and watch profits grow)
3.Cover cheap options (If sell an option for $1 and goes to $.05 just cover it and move on)
4.Don’t sell naked options (no protection means blow-out risk)
5.Sometimes the best trade is no trade
6.Never add to a losing trade
7.Countertrend Trading is Dangerous (If trading against the trend, trade smaller or smaller stops)
8.Premium kills (Owning too much premium, every day will cost money with no stock movement)
9.The TV Bandwagon (Never take a trade based on a TV anaylst)
10.Every trade is different (Some require more time, more movement, and more risk)
Top 10 Rules for Trading Psychology
1.Never add to a losing trade
2.Stay positive and confident
3.Past performance is not indicative of future results
4.Don’t ever get too emotional of a trade
5.Don’t blame others, only you control your trading account and P&L
6.Your only as good as your last trade
7.Never risk money you can’t afford to lose
8.Accepting a loser is the hardest part, but you will live to see another day.
9.Cut losses and add to winners
10.Always have a Gameplan and never vere from it.
Top 10 Ways I Became Profitable
1.Patience is a virtue, waiting for the right trade is just fine
2.Define risk vs reward, never risk money can’t afford to lose
a.What am I willing to risk on this trade?
b.Where is profit level #1 #2 and #3
c.If stock or option moves against me, where will I punt this trade.
3.Never add to a loser, I will never add to losing trade unless it is part of the Plan.
4.Don’t overtrade, it’s a commission buster. Trading is not cheap
5.Don’t get emotional, Not every trade will be a winner; moving on is important.
6.Stick with a winner. Always stick with the trend and if trading countertrend, trade smaller.
7.Technical levels work; moving averages, support, resistance are great indicators.
8.Caution during earnings, company announcements, and expiration.
9.Bet bigger when winner, smaller when losing. Scale back if not trading well.
10.Never play the: would have, could have, should have game. The trade is over, move on.