Options FAQs

Definitions

Strike Price: the price at which the option contract can be converted into a stock.

Expiration Date: the date on which the option expires.

‚ÄčPremium: the price you pay if you buy an option or the price you receive if you sell an option.

Exercise: the buyer of an option has the right to exercise the option and buy or sell stock depending on the type of option contract.

Assignment: the seller has the obligation to either purchase or sell stock at the strike price.

American Options: can be exercised or assigned at any time prior to the expiration date.

European Options: can only be exercised or assigned on expiration.

What is an Option?
 
Options are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares of stock at a predetermined price within a designated time period. Each standard contract represents 100 shares of stock.
 
What is a Call?
 
An American Call Option is a contract that gives the buyer the right to buy 100 shares of an underlying equity at a predetermined price (the strike price) for a specific time period defined by the expiration date. The seller of a Call Option is obligated to sell the underlying security if the Call buyer exercises his or her right to buy on or before the option expiration date. For example, one contract of the XYZ May 21 60 Calls entitles the buyer to purchase 100 shares of XYZ common stock at $60 per share at any time prior to the option's expiration date of May 21.
 
What is a Put?
 
An American Put option is a contract that gives the buyer the right to sell 100 shares of an underlying stock at a predetermined price (the strike price) for a specific time period defined by the expiration date. The seller of a Put option is obligated to buy the underlying security if the Put buyer exercises his or her right to sell on or before the option expiration date. For example, 1 contract of the XYZ May 21 60 Puts entitles the buyer to sell 100 shares of XYZ common stock at $60 per share at any time prior to the option's expiration date of May 21st.
 
When is an option in-the money (ITM)?
 
An ITM Call option’s strike price is below the actual stock price. For example, an investor purchases a Call option with a strike price of $95 in XYZ stock which is currently trading at $100. The investor’s position is in the money by $5. The Call option gives the investor the right to buy the equity at $95. An ITM Put option’s strike price is above the actual stock price. For example, an investor purchases a Put option with a strike price of $110 in XYZ stock which is currently trading at $100. This investor’s position is In-the-money by $10. The Put option gives the investor the right to sell the equity at $110.
 
When is an option at-the money (ATM)?
 
For both Put and Call options, an option is ATM when the strike and the stock price are the same.
 
When is an option out-of-the-money (OTM)?
 
An OTM Call option’s strike price is above the actual stock price. For example, an investor purchases an OTM Call option with a strike price of $120 on symbol ABCD which is currently trading at $105. This investor’s position is out of the money by $15. An OTM Put option’s strike price is below the actual stock price. For example, an investor purchases an OTM Put option with a strike price of $90 on symbol ABCD which is currently trading at $105. This investor’s position is out of the money by $15.
 
What are the Greeks and why should you care?
 
Options Greeks allow traders to make more informed decisions by measuring the different factors affecting the price of the option (delta, gamma, theta, vega and rho).
  • Delta – the change in the price of an option for a $1 change in the price of the underlying
  • Gamma – the change in delta for a $1 change in the price of the underlying
  • Vega – the change in the option price for a 1-point change in volatility
  • Theta – the change in the price of an option given a decrease in time to expiration
  • Rho – the change in the price of an option relative to a change in the risk-free interet rate
 
Advanced Metrics you should know
 
  • Volatility Forecast -  the use of historical volatility data, in combination with the characteristics of volatility, to predict future realized volatility. This metric is compared to option implied volatility (premium levels) to determine value (cheap or expensive).
  • Skew – measures the difference in implied volatility between out of the money puts, out of the money calls and at the money options. Skew levels may be used to help identify directional sentiment when there is a supply and demand shift in out of the money options.
  • Option Event Variance – a statistical measure that quantifies the expected event percentage move in an underlying as determined by the level of implied volatility in a given option. This metric us used to help determine if implied volatility is cheap or expensive prior to an event.
  • Historical (realized) Volatility – a measure of how much the stock price fluctuated during a given time period.
  • Z-score – indicates how many standard deviations an element is from the mean. Z-scores of implied volatility and skew are evaluated to compare metrics versus normalcy. This method is used to help identify and quantify levels of risk and premium.
  • Standard Deviation – a measure of the dispersion of a set of data from its mean. 68.27%, 95.45% and 99.73% of values lie within one, two and three standard deviations of the mean, respectively.
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Call Strategies

What is a Long Call?
 
An alternative to buying stock, and will profit if a stock rises above the call strike plus the premium paid. Risk is reduced to only the premium for the call. This strategy should be implemented in a low volatility environment and if the investor thinks the stock will rise.
Risk Level: Low
 
What is a Short Call?
 
An alternative to short selling stock, and will profit if a stock falls below the strike price. Profit is limited to the premium collected from the sale of the call. The risk profile is identical to shorting a stock above the strike price plus the premium collected. This strategy should be implemented in a high volatility environment and if the investor thinks the stock will fall.
Risk Level: High
 
What is a Long Call Spread?
 
Buy 1 call at a lower strike and sell 1 call at a higher strike, using the same expiration. The strategy is a cheap alternative to buying calls and will profit if stock rises above the lower strike plus the premium paid. The strategy reduces the premium paid versus a call purchase, but has limited upside. This strategy should be implemented if the investor thinks the stock will rise and volatility is cheap.
Risk Level: Low
 
What is a Short Call Spread?
 
Sell 1 call at a lower strike and buy 1 call at higher strike using the same expiration. Profit is limited to the premium collected from the sale of the call spread. This strategy is a less risky alternative to selling naked calls and will profit if the stock falls below the lower strike plus the premium collected. This strategy should be implemented if the investor thinks the stock will fall and wants a defined risk profile.
Risk Level: Low
 
What is a Buy Write (Covered Call)?
 
Long stock and sell 1 out-of-the money call. This strategy is used by investors when they achieve gains in the stock and are willing to sell at a certain strike price. The strategy is also used to gain income from the premium from the sale of the call. The strategy should be implemented when investors forecast the upside gain in the stock is limited and volatility is high.
Risk Level: Medium
 
What is a 1 x 2 Call Spread?
 
Buy 1 call at a lower strike and sell 2 calls at higher strike using the same expiration. The strategy is a cheaper alternative to buying a call spread but with a similar upside risk profile to a short call strategy. This strategy should be implemented if the investor forecasts the stock to rise above the lower strike but not above higher strike.
Risk Level: High
 
What is a Long Call Butterfly?
 
Combining 2 short calls at a middle strike, and 1 long call each at a lower and upper strike using the same expiration. This strategy is considered bullish if the middle strike is above the stock price. The strategy is most profitable if the stock closes at the middle strike on expiration. This strategy is implemented when volatility is high, and the investor has a bullish view on the stock.
Risk Level: Low
 
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Put Strategies

What is a Long Put?
 
An alternative to being short a stock and will profit if the stock falls below the put strike plus the premium paid. Reduces the risk profile to only the premium paid for the put. This strategy should be implemented in a low volatility environment and if the investor thinks the stock will fall.
Risk Level: Low
 
What is a Short Put?
 
An alternative to buying stock and will profit if stock stays above the strike price. Profit is limited to the premium collected from the sale of the puts. The risk profile is identical to buying the stock below the strike price minus the premium collected. This strategy should be implemented in a high volatility environment and if the investor thinks the stock will rise.
Risk Level: High
 
What is a Long Put Spread?
 
Buy 1 put at a higher strike and sell 1 put at lower strike using the same expiration. This strategy is a cheap alternative to buying puts and will profit if the stock falls below the higher strike minus the premium. The strategy reduces the risk to only the premium paid for the spread but limits the downside profit potential. This strategy should be implemented if the investor thinks the stock will fall.
Risk Level: Low
 
What is a Short Put Spread?
 
Sell 1 put at a higher strike and buy 1 put at lower strike using the same expiration. Profit is limited to the premium collected from the sale of the put spread. This strategy is a less risky alternative to selling puts and will profit if the stock stays above the higher strike minus the premium collected. This strategy should be implemented if the investor thinks the stock will rise but wants a defined risk profile.
Risk Level: Low
 
What is a Long Put Butterfly?
 
Combining 2 short puts at a middle strike, and 1 long put each at a lower and upper strike using the same expiration. This strategy is considered bearish if the middle strike is below the stock price. The strategy is most profitable if the stock closes at the middle strike on expiration. This strategy is implemented when volatility is high, and the investor has a bearish view on the stock.
Risk Level: Low
 
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Complex Strategies

What is a Long Risk Reversal?
 
Buy 1 call at a higher strike and sell 1 put at a lower strike using the same expiration. This strategy has a similar risk/reward profile as a long stock position and is profitable if the stock rises above the higher strike. Investors should implement if they are bullish.
Risk Level: High
 
What is a Short Risk Reversal?
 
Sell 1 call at a higher strike and buy 1 put at a lower strike using the same expiration. This strategy has a similar risk/reward profile as a short stock position and is profitable if the stock falls below the lower strike. Investors should implement if they are bearish.
Risk Level: High
 
What is a Call Spread Collar?
 
Buy 1 call at a lower strike and sell 1 call at a higher strike, and sell 1 put at a lower strike with the same expiration. The risk profile is the same as being long a stock when it trades below the put strike.The spread is profitable when the stock trades above the long call strike plus or minus the premium paid or collected. Investors should implement this strategy if they are bullish.
Risk Level: High
 
What is a Put Spread Collar?
 
Buy 1 put at a higher strike and sell 1 put at a lower strike, and sell 1 call at a higher strike with the same expiration. The risk profile is the same as being short a stock when it trades above the call strike. The spread is profitable when the stock trades below the long put strike plus or minus the premium paid or collected. Investors should implement this strategy if they are bearish.
Risk Level: High
 
What is a Long Straddle?
 
Buy 1 call and buy 1 put at the same strike with the same expiration. The risk is limited to the premium paid. This strategy can be considered both bullish and bearish and investors use this strategy when volatility is cheap and they want to profit if volatility rises. 
Risk Level: Low
 
What is a Short Straddle?
 
Sell 1 call and sell 1 put at the same strike with the same expiration. The profit is limited to the premium collected. The risk is similar to being short a stock when it rises above the strike price and long stock when it falls below the strike price. This strategy can be considered neutral and investors may use this strategy when volatility is expensive and want to profit if volatility falls.
Risk Level: High
 
What is a Long Strangle?
 
Buy 1 out-of-the-money call and buy 1 out-of-the-money put with the same expiration. The risk is limited to the premium paid. This strategy can be considered both bullish and bearish and investors may use this strategy when volatility is cheap and they want to profit if volatility rises.
Risk Level: Low
 
What is a Short Strangle?
 
Sell 1 out-of-the-money call and sell 1out-of-the-money put at the same strike with the same expiration. The profit is limited to the premium collected. The risk is similar to being short a stock when it rises above the call strike price and long a stock when it falls below the put strike. This strategy can be considered neutral and investors may use this strategy when volatility is expensive and they want to profit is volatility falls. 
Risk Level: High
 
What is a Calendar Spread?
 
Buy 1 Call/Puts of a longer-term expiration and sell 1 Call/Put of a near-term expiration.
        Limited profit potential / limited risk
 
What is a Iron Condor?
 
Sell 1 out-of-the-money call spread and sell 1 out-of-the-money put spread with the same expiration. Profit is limited to the premium collected from the sale of the call and put spreads. This strategy is a less risky alternative to selling straddles and strangles and will profit if the stock stays below the short call and above the short put. Investors should implement this strategy when volatility is high and they are neutral in the stock. This strategy has a defined risk profile.
Risk Level: Medium
 
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