What are Options?
Extrinsic Value or Time Value
Fishback Option Value (FOV)
Good till Cancelled (GTC)
Intrinsic Value or Exercise Value
Naked Option Selling
ODDS Probability Cones
Option Pricing Models
Physical Delivery Settlement
Strike Price/Exercise Price
Assignment is the term that is used to describe that the option buyer has exercised their right and they have assigned a long or short position in the underlying asset to the option seller.
At-The-Money or ATM is a term used to describe the strike price of an option. The term is defined as the strike price that is closest to the current price of the underlying asset.
This term is often used loosely to describe multiple strike prices that are near the current strike price, usually one above the current asset price and one below. You may need to be careful in communications to clearly define the strike you are talking about in some circumstances where you need to be specific.
In the images below you can see that most software platforms use color or sometimes other features in the option chain to help identify options that are at-the-money.
The term Back Month refers to an options expiration date. It does not identify a specific month like the term Front Month, but it describes all of the months where options exist after the Front Month.
Back Month is often used when describing a calendar spread. The option that expires first is a Front Month, and the option that expires last is the Back Month. In the image below all expirations beyond 2019-01-16 could be back months unless they were the first expiration of a calendar spread.
Beta is a statistical measure that is used to compare the volatility of an asset to the volatility of the entire market. The entire market has a Beta Value of 1. Assets with a beta below 1 are less volatile than the market, while assets with a beta above 1 are more volatile than the market.
Beta calculations are often used to compare volatility of an asset to another benchmark such as the S&P 500 Index. Beta can also be positive or negative in value. Positive values tell you that the asset tends to move in the same direction as the benchmark, negative values tell you that the asset tends to move opposite of the benchmark.
You may hear the term High Beta Fund or ETF. This usually refers to leveraged funds designed to yield higher returns than the benchmark asset. For example the high beta ETF symbol SSO is designed to make two times the returns of the S&P 500. They can achieve this using futures, options, or other leveraged assets. High beta funds like this can double the returns but they also double the losses.
A calendar spread is any option trade that includes a combination of options across different expiration dates. Typically, this type of spread is used to capture volatility differences between front month and back month options.
The term calendar spread is a category of option strategies. There are many strategies that fit the definition. A diagonal is a type of calendar spread. In its typical use calendar spread refers to a strategy where you sell the front month call or put and simultaneously buy the back month call or put with the same strike price.
The best outcome would be a rise in implied volatility of the back month option, while the front month option decays in time value at a faster pace. Ideally the price would finish near the strike price. a big move in either direction causes the trade to lose money.
A call option is a contract where the seller (writer/grantor) of the option grants the option buyer (holder) the right, but not the obligation to buy shares of an asset at a specified price (strike) within a specified period of time (expiration date).
The seller of the option agrees to this contract because of the compensation (premium) the option buyer is willing to provide.
Commissions have been a part of investing for a very long time. The commission is a fee collected by your broker. Your broker receives this commission in exchange for providing you with stock quotes and services related to the market transactions you engage in.
Commissions have been coming down in price for many years. Much of this cost reduction came from the technology innovations and increased competition.
A few companies are further disrupting commission structures by offering brokerage services commission free. You may be thinking, How can they do that? The answers are not always simple, but brokerages often make money in other ways. Like banks, brokerages can make money from interest on cash that is in their accounts uninvested. They may also earn interest loaning shares out to short sellers, and large market participants often pay for order flow because they need orders to offset large block orders.
Robinhood has caused other brokerages to make similar offerings. These offerings tend to be light on services. So if you pay commissions for services that you will use, it is often not a bad deal. Is commission free trading right for you? If you don't need much in the ways of services, it could be great. But if you need a little more, you may want to stick with a more traditional brokerage.
Covered usually refers to selling of options in a hedged method. The covering of your option writing can be done with a stock position or another option position. Covered Calls, Credit Spreads, Covered Short are examples of covered positions.
Covering also refers to closing an open position. Covering in general refers to removing or limiting risk.
A covered call is strategy that involves an option and owning shares of a stock. You sell a call option for each 100 shares of stock you own. This type of trade is also called a buy-write because you are buying stock and writing an option.
This strategy is by far the most popular option strategy used. It is a covered position because you are selling a call option and covering your risk by purchasing the stock.
The strategy has less risk than owning the stock because the premium you collect offsets some of the risk of owning the stock. The trade off is that in order to get the lower risk, you also limit your profit potential.
Covered Call Overwriting is when you own stock and sell a call with a strike price that is above the current stock price.
Covered Call Underwriting is when you own stock and sell a call with a strike price that is below the current stock price.
A credit spread is a combination trade where you buy and sell options. The options you are selling are more expensive than the options you are buying. This results in a net credit to your account.
A debit spread is a combination trade where you buy and sell options. The options you are buying are more expensive than the options you are selling. This results in a net debit to your account.
Delta is a statistical term that measures an option's sensitivity to price changes in the underlying asset. Specifically it tries to determine what will happen to the option if the stock moves up in price by $1. It may be helpful to think of Delta as a speed measure relative to the change in stock price.
Because call options make money as the underlying asset moves up, all call options have positive values. At-the-money call options have a delta near 50%. This means that if the the underlying asset moves up, you could expect that the option will increase in value by 50% of the $1 up move or $0.50.
Because Put options lose money as the underlying asset moves up, all put options have negative values. At-the-money put options have a delta near -50%. This means that if the the underlying asset moves up, you could expect that the option will decrease in value by 50% of the $1 up move or -$0.50.
In the option chain below you can see how delta changes relative to the stock price by how far in or out-of-the-money the strike price is. Delta values will range between +1 and -1.
Position Delta can be very useful measure of the sensitivity of the overall position to price. When using complex strategies this measure can be used to figure out how bullish or bearish your position is. The calculation is simple. Just add the delta of each option contract together. If I wanted to make $1 for every $1 increase in the underlying asset, I could buy 2 call options with a delta of .50.
If I bought a call with a delta of .50 and bought a call with a delta of .25, I would have a position delta of .75.
Delta Neutral trades are non-directional trades. They do not care which way the stock moves. Delta neutral trades are perfectly hedged and have a position delta of 0. A straddle trade is a good example of a delta neutral strategy. If you buy a call with a delta of .50 and simultaneously buy a put with a delta of -.50 your position delta would be 0.
A Diagonal is a type of calendar spread. A diagonal is a spread where you sell a front month option and you simultaneously buy a back month option with a different strike price. You can also sell back month and buy front month options but this is not typically done due to unfavorable margin requirements. Diagonals can result in a credit or a debit to your account.
Diagonals are a combination of a vertical spread and a horizontal spread hence the name diagonal. It combines options of different strike prices like a vertical spread, and different expirations like a horizontal spread.
A Diagonal Debit Spread has a directional bias and the stock needs to move into the profitable range.
A Diagonal Credit Spread has a directional bias and the stock needs to not move into the unprofitable range.
Options provide almost unlimited flexibility. Because of this flexibility, there are many ways to accomplish the same goals. Equivalent Positions are trades that carry similar risk, reward, and probability profiles.
A married put strategy is often referred to as a synthetic call purchase. This is specifically because they are equivalent positions. An advantage of the married put is that you own the stock so you collect any dividends.
The Ex-dividend Date (ex-date) is the first day that a stock will start trading without the value of the declared dividend. In other words shareholders of record the day before the ex-date will receive the declared dividend even if they sell their shares on the ex-date.
Option holders do not receive dividends, however dividends do get factored into option prices as the market anticipates the drop in the stock price by the dividend amount on the ex-dividend date.
Option Holders can exercise without breaking a sweat. That is because option holders have rights that they can exercise effortlessly. The term exercise refers to the holder using the rights that they purchase to buy or sell shares of the underlying asset of the option they purchased.
There are two styles of options, American Style and European Style.
- American Style options give the holder the opportunity to exercise their rights at any time up to the expiration date.
- European Style options give the holder the opportunity to exercise their rights only on the expiration date.
A call option holder has the right to buy shares at the strike price. If they bought American Style options they can exercise their rights anytime they choose before the options expire. All the holder needs to do is notify their broker that they wish to exercise their rights on or before the expiration date. You should be aware that brokerage firms can have their own deadlines on the expiration date. For example my broker gives me 26 minutes after the market close on the expiration date to notify them of my wish to exercise.
When a holder exercises their right before expiration it is called early exercise. This usually does not happen if there is still some time value on the option. When time value is gone or when the value of the option drops below the dividend amount early exercise becomes more likely.
There is also an automatic exercise rule. This rule is also called exercise by exception. If your option is one penny in the money, your broker will exercise the option for you, unless you tell them not to do so. You are not obligated to exercise your rights, but the automatic exercise rule may help you profit if you simply forget that your option has value.
Expected Return is a mathematical calculation that helps you balance risk, reward and probability to figure out the expected future outcome of a single trade or a trading system's performance. The formula is simple enough grade school children can do it. Here it is written in plain english.
The harder part of this formula is getting the data to enter into the formula. Fortunately software like our own ODDS Online is available to provide these values. And in the case of ODDS Online it will provide the resulting expected return value with no effort.
Using this formula can be enormously helpful in guiding your expectations and perhaps even your allocation.
A defining characteristic of options is that every option has an expiration date which defines the term or the duration of the option. The number of terms available varies by the demand for options on the asset. More popular options have a larger number of terms available.
For example: SPY options have a larger demand than every other asset at this time. SPY has option terms that expire yearly, quarterly, monthly, & weekly on Monday's, Wednesdays, & Fridays. Assets that are not in high demand may have monthly and quarterly options going out three to six months.The term is a key component of the option because the time value of the option is what holders pay for.
Extrinsic Value is a fancy name for Time Value. You can break an options value into two parts, Extrinsic or Time value and Intrinsic or Exercise Value. Time value is the portion of an options premium that the option writer gets to keep. It is called time value because it pays for the term of the option. In general, the greater the time left in the term, the more expensive the option. This is because the more time there is in the term, the greater the probability that some unknown information will come to light and cause a change in the stock price.
The longer the term the greater the risk to the option seller, the greater the risk, the higher the premium required to convince an investor to sell the option.
Fair value is a statistical calculation that attempts to determine the fair value of an option based on known information and mathematical models.
Fisher Black, Myron Scholes and Robert Merton won the Nobel Prize for bringing order to the options markets with their model. Their Black-Scholes Option Pricing Model was able to produce a fair option price based on a number of known factors and a few key assumptions.
The problem with fair value is that a fair value is only as accurate as the model it is based on. The fair value of an option using the Black-Scholes Model uses known information such as the current stock price, the strike price and the number of days till expiration. It also makes some assumptions that are debatable and in some cases are known to be flawed. Examples of this are the assumption that volatility of the underlying asset in the future will be the same as is has been in the past, and that the assets price will be lognormally distributed over time.
The creators of the model know these assumptions are not as accurate as some would hope, but they were not trying to be perfect as much as they were trying to get close to a fair price for the options.
Fisher Black said, “Estimation' suggests a Bayesian approach to data, while 'testing' suggests a classical approach. I prefer estimation, since I think researchers who want to test often choose models that are more specific than the economics require." Even though others have created more accurate models for some assets, the Black-Scholes model is still in use today because of its ease of use, and it's calculation speed.
Fishback Option Value provides a more accurate fair value than models. The weakness of models in determining fair value is that a model will never fit every asset. John Bender, one of Jack Schwager's Market Wizards said, "It's not a matter of coming up with a one-size-fits-all model that is better than the standard Black-Scholes model. The key point is that the correct probability distribution is different for every market and every time period. The probability distribution has to be estimated on a case-by-case basis"
Faster computers and reliable data have given Don Fishback the tools to forgo another model and instead use the actual price distribution of the stock to estimate the most accurate fair value of option prices today.
Front month options are those options that expire next. The term is also used to describe the first expiration of an option combination trade with options that expire at different times, such as a calendar spread.
Gamma is a measure of the rate of change in delta If you think about delta as the speed of an option, gamma would be measuring the acceleration. If an at-the-money option has a delta of .50, a gamma of .05, and the stock increased by $1, we would expect the option to gain $0.50 in value and the new delta of that option to be .55.
Gamma is always positive for long option positions and negative for short option positions. Larger gamma values show greater volatility than lower gamma values. The highest gamma values belong to at-the-money options and values drop as the strikes move away from the price of the underlying asset.
Good Till Canceled (GTC) is a type of order that you give your broker. Usually you specify limit price for your transaction. This limit price is used to try and fill your trade and the order will stay active till it is filled or you cancel the order. Many brokers will have a time limit where they will automatically cancel the order after a period of time.
Hedging is a practice of reducing or otherwise limiting risk. In the stock market, this can be done by taking a position in an asset that offsets your holdings or makes money in a related but opposite way. For example: by law we are required to hedge our liability when we drive a vehicle. Driving requires risk taking. If you cause a wreck, you are liable for damage done to property or people. To hedge this liability, law requires that we purchase insurance. Insurance offsets our liability and reduces our risk.
Often stock shareholders will buy a put option to limit their risk in holding shares of the underlying stock. Like insurance they pay a premium for the put option and if the stock drops below the strike price, the put gains in value offsetting the losses in the stock. This strategy is called a married put.
Historical Volatility also called realized volatility is a statistical measure of an asset's price fluctuations over a period of time. The formula is: one standard deviation of the natural logarithm of the price change annualized. The image below shows the formula in mathematical terms.
Measuring volatility helps investors understand which assets are more or less risky to hold. A stock that frequently has large price swings would be more risky than a stock that has small price swings. Indexes are designed to reduce volatility through diversification. As you can see in the images below, SPY an S&P 500 ETF, is much less volatile than NFLX. It would be less risk to hold SPY and more risk to hold NFLX.
A horizontal spread is an option combination trade where the holder of the spread buys and sells options of the same type with the same strike price and different expirations. The logical reason for this type of trade is to capture time value related to volatility differences between the two options.
The best result occurs when the stock closes on the strike price at the first expiration while the volatility rises on the back month option.
Usually the holder will sell the front month option and buy the back month option. They typically do this because selling the back month option and buying the front month results in very poor margin treatment.
Option pricing models can use math to convert historical volatility into a fair option price based on a known factors, and statistics. These same models that solve for the fair option price in one direction can be turned around using the options current price to solve for the expected or implied volatility in the future.
A common way to look at implied volatility is a measure of relative price of the options. A chart of implied volatility prices is like looking at a chart of how expensive or cheap the options have been in the past. When implied volatility is currently high relative to the past, you can say that options are currently expensive. If implied volatility is currently low relative to the past, you could say that options are currently cheap.
Implied volatility is also used as a risk measure. When implied volatility is high it means the market is expecting future stock moves to be larger. When implied volatility is low, it means the market is expecting future moves to be smaller. While implied volatility does tend to be high in bearish situations, it is important to note that implied volatility is not a directional indicator. It simply predicts the size of a future move. Higher implied volatility tends to occur before earnings announcements regardless of bullish or bearish expectations.
The CBOE Volatility Index (VIX) is a calculated indicator that combines the implied volatility of all the constituent stocks of the S&P 500 Index. The VIX is used to gauge the volatility of the market as a whole.
Intrinsic Value is a fancy word describing an options exercise value. Option prices can be broken down into two essential parts, intrinsic and extrinsic values. Intrinsic or exercise value is the part of the options value that is not extrinsic or time value.
An option gains exercise value when the option moves in-the-money. For call options, the exercise value calculation is stock price - strike price, if the stock price is above the strike. If the strike price is greater than the stock price the option has no exercise value.
For put options, the exercise value calculation is strike price - stock price, if the stock price is below the strike. If the strike price is less than the stock price the option has no exercise value. In the charts below both the call option on the left and the put option on the right have exercise value because the yellow line shows that the asset is in the money.
LEAPS are long term options that expire in terms past one year, usually in January. They are also called yearlys. When there is enough demand for options that expire in longer terms, LEAPS are added to the term structure. LEAPS is an acronym that stands for Long-term Equity Anticipation Security. LEAPS work just like other options, but the longer term gives investors the opportunity to take advantage of long-term trends or the ability to hedge over long periods of time. Because of the long duration of these trades, the cost of LEAPS are typically higher than shorter terms.
A Leg describes a component within an combination trade that involves multiple compontents. For example: if an investor purchased a 100 call option and a 100 put option with the same expiration on stock XYZ, the 100 call is a leg and the 100 put is a leg. This combination trade, known as a straddle, has two legs. In trades that involve owning the stock like a covered call trade, the stock is one leg and the call option is another. Each component is a leg.
Leverage in trading is the ability to make a small investment produce large gains. For example on 12/21/2018 a person could have bought 100 shares of Dollar Tree stock (DLTR) for $83.46 per share for a total investment of $8,346. One week later they could have sold that stock for $87.73 per share for a total of $8,773. This would result in a profit of $427 or a percent gain of 5.11%
Another investor could have purchased one weekly call option at the 83.50 strike price that expired one week later on the 28th for a total investment of $140. A week later they could have sold that same option for $380. That is a gain of $240 or in percentage terms that is 171% gain. If you wanted similar dollar amount you could have bought two call options for $280 and your reward would have been $480. The options then would have given a greater reward in both dollar and percent gains with an investment that is 3% of the investment required to buy 100 shares of stock. That is leverage.
A limit order is a type of trade order that you provide your broker. The distinguishing trait of a limit order is that you specify the price for your order. The broker will then get the order at the limit price or better otherwise they do not execute the trade. You can place a limit order to buy where you will purchase at the price specified or lower, and you can place a limit order to sell where you will receive the price specified or higher.
Option Pricing Models need to have an estimate of price distribution in order to value an option or estimate a probability. In many cases, models will use a lognormal distribution of prices for its convenience. Lognormal distributions are often used instead of a normal distribution because of the markets continuous nature and because a stock price cannot go below 0 but can go up without limit. In a lognormal distribution the probability of a stock price drop by 50% is equal to a stock increase of 100%.
With any model, you will have varied levels of success because asset price distributions do not follow models precisely. Models are often used broadly over many different assets that are not related and expected to produce similar results. For this reason Don Fishback has developed a model free method for valuing options that uses the stock's actual price distribution. A lognormal price distribution is a bell curve of the expected log changes in the asset price over time.
Long is a term that refers to the purchaser of an asset. If you a long stock, you are bullish because you bought the shares. If you are long a call option you are also bullish because you bought the call. But long does not mean that you are bullish. If you are long a put option you are long because you bought the put, but you are bearish because the put makes money as the stock falls in price.
Margin in it's most broad use is defined as using borrowed money to invest. For example if you want to buy stock XYZ at $100 per share your broker may allow you to buy those shares with $50 of your own money and $50 of borrowed money. This means that you could buy twice the amount of shares with the same amount of money.
Borrowing to invest provides a way to add leverage to your investment, but that leverage comes at a price. The price is literal. You must pay interest on the money you borrow. You must also use the shares you buy with the borrowed money as collateral on your loan. If those shares lose value your broker may reduce the amount they are willing to finance on the asset. This could result in a margin call where the broker will require more of your money to offset the drop in value of the collateral shares.
We do not recommend trading with borrowed money until you are more experienced. If your account gets over leveraged, you could be held liable beyond the value of your account and you would be required to add money to your account immediately or your positions could be liquidated to meet the margin demands.
In option trading the term margin is often referred to as the margin requirement or the amount of cash to be held as collateral to meet any required obligations your option trade may incur. For example. If you were to sell a put option you would have the obligation to buy the underlying asset at the strike price if the holder decided to exercise their rights. If you have a margin account your broker would treat the margin requirement as if you bought the stock on margin at the strike price. If you did not have a margin account you would be required to hold in cash the full value of the shares at the strike price. This is known as a cash secured naked put.
When you have an option combination trade where options are being bought and sold, such as a credit spread your margin requirements are usually the amount you will be at risk for losing in the worst case scenario. For example, if you were to sell a put option at a 260 strike and buy an option at a 257 strike for a net credit of $0.21 your max risk would be $279 per spread. In most cases your broker would have a margin requirement of $279 per contract.
A Married Put trade is where you buy shares of stock and for each 100 shares of stock you own, you buy 1 put option. This is a very common way to hedge a stock portfolio. The stock has the potential to lose money till it reaches the strike price of the put option. At that point the put option will make money at the same rate that the stock loses money.
A married put has unlimited profit potential with limited risk before the option expires. After the option expires your risk would be the same as owning the stock.
Naked Option Selling refers to selling options without a hedge. When you sell a put option with out a hedge you are obligated to buy shares of the underlying asset at the strike price. You collect a premium for taking on this obligation. That premium is your max profit of the option trade. This trade is often used to collect monthly premiums like an insurance company. This reward potential of selling a naked put is limited and the loss potential can be large but it is limited to the strike price minus the net credit.
Selling a naked call option is another story. This trade has limited profit potential and unlimited loss potential. That is because when you sell a call option you are obligated to deliver shares of the stock at the strike price. Because you sold the call without having a hedge, you do not own the stock so you are obligated to buy the stock at the current price and then deliver the stock at the strike price. Since a stock price does not have a limit to how high it can go, your risk is truly unlimited. Berkshire Hathaway Class A stock trades at $309,180 per share.
Neutral strategies are those that do not rely on choosing the direction of the underlying asset. A call option is a directional trade that makes money as the underlying asset price rises. A put option is a directional trade that makes money as the underlying asset price falls. Individually these strategies are not neutral. But if you combine a call option and a put option, you no longer care which direction the underlying asset moves, you just want the asset to move bigger than the cost of the options. This strategy is called a straddle and it is a neutral strategy.
A Normal Distribution is another name for a Bell Curve. When analyzing options it is useful to understand probability because option prices are based on the probability of future price moves. Bell Curves are often used in statistics for convenience, however a normal distribution should not be used to analyze stock prices because a normal distribution is symmetrical. That is it expects a distribution of the subject under analysis to be equal on both sides of the curve. A coin toss is a good example for a normally distributed event. There are two options, heads or tails. The chances of one or the other are equal.
A normal distribution should not be used to analyze a stock price. The reason is that both sides of the curve are not equal. A stock currently priced at 100 can move up $200 to $300 but it cannot move down $200. For this reason option pricing models tend to use lognormal or other logarithmic distribution models. A lognormal distribution may still look similar to a bell curve when displayed with a log scale, but it is actually shaped differently.
With any model, you will have varied levels of success because asset price distributions do not follow models precisely. Models are often used broadly over many different assets that are not related and expected to produce similar results. For this reason Don Fishback has developed a model free method for valuing options that uses the stock's actual price distribution. A normal distribution of prices is a bell curve of the expected changes in the asset price over time.
ODDS Probability Cones were introduced by Don Fishback in the MetaStock software back in 1998. Since then, these cones have become an essential tool in nearly every options brokerage toolkit. The indicator plots a cone at probability targets predicted by volatility. Different platforms will have different choices about the use of the indicator. You can choose to use historical volatility. This would be appropriate if you thought that the stock would do in the future what it has done in the past.
You can use implied volatility as well. This will tell you what the options market is expecting in the future based on the current options prices. Depending on the platform you are using, you can often choose a standard deviation target or a probability target as well as a date to project out to. In the example below we show a cone based on implied volatility and we set the target to 90%. This cone says that current options prices are predicting a 90% chance that the stock will be above the lower half of the cone and a 90% chance it will be below the upper half of the cone. That is different than saying there is a 90% chance the stock will be inside the cone. In fact, this would suggest an 80% chance of being inside the cone over this time period.
Open Interest is the total number of open option contracts. That is the number of contracts that exist. If you were to liken this term to a stock term it would be the number of shares outstanding. Though, open interest on options is still very different than shares outstanding. Shares can have great volume in the market and the number of shares outstanding do not change unless the stakeholders decide to raise more capital by diluting existing shares.
Options do not need to have a board meeting to decide the number of options contracts. If there is a seller and a buyer, you have an open contract until the seller buys back the option, the buyer exercises their rights, or the option expires. Open interest is much more fluid than shares outstanding because the market decides the demand for options.
Open interest is a good measure for demand of the options. If there is large volume and open interest is rising, you could say that demand for those options is rising, because there are more people interested in buying and there are not enough sellers of existing contracts.
If there is large volume and open interest is falling, you could say that demand for those options is also falling because existing sellers are buying back their contracts to exit at a greater rate than new buyers are buying new contracts. This is not necessarily a bullish or bearish indication on the stock, it is an indication of demand for the options.
Options on SPY are in large demand.
Options on TZA are not in large demand.
Option Pricing Models are useful mathematical tools to help investors price options. One of the most famous models is the Black-Scholes Option Pricing Model which made creators Fischer Black, Myron Scholes and Robert Merton legends in the financial community and the popular model even earned the creators a Nobel Prize in economics. Fischer Black died before Scholes and Merton received the Prize. Nobel Prizes are not awarded posthumously.
The Black-Scholes Model introduced a reasonable method for determining a fair option price based on a number of factors and a few assumptions. Fischer Black might be surprised that the model he created is still widely used today. He recognized some of the model's flaws. He said, "The Black - Scholes formula is still around, even though it depends on at least 10 unrealistic assumptions." There are other models like the Cox-Ross-Rubinstein Binomial Model, the GARCH Model, and many others.
While each model has individual strengths and weaknesses, all models have a weakness in common. That weakness is that they are models. John Bender, one of Jack Schwager's Market Wizards said, "It's not a matter of coming up with a one-size-fits-all model that is better than the standard Black-Scholes model. The key point is that the correct probability distribution is different for every market and every time period. The probability distribution has to be estimated on a case-by-case basis." No model can fit every security because Tesla stock does not behave like Kellogs. Amazon stock does not behave like Boeing. No matter how good your model is, the price distribution of your model will never perfectly fit the price distribution of one asset, let alone every asset.
That is why Don Fishback created a better way to value options. Technology now lets us use the price distributions of each asset individually instead of using modeled price distributions. Fishback Option Value (FOV) is a more accurate more modern way to value options.
One look at the following graph and you can see that the SNAP price distribution in blue does not match the theoretical model distribution in orange. If your prices are determined using the theory in orange, your prices are probably off.
Out-Of-The-Money (OTM) is a term that refers to options that have no exercise value. The price of the option is entirely time value. For call options this is when the asset price is currently below the strike price of the option. For put options this is when the asset price is above the strike price of the option.
Put Call Parity describes the characteristic of the options at the same strike with the same expiration having the same amount of time value or very close to it. This relationship exists because if there is an imbalance in time value for these options, there is an opportunity for a risk free trade. For example, with options you can create synthetic stock positions. You can buy a call option and simultaneously sell a put option to create a position with the same risk/reward profile of owning the stock. It is an equivalent position. The graph below shows a synthetic long stock position in AAPL.
If there is an imbalance in the time value of the put and call at the same strike price, it creates an arbitrage opportunity. For example in this case you can buy the call and sell the put at the 172.50 strike price for a net debit of 1.04. That debit is .70 less than the difference between the current stock price and the strike price, 1.74. This opens up an arbitrage opportunity where I can enter the synthetic long position and simultaneously sell short the stock at 174.24 to receive a guaranteed profit of 0.70.
Regardless of the value of the stock when the option is exercised it will result in an offsetting transaction and the profit will be .70. That is why the profit loss graph is a flat profit.
These trades do exist in the real world. This example is using the closing prices of AAPL stock and options from 2/6/19. Small imbalances allow arbitrage opportunities. Usually when these imbalances occur, the rates of return are similar to other guaranteed rates of return. Because of this arbitrage opportunity, Put-Call Parity is a realistic assumption. There are circumstances where things can get really out of balance. Such as situations where there are no shares available to borrow for a short position in the stock.
An option price is called the premium. This is one of many similarities that options share with insurance policies. The option buyer pays a premium to the option seller as compensation. The premium is the incentive the option seller needs to agree to the obligations that go along with option writing.
A put option is a contract where the seller (writer/grantor) of the option grants the option buyer (holder) the right, but not the obligation to sell shares of an asset at a specified price (strike) within a specified period of time (expiration date).
The seller of the option agrees to this contract because of the compensation (premium) the option buyer is willing to provide.
Quarterly options are those options that expire every three months. There are a few types of Quarterlys where this term is used. There are quarterly option series. These options expire in 3 month intervals. There are quarterly index expirations. These are options that expire quarterly on certain broad-based indexes. And there are quarterly end of month expirations. These options expire on the last day of the month every quarter. They do not expire on Fridays unless Friday is the last day of the month that ends the quarter.
A ratio strategy is a category of option combinations where you buy and sell options but instead of buying and selling equal numbers of contracts, you buy and sell in unequal numbers of contracts. One such strategy is called a ratio spread. For example, a call ratio spread is very much like a vertical spread but you sell more contracts than you buy at different strikes with the same expiration. Instead of selling one call for each call bought you would sell two or more. Most commonly two options are sold. Sometimes this can result in a credit.
A call ratio spread has a higher probability of profit and if you can get a credit it guarantees profit if the stock moves down, making a call ratio spread a bearish position. The drawback to this position is that it comes with unlimited risk. Your broker may not allow option trades that have unlimited risk. Because you are selling more options that you are buying, you have at least one uncovered or naked call sold.
If your broker will not allow a call ratio spread because of the unlimited risk, they may allow a put ratio spread. A put ratio spread is a bullish strategy, but the risk of a naked put is like the risk of buying the stock at the strike price of the option sold.
Another ratio strategy when you buy more options than you sell is called a Ratio Back Spread. This strategy flips the ratio spread over to provide unlimited profit on the bullish call back spread and profits down to zero on the put back spread.
Rho is another measure of the Greek values that measures option sensitivity to changes in the risk free interest rate. Specifically Rho predicts what will happen to the option price if the risk free interest rate increases by 1 percentage point. This value is typically used by money managers over a portfolio of options investments to show the portfolio's exposure to interest rate changes.
Call options rise as the risk free interest rate rises, so call Rho is always positive. Put options fall in value as the risk free interest rate rises, so put Rho is always negative. Rho values are larger for in-the-money options and decrease in value as the option moves out-of-the-money.
Rolling an option is a method of extending a trade in time or a method of adjusting a position to reduce risk or take profits.
Rolling out describes the action of closing an option trade at one expiration and simultaneously buying another option at the same strike at an expiration that is further out in time. You would use this method if you feel the trade is still viable but it needs more time. You will very likely pay a little more premium for the added time.
Rolling up is a method of reducing risk or taking profit on an existing trade. For example if you owned a call and the call was in-the-money and you want to stay in the trade but also take profits or reduce your risk, you could sell your existing contract and simultaneously buy an option at the same expiration with a strike price that is higher and cheaper than the value of the option you are currently holding.
Rolling down is a method of reducing risk or taking profit on an existing trade. For example if you owned a put and the put was in-the-money and you want to stay in the trade but also take profits or reduce your risk, you could sell your existing contract and simultaneously buy an option at the same expiration with a strike price that is lower and cheaper than the value of the option you are currently holding.
Rolling Up & Out
Rolling Up & Out is a method of reducing risk or taking profit on an existing trade that may need more time. For example if you owned a call and the call was in-the-money and you want to stay in the trade for a longer period of time but also take profits or reduce your risk, you could sell your existing contract and simultaneously buy an option at the a different expiration with a strike price that is higher and cheaper than the value of the option you are currently holding.
Rolling Down & Out
Rolling Down & Out is a method of reducing risk or taking profit on an existing trade that may need more time. For example if you owned a put and the put was in-the-money and you want to stay in the trade for a longer period of time but also take profits or reduce your risk, you could sell your existing contract and simultaneously buy an option at the a different expiration with a strike price that is lower and cheaper than the value of the option you are currently holding.
Physical Delivery Settlement refers to the way options are settled when the contract is exercised by the holder. Physical Delivery means that upon exercise shares of the underlying asset are exchanged at the strike price. A physical transaction takes place and cash moves from one account into the other in exchange for shares of the underlying asset being transferred.
Cash Settled options are often used when the underlying asset of the option is difficult to transact. Index options are an example of this. For example: if an investor believed the S&P 500 was likely to move up, and they wanted to capitalized on this belief, but had limited funds to do so, they might buy a cash settled SPX option instead of incurring the cost of buying shares of the index constituent stocks.
In this case, if the index does move up beyond the strike price as the holder expects, when the holder decides to exercise their rights, instead of receiving shares, the holder would receive the cash value of the difference between the current index value and the strike price. There is no delivery of shares because the option is cash settled.
Because the option writer does not need to deliver the assets that make up the index, both the writer and the holder can participate in the index without actually holding index assets.