Advanced Option Trading Terms You Should Know

If you are using options, it is important to know advanced options trading terms and their meanings. The option trading terms below are commonly used and it is an advantage to every investor to understand the terms. Some are more obscure, but every investor should know and understand the following option trading terms.

Hedge – A trade that offsets, or partially offsets, the risk of owning another position. As an example, when you buy a call option and sell another, your potential profits are reduced. But, so are potential losses. Hedged positions are referred to as spreads.

Spread – An order instructing your broker to fill two (or more) orders for different options simultaneously. Your broker must execute both parts of the order, or neither. In order to open a hedged position, a trader who buys a bullish call spread buys one option, hoping to profit when the sock moves higher. But, to reduce the cash needed, you may create a position by selling a different call option – with a higher strike price.

Cash-settled – Upon execution, instead of transferring shares, the intrinsic value of the option, in cash, is transferred from the option seller to the option owner.

Derivative – An instrument whose value depends on the value of another instrument. In other words, its value is derived from the value of the other. Options are derivative products.

Equivalency – The concept that two or more different option positions appear to be very different, but, in fact, have identical risk and rewards. These positions are said to be equivalent, or synthetic. As an example a covered call is equivalent to a naked put (same strike and expiration) and is often referred to as a ‘synthetic put.’

Inside market – The true bid-ask market for an individual option or spread. It’s often narrower that the published market. To make the trade you don’t have to pay the offer on one option and sell the bid on the other. You can do better.

NBBO – The national best bid and offer. This should be a beginner’s term, but it is usually not the case.

Open Interest – A number of options that have been opened, but not yet closed or expired.

Settlement Risk – Is the risk associated with owning a position when you are at the mercy of the market’s opening price. European style options cease trading Thursday, before the 3rd Friday of the month, but the final closing price of the underlying, is not determined until the following morning. The Settlement Price, can be very different from Thursday’s close, resulting in unexpected large gains or losses. Settlement risk is the money gained or lost by accepting the settlement price Friday, instead of exiting Thursday.

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