Option Trading Concepts to Help You Build a Solid Foundation

16. Option Trading Terminology

Long Call

A position created by buying a call option.

A long call:

Is subject to negative time decay
Benefits from an increase in implied volatility
Benefits if the underlying commodity moves higher (is delta long)
Is subject to limited risk

Long Put

A position created by buying a put option.

A long put:

Is subject to negative time decay
Benefits from an increase in implied volatility
Benefits if the underlying commodity moves lower (is delta short)
Is subject to limited risk

Short Call

A position created by selling a call option that's not owned (selling a call option that was not previously purchased).

A short call:

Earns positive time decay
Benefits from a decrease in implied volatility
Benefits if the underlying commodity moves lower (is delta short)
Is subject to open-ended risk

Short Put

A position created by selling a put option that's not owned (selling a put option that was not previously purchased).

A short put:

Earns positive time decay
Benefits from a decrease in implied volatility
Benefits if the underlying commodity moves higher (is delta long)
Is subject to open-ended risk

Out-of-the-money Call

A call whose strike price is higher than the price of the underlying commodity.

Out-of-the-money Put

A put whose strike price is lower than the price of the underlying commodity.

Short Strangle

A spread position consisting of an out-of-the-money short call and an out-of-the-money short put.

A short strangle:

Earns positive time decay
Benefits from a decrease in implied volatility
Can be delta neutral, delta short or delta long
Is subject to open-ended risk

Delta

A measure of how much an option's price will change if there's a unit change in the underlying futures price. Delta often is interpreted as the probability the option will be in-the-money by expiration.

Gamma

A measure of how fast delta changes, given a unit change in the underlying futures price.

Theta

The amount option premium decays in a day if the underlying futures price remains unchanged.

Performance Graph

A performance graph plots profits and losses for an options position (vertical axis) versus prices for the underlying futures contract (horizontal axis). The performance graph for a short strangle is shaped like an upside-down "U" because losses can quickly occur if there's a large market move. Profits from option time decay, on the other hand, accumulate slowly over time. This is consistent with the adage "Misfortune strikes swiftly while good things eventually come to those who are patient."

Closing transaction

The purchase of a short call or a short put. Also the sale of a long call or long put.

Option Open Interest

The number of open options positions. For example, if total call open interest is 2,000 there are traders holding 2,000 long calls and 2,000 short calls. 1 long call and 1 short call having the same strike price create open interest of 1. By contrast, equities are issued in fixed quantities. For example, the number of outstanding IBM shares is a fixed number that won't change unless IBM issues additional shares or splits it stock. Options, on the other hand, are created when a buyer and seller trade and create open interest. This is a very important distinction between equities and options because it shows that option supply (option open interest) is a function of demand. And that's the reason option open interest changes daily.