Glossary of Terms
American Style Option an option can be exercised at any time prior to expiry.
At-the-money Option an option whose exercise price is at or very near the price of the underlying.
Call Option an option that gives the holder the right, but not the obligation, to buy the underlying from the call writer at a fixed price. This right expires on the expiry date. In the context of this book the underlying is stock or equity.
Call Spread (Vertical) a portfolio consisting of a long position in one call option and a short position in another call option. The options have different exercise prices but the same expiry.
Delta the rate of change of an option price with respect to a change in the underlying. The delta is a measure of the sensitivity of the option price to changes in the price of the underlying. Also known as the hedge ratio.
Delta Contour a line or curve on the standard price series chart connecting all points with the same delta. The delta contour gives an indication of how the sensitivity of an option changes over time as the underlying price changes.
Dynamic Replication a process by which any option can be replicated. The process involves the continual buying or selling of the underlying in such a way that the net payoff is identical to the payoff of the desired option. The cost of options replicated dynamically will be a function of the volatility actually experienced. The cost of static exchange traded options is a function of future expected volatility.
European Style Option one that can only be exercised on the final (expiry) day.
Exercise Price the price at which the underlying is bought or sold when an option is exercised.
Exercise lor a call option, exercising is the act of turning an option to buy into actually buying the underlying. For a put option, exercising is the act of turning an option to sell into actually selling the underlying.
Expected Value the long run probabilistic value of an uncertain outcome. Expiry Date the final day in the life of an option.
Exposure the equivalent quantity of the underlying that gives exactly the same absolute profit or loss when the price change is small.
Fair Value or Price an option is fairly priced if, in the long run, the profit to a given strategy is zero.
Floating volatility when the volatility profile (smile or smirk) moves or floats up or down with the underlying price.
Gamma the rate of change of the delta. Hedge Ratio see delta.
Hedging the process of removing the risk of experiencing a profit or loss from an options position.
Historic Volatility a measure of the volatility experienced over some previous period.
Implied Volatility the volatility implied by the price of an option.
In-the-money Option an in-the-money call option has an exercise price lovu'i than the current price of the underlying. An in-the-money put option h;i^ ,in exercise price higher than the current price of the underlying.
Intrinsic Value the value of an option if it were immediately exercised.
Linear Relationship one that can be represented graphically by straight
IIIK^ or planes.
Long Position buying a stock or an option results in what is known as a long position. Being long of something will produce a profit (loss) if the price increases (decreases).
Long Volatility a long volatility position is one that is long options (puts or calls) but at the same time is market neutral.
Maturity Date see expiry.
Non-linear Relationship one that, when represented graphically, involves curves not straight lines.
Out-of-the-money Option an out-of-the-money call option has an exercise price higher than the current price of the underlying. An out-of-the-money put option has an exercise price lower than the current price of the underlying. 1
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Put Option an option that gives the holder the right, but not the obligation, to sell the underlying to the put writer at a fixed price. This right expires on the expiry date.
Put Spread a portfolio consisting of a long position in one put option and a short position in another put option.
Rehedging the process or rebalancing the market exposure of a portfolio of options.
Short Position selling a stock or an option as an opening trade results in what is known as a short position. Being short of something will produce a loss (profit) if the price increases (decreases).
Short Volatility a short volatility position is one that is short options (puts or calls) but at the same time is market neutral.
Simulation in the context of this book a simulation is the computer generation of an artificial stock price series and/or an option price series.
Stock Borrowing the process by which most individuals establish short stock positions.
Strike Price also known as exercise price.
Synthetic Options a synthetic option is generated by dynamically buying and selling stock. See dynamic replication.
Theta the rate of change of an option or portfolio of options with respect to time.
Time Decay see theta.
Time Spread a portfolio consisting of a long position in one option and a short position in another option. The options usually have the same exercise prices but different times to expiry.
Time Value the time value of an option is the difference between the option price and the intrinsic value.
Underlying the financial asset that underlies an option. In this book the underlying is always stock.
Vega the rate of change of an option or portfolio of options with respect to changes in volatility.
Volatility a measure of the degree of the fluctuations in the price of something.
Volatility Smile a special situation in which options with different strike prices have different implied volatilities. With a smile, the at-the-money strike has the lowest implied volatility and those either side increase with increasing distance.
Volatility Smirk a special situation in which options with different strike prices have different implied volatilities. With a smirk the implied volatility distribution is asymmetric. One type of smirk has lower strike prices with low volatilities and higher strike prices with higher volatilities. The reverse situation is also possible.