How to speak like a derivatives native
Lingua Franca
Bull Spread—A trade where one option is bought and another option with a higher strike price is simultaneously sold. The spread will increase in value if the underlying instrument increases in value. Bull spreads can be constructed with two calls or with two puts, but calls are usually more economical and, therefore, more common. Such spreads are sometimes called bull-call spreads to differentiate them from the less common bull-put spreads.
Bear Spread— A trade where one option is bought and another option with a lower strike price is simultaneously sold. The spread will increase in value if the underlying instrument decreases in value. Bear spreads can be constructed with two puts or with two puts, but puts are usually more economical and, therefore, more common. Such spreads are sometimes called bear-put spreads to differentiate them from the less common bear-call spread.
Straddle—The simultaneous purchase of a call and put with the same strike price and the same expiration date. The strategy is used by investors who expect a large move in the price of the underlying asset, but are not sure of the direction of the expected move.
Strangle—The simultaneous purchase of a call and put with the same strike prices and the same expiration date. The strategy is used by investors who expect a large move in the price of the underlying asset, but are not sure of the direction of the expected move
Short Straddle or Strangle—The reverse of the two positions described above. In both cases, the investor is selling both calls and puts. This position will profit if the market remains in a range, but could result in very large losses if the market moves a great deal in either direction. Investors that hope to profit from a period of consolidation often use this strategy.
Butterfly(Long)—The sale of two options with the same strike price and the simultaneous purchase of one option with a higher strike price and one option with a lower strike price, all with the same expiration date. A butterfly can be created using just calls, just puts, or puts and calls in combination. In the latter case, the position is the same as selling a straddle and buying a strangle. Investors use this position when they expect a period of consolidation. Unlike the short straddle and short strangle, however, the potential loss on a butterfly is limited.
Condor(Long)—A similar and less common position than the butterfly, a condor is made by selling two options with consecutive strike prices and simultaneously buying an option with the next lower and the next higher strike prices. All the options have the same expiration date. The payoff of a condor is similar to that of a butterfly except that the maximum gain is achieved anywhere between the strike prices of the options sold, whereas the maximum profit on a butterfly is only achieved at the single strike price where the two options are sold.
Calendar Spread—A long position in an option (call or put) with a short position in a shorter dated option with the same strike price. The position yields the maximum profit if the underlying instrument is exactly at the same strike price of the two options on the expiration day of the shorter-dated option, which is the one which was sold short. At that point, the short option expires worthless and the longer-dated option can be sold for a net profit. Alternatively, the long option can be held for further potential appreciation.
Synthetic Long—A long call and a short put with the same strike price and expiration. The combination of these two positions acts just like a long position in the underlying instrument (stock, bond, commodity, etc.).
Synthetic Short—A short call and a long put with the same strike price and expiration. The combination of these two positions performs just like a short position in the underlying instrument.
Conversion—A long underlying position together with a short call and a long put. The long position in the underlying instrument is completely hedged by the synthetic short position created with the options. Traders will often use this trade to lock in a small profit when an option’s price gets out of line.
Reversal—A short underlying position together with a long call and short put. The option positions are equivalent to a synthetic position which is offset by the short position in the underlying instrument.
It’s Greek To Me
Delta—The rate of change in an option price for a one-point move in the underlying instrument. In graphical terms, one can picture the option value along the y-axis and the stock price along the x-axis. The delta is the slope of the option price for a small change in the stock price. Deltas for calls can range between zero and one, and for puts, the range is between zero and minus one. Deep in-the-money calls, for example, have a delta close to one because the option price increases by one point for each point increase in the price of the underlying stock.
Gamma—Gamma describes the chance in delta for a one point change in the stock price. In mathematical terms, gamma is equivalent to the second derivative of the option price relative to the underlying security.
Delta-Hedging—A strategy for re-hedging an option position by constantly adjusting the position in the underlying instrument so that the total delta of the positions remains close to zero. Because the delta of the position changes (gamma), options traders must readjust their hedges as the underlying instrument moves.
Theta—The relationship between an option’s price and the passage of time. Theta—which is technically the derivative of an option’s price relative to time—is used to describe the decay in an option’s premium over time.
Volatility—A term to describe the variability of a stock’s price. The most common measure of volatility is the annualized standard deviation of the returns, which is used in the Black-Scholes option-pricing model. Volatility in the underlying instrument is generally favorable for an option because even if the stock moves against the option holder, the loss on the option is limited, whereas a large move in your favor can lead to extremely large percentage returns. Since it is impossible to know how volatile a stock will be in the future, the historical volatility is often used as a reasonable estimate.
Implied Volatility—The volatility implied by the price of the option. If one knew what the volatility of the stock would be in the future, one could calculate a fair price for an option using the volatility, along with the stock price, strike price, time to expiration, interest rate and dividends. Since we cannot know the future volatility as described above, and calculate an estimate for the option price. If one uses the actual option price in the market, and then solves the equation backwards—leaving all the other factors the same—one can calculate the future volatility implied by the market price of the option.
General Derivative Terminology
Swap—An agreement between two parties to exchange the returns from different assets without actually exchanging the underlying assets. Swaps can be applied to a wide range of instruments, but a typical swap is one in which one party pays a fixed-interest rate in return for the floating-rate return on a different asset. Another common swap is to trade the payment of a selected Libor rate for the returns from a selected stock index.
Fair Value—A term used to describe the theoretical value of a future based on known factors. In the case of stock index futures, for example, the fair value depends on the underlying index level, time to expiration, interest rates and the expected dividends of the stocks in the index.
Give-up—An arrangement whereby the executing broker passes a trade to a different broker for clearing. Often a company will use different brokers for executing futures trades, but may ask that all of them be “given-up” to a single broker to simplify settlements.
Haircut—The dollar requirements to finance a trading position mandated by a regulatory body or by one’s clearing firm.
Rollover—A trade to extend a futures (or options) position by closing the contract that is about to expire and replacing it with the same position in a further dated contract. If someone holds a long position in a March future and wanted to “rollover” the position, he or she would sell the March contract and simultaneously buy a June contract, which would allow the investor to remain long for three additional months.
Bruce Benson is a senior vice president-derivatives at Baring Securities in New York.