Terminology

The options world has a lot of its own language you’ll need to understand- here are some of the key terms and what they mean in simple English.

Derivative

Options are derivatives. Most people are familiar with the word, but few really think about what it means. A derivative means something that’s value is derived from something else. In and of themselves, options aren’t really anything- they only have value because of their underlying asset. It would be downright foolish for me to buy or sell UPS options, unless I actually had a view on UPS the stock- because that’s what’s going to drive my option price.

Think of options this way- options are simply a way to express a view on a stock or asset- if you think an asset is priced too low- great, you can express that view by buying call options. If you’re right, you’ll make money. If you think the price of something is too high, or you hold a lot of it and you’re worried about the price falling, you can buy put options- so you’ll make money if it falls and protect your large position. Each and every time, you’re totally reliant on what happens to the underlying asset.

Long/ Short

 ‘Long’ means you’re buying something, ‘short’ means you’re selling something- and something that you don’t actually own. That brings up an obvious question- how can you sell something you don’t own? While shorting is technically selling something you don’t even own, think of it as if you borrowed something and immediately sold it. And because you borrowed it, you’ve got to return it to the real owner at some point. So you’ll have to buy it back, in order to return it to its original owner.  

Example: I think the share price of Rolls Royce is going to fall, so I can sell it short, or ‘short’ 100 shares. I don’t own any Rolls Royce shares, so by creating a short position I am technically borrowing 100 shares from someone (usually a broker) and I then get to immediately sell them. Now I owe the broker 100 shares, and at some point he/ she is going to want them back, which means I’ll have to buy them in the market to deliver them. So I’m hoping the price falls, so that I can buy them for less than I sold them for, keeping the difference. (note, nobody does anything for free, so as the party shorting a stock I will have to pay interest to whoever I’m borrowing it from).

Shorting in options is the same as writing, or selling options. It means creating the contract and offering it to someone else.

Stock settled vs Cash settled 

There are two settlement types in options. Stock settlement (also known as physical settlement) involves a physical transfer of shares when the option is exercised, as stipulated by the contract. For example if you’re short a put option, you’re committing that someone else can sell you shares- and if they exercise that option, you have to physically buy the shares. Single stock options are typically physically settled.

Cash settlement is when there is no exchange of physical stock at expiry, there is simply an exchange of cash from one party to another. The profitable side of the contract receives their profit in cash rather than physical stock delivery or exchange. Index options are cash settled, given that you can’t actually buy an index itself. (You can only buy products that track the index, not the actual index).

In the money/ Out of the money

People will refer to an option as being ‘in the money’ or ‘out of the money’ and fortunately those terms are fairly intuitive. Let’s take a call option as an example; a call is the right to buy at a set price. That call will be ‘in the money’ if the strike price is below the current market price, i.e. the option is giving the holder some intrinsic value and they’d make a profit if they exercised their option immediately today.

If instead the current market price is below the strike price, the option is ‘out of the money’- there would be no point in exercising the option as you can buy the stock in the market more cheaply than via the option itself. The reverse is the case with puts- puts are ‘in the money’ if they’re giving you the right to sell a stock for more than its trading for currently, and out of the money if they give you the right to sell for less than the current market price.

In simple terms:

-         In the money: option contract is profitable and would be worth exercising

-         Out of the money: option contract isn’t currently profitable and is not worth exercising

Now, while out of the money the contracts themselves may not be immediately and obviously profitable, you can still make money from them, they can still be useful, and we will come onto that later. Option contracts can of course also trade out of the money for considerable periods of time and still end up in the money on expiry, if prices move sufficiently in the right direction.

In the above UPS example, if the stock is trading for $300 today, a $200 call option would be ‘in the money’ by $100, as you’ve got the right to buy stock for $100 less than the current price- that’s great for whoever owns the call. Whereas the $200 Put option is ‘out of the money’ as it offers no real value- it only lets you sell something for $200 that you could sell in the market for $300 anyway.

Skew

Skew is a quirk of options- now there are complex mathematical reasons for skew that are not necessary to understand at this level, but in simple terms skew means that for an equivalent distance from the current price (e.g. 10% out of the money) puts are more expensive than calls.

The simple reason for skew is that stock prices tend to grind up slowly, but crash down hard occasionally, so they exhibit more volatility to the downside than the upside. That is reflected in the prices of upside and downside via calls and puts. So puts are more expensive because mathematically they have a slightly higher probability of ending in the money.

On top of that, market forces play a part- there are structurally more market participants who use options for protection (buying puts to protect their long stock positions and reduce their downside) than there are people continually wanting to buy upside via calls. Some large investors (charities, pension funds etc) even have to consistently buy puts as protection, and this elevates the prices by ensuring a consistent level of buyers and consistent demand.

In the rare cases where calls are more expensive, that’s called negative skew.