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Glossary of option terminology

The terms here are commonly used in the trading of options.

Abandonment
Allowing an option to expire unexercised.

American-Style Exercise
An option which may be exercised on any business day prior to expiry.

Assignment
Notice sent by the Clearing House to the option writer informing him that his option has been exercised.

At-the-money option
An option whose exercise price is the same as, or closest to, the current market price of the underlying share. For example, if the share price is 260p, an option with an exercise price of 260p would be precisely at-the-money. An exercise price of 261p would also be termed at-the-money.
Backwardation
A futures market where further dated delivery months trade at a discount to the near month. Also, where a bid is higher than an offer. This is possible in a quote driven market, but will not occur in an order driven market as bids and offers will interact and trade at a matching level. Backwardation may also occur during an auction process where bids and offers are submitted prior the application of an uncrossing algorithm, which then executes orders at the uncrossing price.

Bid/offer spread
The difference between quoted bid and offer prices. For market makers, these must be within the maximum levels set by LIFFE.

Butterfly
A recognised LIFFE option strategy which involves, in one single transaction, the simultaneous purchase (sale) of a call (put) at one exercise price, the sale (purchase) of two calls (puts) at a higher exercise price and the purchase (sale) of a call (put) at an equally higher exercise price.

Buyer of an option
The party who, through purchase, acquires the right conveyed by the option. Also commonly referred to as the option holder, where the purchase is to open a position. See opening purchase.

Buy-Write
Purchase of stock and simultaneous writing of call options against stock position.

CAB
A cabinet bid, which is a facility enabling holders of deep out-of-the-money options to close their positions at a nominal £1 per contract.

Calendar Spread
The sale (purchase) of a near month call option (put option) and the simultaneous purchase (sale) of a longer dated call option (put option) at the same exercise price.

Call option
An option that conveys to the option buyer the right but not the obligation to purchase 1,000 shares 6 at a fixed price per share at any time during the life of the option.

Call Spread
The simultaneous purchase (sale) of a call at one exercise price and sale (purchase) of another call at a higher exercise price.

Cash Market
The market in the underlying instrument.

Cash settlement
In the case of index options contracts where it is impossible or impractical to effect physical delivery, open positions are closed out on the day of exercise or the last day of trading at a price determined by the underlying index level.

Class
All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Vodafone AirTouch plc call options.

Clearing House
The organisation which guarantees the performance and settlement of exchange traded contracts to its members - the London Clearing House (LCH).

Closing purchase
A transaction whereby an option writer buys an option identical to one previously sold, thus ending his obligations as an option writer.

Closing sale
A transaction whereby an option holder sells an option identical to one previously purchased, effectively terminating his rights as an option holder.

Combo
The simultaneous sale (purchase) of a call at one exercise price and purchase (sale) of a put at a lower exercise price.

Contango
A futures market where further dated delivery months trade at a premium to the near month.

Contract size
The number of shares of the underlying security, or the cash amount for Index options, represented by the option contract.

Covered Writing
In the case of call writing, covered means having a holding of shares at least equal to that implied by the short call option position, and in the case of put writing, covered means having a cash sum sufficient to take up the underlying security if assigned on the short put position.

Delta
The rate of change in option premium for a given change in the price of the underlying. Equal to the change in option premium divided by the change in underlying price.

Delta Neutral
A position where the sum of the deltas of the component legs adds up to 0.

EDSP
The Exchange Delivery Settlement Price - the price which determines the price for physical delivery of the underlying instrument or the price at which contracts are cash settled.

European-Style Exercise
An option which may be exercised only on its expiry day.

Ex dividend
The day on which a dividend paying stock trades without the right to receive the dividend.

Exercise
The use of the right by the option holder to purchase the underlying shares at the exercise price if the option is a call, or to sell the underlying shares at the exercise price if the option is a put. Equity options traded on LIFFE are ‘American-style’ options; they can be exercised by the option holder at any time prior to expiry.

When a call is exercised, the writer is obliged to make delivery of i.e. sell the underlying shares at the exercise price of the option and the buyer is obliged to take delivery i.e. buy.

When a put is exercised, the writer is obliged to take delivery of i.e. purchase the underlying shares at the exercise price of the option and the buyer is obliged to make delivery i.e. sell.

LIFFE equity option contracts are normally for 100 or 1,000 shares. It is important, however, to recognise that this can change as a result of corporate events such as rights issues, share splits, etc.

Exercise Notice
A formal notification to the Clearing House that the holder of a call (put) option wishes to buy (sell) the underlying at the exercise price.

Exercise price
The fixed price per share at which a call option conveys the right to purchase the underlying shares and at which a put option conveys the right to sell the underlying shares. Also referred to as the option strike price. Example: A call option with an exercise price of 260p conveys the right to purchase 1,000 shares at a price of 260p per share.

Expiry date
The last date on which an option holder can exercise the right conveyed by the option. After that date, the option ceases to exist.

Extrinsic Value
Time value. That part of the option premium which is not accounted for by its intrinsic value.

Gamma
The rate of change of an option's delta relative to a given change in the underlying. Equal to the change in option delta divided by the change in the price of the underlying.

Gearing
The nominal value of the option divided by its premium. The ratio of exposure to investment outlay, e.g., if an investment of £1 gives an exposure equivalent to a £10 investment, the level of gearing is 10.

Guts
A recognised LIFFE option strategy, which involves the simultaneous purchase (sale) of an in-the-money call at one exercise price and the purchase (sale) of an in-the-money put at a higher exercise price in one single transaction.

Hedge
Industry, tax and regulatory definitions of what constitutes a hedge differ. Broadly, the industry standard is that a hedge reduces risk in the overall asset /liability position, whether this be effected through a long or short futures or options position. However, UK regulators tend to regard only short hedges as hedges, with long hedges being classed as portfolio management.

Implied Volatility
The volatility of the underlying instrument implied by the market value options price.

In-the-money option
An option that has intrinsic value. In the case of a call, an option whose exercise price is below the current underlying share price, or in the case of a put, an option whose exercise price is above the current underlying price.

Intrinsic value
The amount, if any, by which an option is currently in-the-money. An option that is not in-the-money has no intrinsic value.

Last Trading Day
The final day for dealing in options contracts for a particular expiry month.

LCH
The London Clearing House - the clearing house for all LIFFE contracts.

Leverage
Gearing.

Long
An open "bought" position.

Lot
One equity or index options contract, e.g., a contract representing 1,000 shares or £10 x Index level.

Margin
Funds that an option writer must maintain on deposit with his broker to assure his ability to fulfill his financial obligation to make or take delivery of the underlying shares. Buyers of equity options, because they pay the entire option premium when the option is purchased, have no further financial obligations and are not subject to a margin requirement. However, should an option buyer exercise his right to acquire the underlying shares, he would then become subject to the margin requirements applicable to the shares acquired. Margin is called from the time the option is exercised until the equity transaction is settled. Margin in respect of the equity transaction is called from both the seller and the buyer of the shares. (Note: equity and index options are the only LIFFE options for which the buyer pays the entire premium up front. Other options – i.e. options on futures contracts – are margined in the same manner as the underlying futures contracts.)

Opening purchase
A transaction whereby the buyer becomes the holder of an option.

Opening sale
A transaction whereby the seller becomes the writer of an option.

Open Interest
The net long and short amount of outstanding positions in a particular contract.

Option Strategy Trades
Recognised option strategies (combinations of calls, puts, futures and stock) which may be traded as a single transaction.

Out-of-the-money option
An option that has no intrinsic value. That is an option which theoretically, it would not be worthwhile to exercise immediately e.g. a call option whose exercise price is above the current underlying share price or a put option whose exercise price is below the current underlying share price.

Premium
The sum of money (determined through the central market on LIFFE CONNECT™) that an option buyer pays for the right to acquire the option, and that an option seller receives for incurring the obligation the option entails. Option premiums are expressed as a cost in pence per share or in £ per Index point. The total cost of an option contract for 1,000 shares (sometimes referred to as a 'lot' ) would therefore be 1,000 times the premium, e.g. one contract with a premium of 14p would cost £140 (1000 x 14p).

Put option
An option that conveys to the option buyer the right but not the obligation to sell a predefined quantity of the underlying asset, e.g., 1,000 shares, at a fixed price at any time during the life of the option (for options with American-Style exercise).

LIFFE equity option contracts are normally for 100 or 1,000 shares. It is important, however, to recognise that this can change as a result of corporate events such as rights issues, share splits, etc.

Put Spread
The simultaneous purchase (sale) of a put at one exercise price and the sale (purchase) of a put at a lower exercise price.

Rho
The rate of change in option premium for a given change in interest rates.

Rollover
The transfer of a futures or options position from one delivery/expiry month to another - involving the purchase (sale) of the nearby month and the simultaneous and corresponding sale (purchase) of a further delivery or expiry month.

Round-trip
The opening purchase (sale) of an option or future and the subsequent opposite and closing transaction in the same contract. Transaction costs are often quoted on a round-trip basis.

Series
All option contracts on the same underlying instrument with the same exercise price and the same expiry date. Put options and call options with the same strike price and same expiry date form two different series.

Seller of an option
The party whose market transaction is the sale of an option. Where the party's opening transaction is a sale, he is referred to as the option writer. Unlike the option buyer, who acquires a specific right, the writer of an option incurs a specific liability (the obligation to make or take delivery of the underlying asset if the holder chooses to exercise the option).

Settlement price
The price used for daily revaluation of open positions.

Short
An open "sold" position.

Spread
A market position involving a degree of risk offset in two or more positions. For options such strategies as ratio, horizontal and vertical spreads are used across strikes prices and expiry months.

Straddle
The simultaneous purchase (sale) of a call and put option in the same expiry month with the same exercise price.

Strangle
The simultaneous purchase (sale) of a call option at one exercise price and a put option at a lower exercise price but with the same expiry date.

Strike Price
Exercise Price.

Theoretical Value
The fair value premium of an option based on recognised pricing methods.

Theta
The rate of change of option premium for a given change in the number of days to expiry.

Tick size
The smallest permitted price movement in a particular contract.

Time value
The amount, if any, by which an option’s premium exceeds its intrinsic value. If an option is not in-the-money, its premium consists entirely of time value.

Time Decay
The process whereby the value of an option premium is eroded as expiry approaches.

Uncovered (Naked)
A position which is not covered by an offsetting position in the underlying instrument.

Underlying share
The specific share to which LIFFE call and put options relate – e.g. 1,000 shares of HSR plc.

LIFFE does not offer options on HSR plc and this company has been used purely for illustrative purposes.

Vega
The rate of change in option premium for a 1% change in the volatility of the underlying.

Volatility
A statistical measurement of the variability of a share’s price, often expressed by the standard deviation.

Volatility Trade
A recognise LIFFE option strategy which involves the simultaneous purchase (sale) of calls against the sale (purchase) of the underlying or the simultaneous purchase (sale) of puts against the purchase (sale) of the underlying in one single transaction.

Writer
The seller of an option contract who is obliged to deliver or take delivery of the underlying instrument upon notification by the buyer (holder).




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