Friday, January 25, 2013

Basic Option Trader Jargon Decoded

Trading jargon is notorious for creating confusion.  Let’s decode 4 critical trading concepts:


Trader explanation:  Imagine a crystal-clear lake. You jump in, you swim with the fishes and you jump out.  But imagine that same lake tarnished with oil.  You jump in, you can hardly move and the fish are especially unhappy.

Trading a liquid product is like swimming in a good lake. You can enter & exit positions quickly.  And with less ‘slippage’!  Slippage is the difference between your trade price, and the average of the bid/ask spread of the stock or option.  But, when you trade a product that isn't liquid, you might get stuck in the trading goo.  You might not be able to execute a trade near its current price, because there aren't enough buyers and sellers. And slippage is potentially higher, because you might have to sell the illiquid product considerably lower, or buy it considerably higher, than its current price.

You can easily identify liquid trading products by high volume, open interest, and bid/ask spreads just a few pennies apart.  Before you place an order, check the liquidity.  If you don't think a product is liquid enough to trade, look for a more liquid stock in the same sector.  Ask your advisor!

Trader explanation:  Volatility (in a sense) “rates” the market's opinion of the range a stock or asset could move in time—say, a day, a week, or a month. Volatility numbers are often expressed as a percentage of the underlying stock price, and are annualized.

Theoretically, a volatility of, say, 30% means that 68 % of the time, the stock could be between + 30 % or -30 % from the current stock price in one year.  But, traders think in dollars and are therefore more likely to care about what the stock might do in the short term—i.e. the next day, week, or month, than one year.  

So how do you convert the “vol” number to a different time frame to dollars?
Monthly: divide by 3.5
Weekly: divide by 7.25
Daily: divide by 16
For example to calculate the range – using the 30% volatility example above for a $50/share stock price – for one month would mean:
(0.30/3.5)* $50            = $4.28
$50 + /- $4.28              = One month range of $45.72 to $54.28

Trader explanation:  Probability is complex math.  Rather than focus on formulas, consider what drives those numbers, namely implied volatility.  All things being equal, the higher an option's price, the higher its implied volatility.  This makes the probability formula generate a higher chance that the out-of-the-money option could be in the money by expiration.

Total market activity – i.e. what traders/investors believe about a given option at its expiration, and how they behave – can drive an option price up or down.  Over time, price fluctuations change the implied volatility, which then affects probabilities.

Probability numbers can't tell you whether a stock is going up or down.  But, they can attach a number to “market expectations” of a price change and/or its potential magnitude.  Although an option might show a low probability of being in the money, it doesn't mean it won't be.

Trader explanation:  To a trader, the cost basis is a position's breakeven price—or the price the stock has to reach for the position to be profitable.  If a trader is long stock, or even long further-expiration calls, often the goal is to reduce the cost basis.  The less a stock has to rise in order for the position to be profitable… the greater the likelihood of making a profit!

One way to reduce the cost basis of long stock is to sell out-of-the-money calls against long stock, or long calls.  You may have heard of a covered-call strategy, where calls are sold against long stock to generate income, and/or to act as a partial hedge.

But traders don't think of it like that.  A stock can't go lower than $0.  So, the lower your cost basis, the less risk.  Also, with a lower cost basis, you can increase the probability of making money on a given position.  To a trader, the credit realized when selling a covered call reduces the cost basis.

This blog strives to educate, and not provide financial advice.  If you need a detailed understanding of some of the terms above, or investment advice, please contact a licensed professional advisor!