In an interest rate swap, the absolute rate is the sum of the fixed rate component and the variable bank rate. If two counterparties exchange a fixed interest rate and a variable interest rate as part of an interest rate swap based on a theoretical amount of principal, the absolute rate is the total of the fixed interest, or premium piece on top of the variable bank lending rate, or reference piece.
Accelerated vesting occurs when a stock option becomes exercisable earlier than originally scheduled. For example, let's assume that John Doe receives options to buy 2,000 shares of Company XYZ, his employer, for $10 a share.
An accreting principal swap is a swap in which the two parties to the contract agree to pay interest on a growing principal amount. In a swap, one party is reducing its exposure to risk while the other party is increasing its exposure to risk in the hopes of getting a higher return.
An American option is a put option or call option that can be exercised at any time on or before its expiration date. For example, an investor holding an American option that expires on the last Friday in March has the right to exercise that option at any time on or before that date. Since the option price moves in sync with the underlying asset, the value of the option may rise and fall multiple times over the life of the contract.
Asset backed securities (ABS) are securities backed by the cash flows of a pool of assets.Home equity loans, auto loans, credit card receivables, and student loans commonly back this class of securities.
An asset-or-nothing call option either pays the value equal to one unit of the underlying asset if that asset is above the strike price or pays nothing if the asset is below the strike price at expiration. An asset-or-nothing call option, also known as a binary option, specifies two possible outcomes.
An asset-or-nothing put option is an option with two possible outcomes: a fixed amount if the market value is below the strike price and no payment at all if it is higher than the strike price. A typical put option will have a market value based on the difference between the market price of the underlying asset and the strike price for that asset.
An assignable contract allows a contract holder to assign his or her rights and obligations under the contract to a third party.The most common assignable contracts are futures contracts.
A back fee is associated with exercising a compound option. Many investors know that they don’t always have to make outright purchases or sales of securities; they can also use puts and calls.
A bear spread is a strategy used in options trading.A trader purchases a contract with a higher strike price and sells a contract with a lower strike price.
A bearish harami refers to a stock market trend indicating that the value of a stock is likely to experience a downwards, or bearish, momentum following a period of upward, bullish movement. In technical analysis, stock market trends are calculated using a number of different methods.
The Black-Scholes model is a formula used to assign prices to European options. The model is named after Fischer Black and Myron Scholes, who developed it in 1973.
Broken dates, also known as "odd dates," are arbitrary maturity dates that do not necessarily match the duration of the bond, option, futures contract, forward contract or other maturing instrument. For example, let's assume that a futures contract for shares of Company XYZ is three months long and is issued on April 1.
A buy-write is an options strategy whereby an investor writes (sells) a call option at the same time he/she buys the underlying. In a buy-write, which is very similar to a covered call, an investor sells a call option and buys the underlying simultaneously.
A calculation agent is a person or company that calculates how much the parties to certain derivatives owe each other. For example, consider an interest rate swap, which is a contractual agreement between two parties to exchange interest payments.
A call on a call is a type of compound option.It is a call option on a call option.
A call on a put is a type of compound option.It is a call option on a put option.
A call option is a contract between a buyer and a seller that gives the option buyer the right (but not the obligation) to buy an underlying asset at the strike price on or before the expiration date.The buyer pays a premium to the seller in exchange for this right.
The phrase call over is used to describe the exercising of a call option. A call option gives its owner the right to buy an asset at a set price (the strike price) on or before a certain day (the expiration date).
A call premium is the price of a call option.It is not the same as the strike price. Supply and demand of the call option determines its premium, but the famous Black-Scholes options pricing model offers a common (though somewhat complex) method for calculating call premiums at any point.
A call ratio backspread is a trading strategy whereby an investor uses long and short option positions to simultaneously hedge against loss and maximize profit if stock prices go up.The strategy differs from butterfly spreads and condor spreads in that it has unlimited upside potential.
Call warrants are securities that give the holder the right, but not the obligation, to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time. Occasionally, companies offer call warrants (usually simply called "warrants") for direct sale or give them to employees, but the vast majority of call warrants are "attached" to newly issued bonds or preferred stock.
A callable security gives the issuer or a third party the right but not the obligation to repurchase the security at a specific price after a certain time. Let's assume you own 100 shares of Company XYZ callable common stock.
"Called away" refers to an investing scenario in which one party to an options contract has the obligation to deliver an underlying asset to the other party to the contract. There are three common situations in which an asset may be called away: Callable Bond is Redeemed Before Maturity Callable bonds give the company issuing the bonds the option to redeem them (or buy them back from you) before the designated maturity date.
Also called the spot price or the current price, a cash price is the current price of a commodity if it were to be sold or purchased today. For example, if you purchase a cup of coffee in a restaurant, you pay the cash price -- the price of the good for immediate delivery.
A cash settlement is a payment in cash for the value of a stock or commodity underlying an options or futures contract upon exercise or expiration. Options and futures contracts are valued based on an underlying security or commodity that may be purchased or sold upon exercise (determined by a price) or expiration (determined by a date).
The Chicago Board of Trade (CBOT) is a commodity futures and options exchange.Several dozen types of contracts trade on the CBOT, and the exchange facilitates hundreds of millions of these trades each year.
The Chicago Board Options Exchange (CBOE) is an exchange used for trading standardized options contracts, including stock options, LEAPS, interest rate options, foreign currency options, and index options. Originally created in 1973 as an extension of the Chicago Board of Trade (CBOT), the Chicago Board Options Exchange (CBOE) became the first exchange to offer standardized options trading.
A clean up call, also known as a calamity call, is a feature of a collateralized mortgage obligation (CMO) that requires the issuer to pay off a portion of the CMO if the underlying mortgages don't generate enough cash to make the principal and interest payments on the CMOs. Let's say Company XYZ has issued $500 million of CMOs that have principal and interest payments of $2 million per month.
A collar option strategy, also known as a "hedge wrapper," is used to lock in the maximum gain and maximum loss of a stock.To execute a collar, an investor buys a stock and an out-of-the-money put option while simultaneously selling an out-of-the-money call option.
A combination trade is an option strategy where the trader takes a position in both call and put options in the same underlying stock.While there are multiple types of combination trades, in this section we will look at a very popular trade called a long straddle.
A compound option is the opportunity to buy or sell an option. Let’s assume John Doe buys a call on an option to purchase 100 shares of Company XYZ at $25 per share by March 31.
A covered call is a call option that is sold against stock an investor already owns. For example, assume that on January 1, Charlie owns 100 shares of IBM stock.
A credit default swap (CDS) protects lenders in the event of default on the part of the borrower by transferring the associated risk in return for periodic income payments. In a credit default swap (CDS), two counterparties exchange the risk of default associated with a loan (e.g.
A credit derivative is a financial instrument thats value is determined by the default risk of an underlying asset. Credit derivatives allow a lender or borrower to transfer the default risk of a loan to a third party.
A deferred payment option is an option contract for which the payment is deferred until, and paid not sooner than, the contract’s expiration date. A deferred payment option operates no differently from a standard vanilla option contract with the exception that payment, should the holder choose to exercise the option, will not be received until the expiration date.
A delivery option is incorporated into an interest rate future contract and allows the writer to specify the time and place of delivery as well as the asset to be delivered. An interest rate future contract contains an underlying short position supplied by the writing counterparty.
Delta is the ratio comparing the change in price of an underlying asset to the change in price of a derivative.It is one of the four main statistics, known as "Greeks," used to analyze derivatives.
A derivative is a financial contract with a value that is derived from an underlying asset.Derivatives have no direct value in and of themselves -- their value is based on the expected future price movements of their underlying asset. Derivatives are often used as an instrument to hedge risk for one party of a contract, while offering the potential for high returns for the other party.
A detachable warrant is a warrant that can be sold separately from the security to which it was originally attached. Warrants are securities that give the holder the right, but not the obligation, to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time.
An E-mini is a stock index futures contract that is electronically traded on the Chicago Mercantile Exchange (CME) and is 1/5 the size of a standard stock index futures contract. An E-mini S&P 500 futures contract is valued using the following formula: E-mini S&P 500 contract value = ($50) x (S&P 500 stock index) As the price of the S&P 500 fluctuates, the price of the S&P 500 E-mini futures contract fluctuates as well.
Early exercise refers to a situation in which an option holder has the right to exercise or assign an option before its expiration date. The option holder may decide to exercise the option before it reaches maturity by buying or selling the option.
An embedded option is a provision in a security (typically a bond) that gives either the issuer (the company) or the investor the right to take some action in the future. Different from a stand alone option, an embedded option is an option that is embedded into the stock, bond, etc., and there may be more than one embedded option in a security.
An Equity Linked Foreign Exchange Option (or ELF-X) is a put option or call option that shelters an investor from foreign exchange risk.It enables an investor to sell a foreign stock position or portfolio at a future date (the expiration date of the option contract) without the risk of foreign exchange loss.
A European option is a type of put or call option that can be exercised only on its expiration date. Suppose an investor, John, buys a European call option on March 1st that expires on the third Friday in March.
An exercise price is the price at which the holder of a call option has the right, but not the obligation, to purchase 100 shares of a particular underlying stock by the expiration date. Options are derivative instruments, meaning that their prices are derived from the price of another security.
An exotic option is any option contract comprising attributes not common to most contracts which result in complicated valuation schemes.It is the opposite of a plain vanilla option.
The expiration date is the last day an options contract can be exercised.After that, the contract becomes null and void.
Usually reserved for discussions about Treasuries, the forward rate (also called the forward yield) is the theoretical, expected yield on a bond several months or years from now. The yield curve dictates what today's bond prices are and what today's bond prices should be, but it can also infer what the market believes tomorrow's interest rates will be on Treasuries of varying maturities.
Futures are financial contracts giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time. Futures are also called futures contracts.
Futures contracts give the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time. The assets often traded in futures contracts include commodities, stocks, and bonds.
Futures markets are places (exchanges) to buy and sell futures contracts.There are several futures exchanges.
A hedgelet is a binary futures contract whose payoff is conditional upon a specific economic occurrence. A hedgelet is a futures contract which hedges that a specific event (for example, movements in interest rates, commodity prices, or exchange rates) will have occurred on or before the contract's expiration date.
An Incentive share option, or ISO, is a type of company share option granted exclusively to employees. It confers an income tax benefit when exercised.
Incentive stock option (ISO) is a type of company stock option granted exclusively to employees.It gives the employee the right, but not the obligation, to purchase shares of a company, usually the option holder's employer, for a fixed price by a certain date.
Introduced in 1981, index options are call or put options on a financial index comprising many stocks. Index options usually have a contract multiplier of $100, meaning that the price of an index option equals the quoted premium times $100.Unlike options in shares of stock or even commodities, it's not possible to physically deliver the underlying index to the purchaser of an index option.
A ladder option is an option contract that allows the holder to earn a profit as long as the underlying asset's market price reaches one or more strike prices before the option expires. A traditional option contract gives the holder the right to buy (call option) or sell (put option) an underlying asset at a preset price, known as the strike price, by the contract's expiration date.
The last trading day is the last time traders may trade a derivative contract before it expires. Derivative contracts (for example, options and futures) have an expiration date, at which time the terms of the contract become null.
A long straddle is an options trading strategy that involves purchasing both a call option and a put option for a particular asset with identical strike prices and expiration dates. Because a long straddle involves purchasing both a call and put option with the same strike prices, a trader who uses this strategy will profit if the price of the underlying asset deviates from the original strike price in either direction.
Long-Term Equity AnticiPation Securities (LEAPS) is a registered trademark of the Chicago Board Options Exchange (CBOE).LEAPS are virtually identical to traditional exchange-traded options, but they expire up to three years in the future, which is much longer than traditional options' nine-month maximum.
A market index target-term security (MITTS) is a debt security that offers potential upside based on gains in a market index while limiting downside losses by guaranteeing the initial investment will be returned if the index declines. First conceived by Merrill Lynch, a MITTS is a debt obligation that exposes an investor to upside fluctuations in a stock market index such as the Dow Jones Industrial Average (DJIA) or S&P 500 Index.
Mini-sized Dow options are leveraged option contracts that use the Dow Jones Industrial Average as the underlying asset. Bought and sold on the Chicago Board of Trade (CBOT), mini-sized Dow options have a leverage ratio of 5:1.
A minimum price contract is a futures contract with a price floor. A minimum price contract has a provision that places a lower limit on the price of a futures contract's underlying asset.
A naked call is an options strategy in which an investor sells a call option unassociated with units of the underlying security. In a naked call strategy, the sale of a call option is predicated on the writing party's belief that the market price of the underlying security will not exceed the specified strike price prior to the expiration date.
Naked option refers to an option contract which does not comprise ownership of the underlying security by the purchasing or selling party.It is the opposite of a covered option.
Naked position refers to any securities holding which has not been hedged for risk by any accompanying options or futures contracts. A naked position in a given security is exposed entirely to fluctuations in its market price.
A naked put is a put option which is unaccompanied by the actual units of the underlying security specified in the contract. The seller, or writer, of a naked put option incorporates a specific quantity of a given security as an underlying in which he does not hold an actual short position.
A naked warrant is a warrant that is not attached to a bond or preferred stock. Warrants are securities that give the holder the right, but not the obligation, to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time.
In the futures market, a narrow basis occurs when the spot price of a commodity is close to the futures price of the same commodity. For example, let's say the price of a bushel of wheat is $1 right now (this is called the spot price).
A net option premium is the difference between the price paid to purchase an option and the price received from the sale of a different option. The formula for net option premium is: Net Option Premium = (Price of Options Sold - Commission on sale) - (Price of Options Purchased - Commission on Purchase) Let's assume investor X buys 100 options of XYZ Company for $10 and then sells 100 options in XYZ Company for $12.
Noncallable refers to a security that cannot be redeemed by the issuer prior to maturity. Sometimes, it is referred to as non-redeemable. When a security is issued, it carries a set term (the time at which the bond may be redeemed for the full value) and coupon rate (the interest rate yield on the bond payable to the bond buyer). Often, bonds are callable, that is, the issuer may decide to retire the bonds earlier than the maturity date. When this happens, the principal and interest are paid up to the date that the bonds are redeemed. However, investors may want to lock in a long term investment at a set rate. To do this, they require that the issuer hold the debt to maturity. These debts are noncallable.
A nonqualified option (NQO) is the right but not the obligation to purchase shares of a company, usually the option holder's employer, for a fixed price by a certain date. Option grants are incentive compensation that encourages employees to focus on doing work that increases the stock price and thus shareholder value, which is the primary objective of all businesses.
Notional principal amounts never change in an interest rate swap, and they are the core of the calculations involved in these transactions. An interest rate swap is a contractual agreement between two parties to exchange interest payments.
Notional values are most discussed in derivatives and currency transactions because those transactions often involve hedging, which means that a small amount of money can influence a very large investment.The term helps distinguish between the amount of money actually invested from the amount of money involved in the whole transaction.
OEX is the ticker symbol of index options on the S&P 100, which trade on the Chicago Board Options Exchange (CBOE). The Standard & Poor's 100 index (S&P 100) is a subset of the famous S&P 500 index.
An offset is a transaction that cancels out the effects of another transaction. Offsetting transactions are common in options and futures markets.
An offsetting transaction is a transaction that cancels out the effects of another transaction. Offsetting transactions are common in options and futures markets.
Open outcry is a trading mechanism that uses verbal bids and offers.It is usually conducted in trading pits on futures and options exchanges.
An option is a financial contract that gives an investor the right, but not the obligation, to either buy or sell an asset at a pre-determined price (known as the strike price) by a specified date (known as the expiration date). Options are derivative instruments, meaning that their prices are derived from the price of their underlying security, which could be almost anything: stocks, bonds, currencies, indexes, commodities, etc. Many options are created in a standardized form and traded on an options exchange like the Chicago Board Options Exchange (CBOE), although it is possible for the two parties to an options contract to agree to create options with completely customized terms.
Option pricing theory is the theory of how options are valued in the market.The Black-Scholes model is the most common option pricing theory.
The Options Clearing Corporation (OCC) is a clearinghouse for equity options and is a guarantor of the obligations in listed options contracts. The OCC confirms, certifies and clears contract trades. It also acts as a market maker and trading specialist for a variety of options contracts.
Options contracts are agreements between a buyer and seller which give the buyer the right to buy or sell a particular asset at a later date (expiration date) and an agreed-upon price (strike price). They’re often used for securities, commodities, and real estate transactions.In other words, buyers can purchase them much like other types of assets within brokerage accounts. What Are Call & Put Options?
"Out of the money" describes an option that is worthless if exercised today.In the case of a call option, the option has no intrinsic value because the current price of the underlying stock is less than the option strike price.
In finance, a perfect hedge is an investing strategy intended to protect an investment or portfolio against all losses.It usually involves securities that move in the opposite direction than the asset being protected.
Portfolio hedging describes a variety of techniques used by investment managers, individual investors and corporations to reduce risk exposure in an investment portfolio.Hedging uses one investment to minimize the negative impact of adverse price swings in another.
A price-based option is a derivative based on the price of an underlying debt security, usually a bond. A price-based option gives the holder the right, but not the obligation, to purchase or sell (depending on whether the option is a call or a put) the underlying bond for a specific price (the strike price) on or before the option's expiration date. For example, let's say you purchase a price-based option on bonds of Intel (INTC) with a strike price of $1,010 and an expiration date of April 16th.
A put option is a financial contract between the buyer and seller of a securities option allowing the buyer to force the seller (or the writer of the option contract) to buy the security. In options trading, a buyer may purchase a short position (i.e.
Put-call parity refers to the relationship between put and call options for a given security, strike price and expiration date.Under put-call parity, the option prices should match, yielding no profit or loss.
A qualifying disposition is the sale, transfer or exchange of stock that an investor acquires from an incentive stock option (ISO) or employee stock purchase plan (ESPP) and is taxed at the capital gains rate. For example, let's assume that John Doe works as a financial analyst in Company XYZ.
A rainbow option is an option linked to two or more underlying assets. Just as rainbows have many colors, options can have many underlying assets.
A Russian option is a type of lookback option which does not have an expiration date. As a lookback option, a Russian option may be exercised according to American or mid-Atlantic settlement rules based on the underlying security's most profitable market price during the life of the option.
A stock option gives the holder the right, but not the obligation, to purchase (or sell) 100 shares of a particular underlying stock at a specified strike price on or before the option's expiration date.There are two kinds of options: American and European.
Strike price, also referred to as “exercise price,” is the specific price at which an investor can exercise an option to buy or sell an option contract’s underlying security, such as stocks, bonds, and commodities. The strike price of an option is a fixed dollar amount that stays the same during the entire option contract term.
Subscription privileges are a clause in an option, security, or merger agreement that gives the investor the right to maintain his or her percentage ownership of a company by buying a proportionate number of shares of any future issue of the security. Subscription privileges are sometimes called "subscription rights," "anti-dilution provisions," or "anti-dilution provisions." Subscription privileges are particularly relevant for convertible preferred stock.
Subscription rights are a clause in an option, security, or merger agreement that gives the investor the right to maintain his or her percentage ownership of a company by buying a proportionate number of shares of any future issue of the security. Subscription rights are sometimes called "anti-dilution provisions," "preemptive rights," or "subscription privileges." Subscription rights are particularly relevant for convertible preferred stock.
A synthetic collateralized debt obligation is a collateralized security which is backed by derivatives such as swaps and options contracts. A synthetic collateralized debt obligation, commonly called a synthetic CDO, seeks to generate income from swap contracts, options, and other non-cash derivatives rather than straightforward debt instruments such as bonds, student loans, or mortgages.
A synthetic futures contract comprises call options accompanied by put options in order to imitate the attributes of a futures contract. A synthetic long futures contract can be simulated using a short put option in conjunction with a long call option.
Also called market risk or non-diversifiable risk, systematic risk is the fluctuation of returns caused by the macroeconomic factors that affect all risky assets. Unsystematic risk is the risk that something with go wrong on the company or industry level, such as mismanagement, labor strikes, production of undesirable products, etc.Systematic risk + Unsystematic risk = Total risk Systematic risk is comprised of the "unknown unknowns" that occur as a result of everyday life.
In the options trading world, there are two components that make up an option's price.The first is intrinsic value (which accounts for the underlying security's perceived value), and the second is time value.
Also known as “being naked,” an uncovered option is the sale of an option involving securities the seller does not own.It is the opposite of a covered option.
An underlying asset is a security on which a derivative is based. For example, options are derivative instruments, meaning that their prices are derived from the price of another security.
An underlying security is an asset that a derivative instrument (e.g.futures, options) derives its value from.
A vanilla option refers to a normal option with no special features, terms, or conditions. Options come in a variety of "flavors." A plain vanilla option offers the right to purchase or sell an underlying security by a certain date at a set strike price. In comparison to other option structures, vanilla options are not fancy or complicated.
A vest fleece occurs when a company accelerates the vesting of its employee stock options. For example, let's assume that John Doe receives options to buy 2,000 shares of Company XYZ, his employer, for $10 a share.
Warrants are securities that give the holder the right, but not the obligation, to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time.Warrants are not the same as call options or stock purchase rights.
Warrant coverage is an agreement to provide warrants to a shareholder. Warrants are securities that give the holder the right, but not the obligation, to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time.
A warrant premium is the percentage difference between the market price of a security and the price an investor pays for that security when buying and exercising a warrant.The formula for the warrant premium is: Warrant Premium = 100 x [(Warrant Price + Exercise Price – Current Share Price) / Current Share Price] Warrants are securities that give the holder the right (but not the obligation) to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time.
The witching hour is the last hour of the trading day. The witching hour occurs between 3 and 4 p.m.
An XPO is a perpetual option. An option gives the holder the right, but not the obligation, to purchase (or sell) 100 units of a particular underlying security at a specified strike price on or before the option's expiration date.
A zero cost collar is a short-term option trading strategy that offsets the volatility risk by purchasing a cap and a floor for the price of a derivative. A zero cost collar strategy would combine the purchase of a put option (i.e.