Advanced Terms & Phrases
In the first part of our section on improving your options trading knowledge we have explained some of the more advanced terms and phrases that you should really understand. We do have a complete list of all the jargon that is used in options trading in our Glossary of Terms, but here we go into some additional detail about the important terms.
Some of these may not be hugely relevant to you, depending on your trading style and the strategies you are using. Nonetheless, it's helpful to be aware of what certain terminology means in case it's significant to you. On this page we cover the following terms and phrases:
Bear Traps & Bull Traps
You should definitely be aware of what bear traps and bull traps are, because you will want to avoid falling for them. Many of the decisions that you make when trading options will be based on whether you believe the market is in a bear state (falling prices or an expectation of falling prices) or a bull state (rising prices or an expectation of rising prices), and these traps are basically misleading indicators that can lead to you making the wrong decisions.
Predicting which way the market is going to move is obviously somewhat crucial when it comes to determining which transactions to make, and if you can accurately predict market movements then you stand a very good chance of being a successful trader. It isn't always easy to forecast which way the market is going to move, and often certain indicators will suggest a bull market or a bear market when in fact the opposite is true.
A bear trap is when the market is beginning to move downwards, or there are indications that it's beginning to do so, but it isn't a strictly confirmed bear market. Such circumstances can lead investors to be bearish in their trades, but then they get into trouble when the market doesn't move as expected.
A bull trap is basically the opposite; there are unconfirmed signs that the market is moving upwards and investors might be encouraged to be bullish. To avoid falling into such traps, it's very important to look for confirmed signals and be as sure as possible about which way the market is going to move before making the appropriate transactions.
Arbitrage is essentially the dream scenario for investors because it creates an opportunity to make profits without taking any risk whatsoever. There are a number of scenarios in which arbitrage can exist, but such opportunities are very hard to come by. They basically involve the simultaneous purchase and sale of financial instruments where there might be price discrepancies that allow you to make an instant risk-free profit.
Arbitrage is a fairly complex subject, and is usually pretty much the domain of professional traders and market makers, although there are certain arbitrage strategies that can be employed by anyone that is confident and experienced enough to try them.
Put Call Parity
Put call parity is a concept that affects how options are priced and, in theory at least, should prevent arbitrage opportunities arising. The basic principle of put call parity is that options should be priced in a way so that positions with similar risk and payoff profiles should expire with the same profit or loss.
The reason this concept should prevent the possibility of arbitrage is that if put call parity is in place then you wouldn't be able to short one position and be long on the other and be guaranteed a profit. Technically, this means that options should be priced in a way that the extrinsic value of calls and puts on the same underlying security, with the same strike price, and the same expiration date should have equal extrinsic value.
In reality, maintaining put call parity in every imaginable circumstance is essentially not feasible. It's actually the responsibility of market makers to maintain put call parity as well as is can be, but deviations are impossible to avoid completely. It is when those deviations occur that arbitrage opportunities emerge.
Quadruple witching is the term used in the United States to describe the third Friday of March, June, September and December. These are the days when index futures, stock futures, index futures options, and stock options all reach their final trading day. Although the final trading day for most stock options is the third Friday of every month, it is the third Friday of the last month of each quarter for the other three instruments. Therefore, the third Friday in each of the months mentioned sees the last trading day for four derivative instruments – which is why the word quadruple is used.
Quadruple witching may not necessarily have any dramatic effect on you because, the markets tend to move in the normal way overall. However, there does tend to be a significantly higher volume of transactions on these days, and higher volatility throughout the course of the day. If you are day trading options then you should be prepared for the fact that these four days of the year do see a lot more activity in the markets.
Level II Quotes
For a large number of traders Level II Quotes (or Level 2 Quotes) aren't particularly relevant, but they can be very useful for very active investors such as those making intra-day trades. Level II Quotes are basically “real time” quotes that the exchanges provide. They detail the exact bid ask spreads that each market maker is offering, and then allows traders to transact with the market maker that has the prices best suited to their trades.
For those that make a number of transactions throughout the day who are looking to make quick trades within small margins have the ability to get the most advantageous prices by using Level II Quotes. This can be a very helpful tool. However, Level II Quotes are largely irrelevant and an unnecessary complication to those that take slightly longer term positions, such those that are swing trading.
The basic definition of hedging is that it's a form of protection against potential loss; it's essentially a technique that is used to reduce, or even eliminate, risk. Car or household insurance, for example, is a form of hedging because you pay insurance premiums to prevent against loss or damage. In financial terms, it's the process of entering a position to protect another existing position.
For example, if you owned Company X stock and didn’t really want to sell that stock, but had some concerns that the stock might fall in value, you could buy puts on that stock. If the stock did then fall in value, you could exercise your option and sell your stock at a more favorable price.
Although most long term investors don’t use this technique, it's a very powerful tool for short term investors. As such, hedging is commonly used in options trading; whether it's used to protect against a portfolio of stocks or to protect against another options position. In fact, most of the strategies you will learn about actually use hedging in one form or another, and it is a concept that you should definitely try and understand.
You can read more on about hedging here.
Open interest refers to the number of open options positions that exist in the market at any time. It's often confused with trading volume, but it's actually quite different. Like volume, open interest is a good indicator of the liquidity of a particular contract so it is something that is well worth becoming familiar with.
You can read more about the subject on this page.
Although it's quite possible to trade options profitably by using straightforward techniques and simply taking single positions on various contracts, the most successful traders use more complex strategies that involve multiple positions effectively combined into one. The positions that are combined are known individually as legs.
Traders will often try and execute the necessary transactions on each of the legs simultaneously, but this isn't always possible. The process for making the transactions for each of the legs separately is known as legging, and this is an important technique to understand if you are using some of the more complicated strategies.
For a more detailed explanation, please click here.
In financial terms, a synthetic position is basically creating a position using one financial instrument, or a combination of financial instruments, to replicate the position of another financial instrument. This might sound a little complicated, but the concept is actually relatively straightforward and there are a few reasons why creating a synthetic position is advantageous.
There are a number of options trading strategies that involve creating synthetic positions, and indeed many traders create synthetic positions without necessarily realizing it. It isn't really a concept that is essential to understand, depending on the style and strategies you are using or planning to use. However, it can be useful to be familiar with the basic concept.
You can read more about synthetic positions on this page.
Option pain, which is also known as maximum pain, is based on something of a controversial theory that the price of the underlying stock of options contracts can be, or is, manipulated in some way to ensure that the most amount of contracts expire out of the money.
Basically, the price of the underlying stock which would cause the most amount of loss to holders of contracts is known as max pain or option pain. It is a theory that is easy to discount for many, and it is certainly not a subject that you must definitely concern yourself with, although there are those that believe it is possible to profit from option pain.
For more information on this subject, please click here.
Rolling is a technique that essentially involves closing one options position and opening another position on the same underlying security using options contracts with different terms. There are three different forms of rolling; rolling forward, rolling up, and rolling down. They each have their own uses. The main use of rolling is as a tool to manage positions, and it's typically to try and maximize profits.
You can read more about this technique here.