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chapter2/6 more definitions

Chapter 2

More Definitions

Here are a few more definitions required for a complete understanding of the next chapter.

• long - a position with a net positive quantity. A long position is not necessarily a bullish position. A long PUT profits from a decline in the underlying stock price, and is therefore bearish.

• short - a position with a net negative quantity. In the stock and option markets, it is possible to sell a security you do not already own. A short sale of a stock is effectively borrowing a stock with the obligation to buy it back later, hopefully at a lower price. In the options market, short selling an option is writing a contract to deliver the underlying security, if the option buyer exercises the option.

• Option Chain - the list of all the options associated with the same underlying security.
• American Style - an option that can be exercised at any time
• European Style - an option that can only be exercised at expiration
• Exercise - to invoke the right associated with the option contract, i.e. to take a position in the underlying stock by exercising the right of the option contract
• Early exercise - invoking the right of the option contract before expiration
• Assignment - being forced to deliver the underlying stock to fulfill the obligation incurred when writing an option contract
• Theoretical price - The computed price of an option, independent of the actual market price . The theoretical price is often computed and compared to market prices in an effort to find disparities in market prices.
• Historical Volatility - the measure of the likelihood of a stock price to change. This is typically expressed as the annualized standard deviation of price changes in the underlying stock for a period of 3,6 or 12 months.
• Implied volatility - the volatility which is computed using the current market price, and other known, fixed model inputs. For example, if the theoretical price can be computed using a formula where the volatility is known:

price = f(historical_volatility, strike, term, rate, yield)

then the volatility can be computed using a similar formula if the price is known

implied_volatility = f(price, strike, term, rate, yield)

The factors effecting option prices are discussed in Chapter 3.

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