Covered call glossary
All-or-none order: A type of limit order with a stipulation of a buy or sell order which instructs the broker to either fill the whole order or don’t fill it at all; but in the latter case, don’t cancel it, as the broker would if the order were fill or kill.
Ask: The price offered by the owner to sell such a security, such as an ETF or an option.
Assigned: The requirement when the seller (writer) of an option receives an exercise notice that obligates him to sell (in the case of a call) the underlying ETF to the holder (buyer) of the option at the option’s strike price. This is done by the option writer’s broker.
At-the-money: An option is at-the-money when the market price of the underlying ETF is at or near the strike price.
Bid: The price a potential buyer is willing to pay for a security, such as an ETF or an option. The highest price a buyer is willing to pay for a given security at a given time; also called Bid price.
Buy to close: A Buy To Close order is the order to make to close a Sell To Open position. It means to close a position through buying that option contract, which simply means to buy back an option contract which you have previously sold short.
Call: An Option which gives the holder the right to buy the underlying ETF at a specified price for a certain, fixed period of time.
Capital appreciation: An increase in the market value of a security.
Capital depreciation: A decrease in the market value of a security.
Capital gain: The amount by which proceeds from the sale of an ETF exceeds the original cost. Occurs when the proceeds from an ETF or an option sale is greater than its cost. When writing covered calls, for example, if you receive $2 per share in premium income and the calls expire worthless, your cost is $0 per share and the capital gain is $2 per share.
Capital loss: Occurs when the proceeds from an ETF or an option sale is less than its cost. When writing covered calls, for example, if you receive $2 per share in premium income and you buy back the calls at $3, the capital loss is $1 per share.
Covered: Implies that the investor who writes a call option owns the underlying ETF, so that if the ETF is assigned the writer has the ETF to deliver to the call holder (buyer).
Covered call option writing: An investment strategy for ETF owners and shareholders of individual companies who are generally seeking a conservative way to increase the income from their shares by selling (writing) calls on the stock they own.
Creation unit: ETFs typically issue in creation unit sizes, from 25,000 to 600,000 shares, in exchange for a predefined basket of underlying index securities. The use of creation units in the construction of ETF shares is critical because they allow for the representation of the underlying assets – the ETF shares, which represent a tiny chunk of a creation share – to be traded intraday. The ability to trade ETFs on an exchange gives them a significant advantage over comparable investment vehicles, such as mutual funds.
Day order: An order to buy or sell a security that expires at the end of the trading day if it is not executed.
Dollar cost averaging: Investment of money at regular or periodic intervals. It is a timing strategy of investing equal dollar amounts regularly and periodically over specific time periods (such as $100 monthly) in a particular investment or portfolio. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time
Exchange Traded Fund (ETF): ETFs represent shares of ownership in portfolios of common stocks that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. By owning an ETF, you get the diversification of an index fund as well as the ability to sell covered calls, sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you’d pay on any regular order.
Exercise: In the case of covered call options, to require delivery of the underlying ETF by the writer (seller) of the options holder (buyer).
Fungible: The term is often used to apply to financial instruments which are identical in specifications. For example, options are highly fungible, since they are highly standardized arrangements.
Good-til-canceled order (GTC): A type of limit order that remains in effect until it is either executed (filled) or cancelled, as opposed to a day order, which expires if not executed by the end of the trading day. A GTC option order is an order which if not executed will be automatically cancelled at the option’s expiration.
Institutional Investors: A professional investment management company. Typically, this term is used to describe large money managers such as banks, pension funds, mutual funds, and insurance companies. Many institutional investors use covered call writing as one of their investment strategies.
In-the-money: A term used to describe an option with intrinsic value. A call option is in the money if the stock price is above the strike price. In the case of covered calls, the strike price of a call option is below the market price for the underlying security or ETF. For example, the call option for an ETF with a strike price of $45 when the ETF is trading at $47 would be $2 in-the-money.
Intrinsic value: The in-the-money portion of an option’s price. For example, if the current market price of an option is $2.5 and the option is in-the-money by $1 and the time value is $1.5. If an option is at-the money or out-of-the-money there is no intrinsic value.
LEAPS: An acronym for Long-Term Equity Anticipation Securities. This means calls and puts with an expiration as long as thirty-nine months. Currently, equity LEAPS have two series at any time with a January expiration. For example, in October 2008, LEAPS are available with expirations of January 2010 and January 2011.
Leverage: A term describing the greater percentage of profit or loss potential when a given amount of money controls a security with a much larger face value. For example, a call option enables the owner to assume the upside potential of 100 shares of stock by investing a much smaller amount than that required to buy the stock. If the stock increases by 10 percent, for example, the option might double in value. Conversely, a 10 percent stock price decline might result in the total loss of the purchase price of the option. The investor hopes to increase the rate of return from an investment by assuming additional risk. Examples of leverage would be buying securities on margin and speculating by purchasing options.
Limit order: A trading order placed with a broker to buy or sell stock or options at a specified limit price or better. Investors would use a limit order to establish a price which they are willing to trade.
Limit price: An order to buy a stock at or below a specified price or to sell a stock at or above a specified price. For an order to write covered calls, this represents the lowest price the investor will accept.
Long-term: Relates to the gain or loss in a security that has been held for a certain period of time greater than a year. For example, to qualify as long-term capital gain under current tax laws, a security must be held for twelve months or more.
Margin: A feature of a brokerage account which permits an investor to borrow funds through the broker to purchase additional securities, thus providing investment leverage, but increasing risk.
Margin call: A call from a broker signaling the need for a trader to deposit additional money into a margin account to maintain a trade.
Market order: Buying or selling securities at the price given at the time the order reached the market. A market order is to be executed immediately at the best available price, and is the only order that guarantees execution.
Odd lot: A unit of trading in securities that is made up of fewer than 100 shares of stock or ETF.
Open interest: The total number of option contracts for an ETF option that are not closed or delivered on a particular day.
Option: A security that represents the right, but not the obligation, to buy or sell a specified amount of an underlying security (ETF, stock, bond, etc.) at a specified price within a specified time.
Option agreement: A signed agreement between an investor who is seeking to open an options account and his or her brokerage firm. This agreement is used to verify the investor’s level of experience and to ensure that the investor clearly understands the various risks involved when trading options. The investor is also supplied a copy of Characteristics and Risks of Standardized Options.
Option chain: For each underlying ETF, the option chain tells investors the various strike prices, expiration dates, and whether they are calls or puts.
Option contract: The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. For stock options, the amount is usually 100 shares. Each option contract has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party.
Option cycle:
A pattern of months in which option contracts usually expire (usually a nine month period). There are three common cycles:
JAJO – January, April, July, and October
MJSD – March, June, September, and December
FMAN – February, May, August, and November
Option Clearing Corporation: The OCC issues all exchange-listed securities options in the United States and guarantees all transactions in those options. The OCC also assigns exercised options for fulfillment, and handles the processing, delivery, and settlement of all options transactions. The OCC is responsible for maintaining a fair and orderly market in options and is overseen by the Securities and Exchange Commission (SEC). It’s jointly owned by the exchanges that trade options.
Ordinary income: Income from sources such as wages, dividends and interest. These items of income do not qualify for special tax treatment. Short term capital gains are also taxed as ordinary income.
Out-of-the-money: An out-of-the-money option has no intrinsic value. A call option is out-of-the-money when the strike price is above the spot price of the underlying ETF. For example, the call option for an ETF with the strike price of $50 when the ETF is trading at 48 would be $2 out-of-the-money.
Premium: Total price of an option: intrinsic value plus time value. The current price at which an option contract trades and the amount a buyer would pay and a seller would receive. Often this word is used to mean the same as time value.
Put: An option contract that gives the owner of an underlying ETF the right to sell at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For the writer of a put option, the contract represents an obligation to buy the underlying stock from the option owner if the option is assigned.
Rolling down: When an investor replaces an old options position with new one at a lower strike price. Usually used when investors are bearish on an ETF.
Rolling forward: To move to an option position with a later Expiration date.
Rolling up: To move to an option position with a higher Exercise price.
Round lot: For common stocks and ETFs the standard unit of trading is a round lot, which is 100 shares or a multiple thereof. Anything less than 100 shares is considered an odd lot.
Securities and Exchange Commission (SEC): A government commission created by Congress to regulate the securities markets and protect investors. In addition to regulation and protection, it also monitors the corporate takeovers in the U.S. The statutes administered by the SEC are designed to promote full public disclosure and to protect the investing public against fraudulent and manipulative practices in the securities markets.
Sell-to-open: The placing of an initial order by an option writer to sell an option in order to establish a position. The writer receives premium income from the buyer of the option. Also referred to as “sell a covered call”
Short position: An investment position where the investor has written an option with the contract obligation remaining outstanding.
Short-term: Relates to the gain or loss in a security that has been held for a certain period of time. Under current tax laws the gain or loss in a security held for less than one year would be short-term.
Strike price: The price at which the holder (buyer) of the call option can purchase the underlying ETF. Also sometimes referred to as the” exercise price.”
Ticker symbol: The abbreviation for an ETF or option used on securities quotation machines. For example, “FFF” is the ETF ticker symbol for the Fortune 500 Index Tracking ETF and “FFFIO” is the option ticker symbol for FFF calls with a September expiration and strike price of $75.
Time value: The difference between the premium paid for an option and the intrinsic value. As an option approaches expiration, the time value erodes, eventually to zero.
Uncovered (naked): implies that the investor who writes a call option does not own the underlying ETF, so that the ETF is assigned the writer must purchase shares at the current market price to deliver to the call holder (buyer). Also known as “naked” because, if the option is exercised, the writer is without shares and is caught naked. If the ETF subject to the call rises significantly, the writer could be exposed to substantial (theoretical unlimited ) losses. This is an extremely high risk strategy.
Unrealized gain: Occurs when the value of the unsold asset rises above the original cost. Also referred to as “paper gain.”
Unrealized loss: Occurs when the value of an unsold asset is reduced below its original cost. Also referred to as a “paper loss.”
Writing calls: Another term for selling covered call contracts on an ETF an investor owns.
