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The Option Trader Decoder Ring: Volatility & Other Trading Jargon

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January 1, 2013
Fundemental Trader Jargon Terms
Fredrik Broden

The jargon of trading is notorious for creating confusion. So for the moment, let’s ditch the textbooks as we decode 5 critical concepts.

1—Liquidity

What a book says: The ability to buy or sell a stock, option, future, or forex, without causing a significant price change.

What a trader says: Imagine a crystal-clear lake. You jump in, you swim with the fishes, 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 the good lake. You can enter and exit your positions quickly. And with less slippage (no pun). Slippage in a word 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 often identify liquid trading products by high volume, open interest, and bid/ask spreads a few pennies wide. 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.

Where to find it: In the thinkorswim® trading platform, go to the Trade page to see the bid/ask prices, and load up the Open Interest and Volume columns. For reference: .01-to-.02 wide bid/ask spreads are very tight; volume in the thousands, and open interest in the tens of thousands, are pretty high.

2—Volatility

What a book says: A measure of the dispersion of the percentage returns of a stock around a mean. (Helpful? Maybe not.)

What a trader says: Volatility in some 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, we're 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?

To convert annual volatility and arrive at monthly, weekly, and daily ranges, a few shortcuts*:

Monthly: divide by 3.5

Weekly: divide by 7.25

Daily: divide by 16

For example, to calculate the range for one month: ((0.30)/(3.5))* $50 = $4.28

$50 + /- $4.28 = One month range of $45.72 to $54.28

Where to find it: In thinkorswim, take a look at the Vol Index, which is the overall implied volatility of a stock's options on the Charts tab. Load the “ImpVolatility” study on a Chart, and you'll see the overall implied volatility level going back to 2003.

3—Probability

What a book says: The likelihood of an event occurring based on a mathematically derived model that describes the distribution of the data set. (Huh?)

What a trader says: No doubt, there's complex math in probability. But 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—what traders and 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.

Keep in mind that 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 its potential magnitude. Although an option might show a low probability of being in the money, it doesn't mean it won't be. A low probability isn't a 0% probability, and also isn't impossible.

Where to find it: On the thinkorswim Trade page, you can see the probability of an option expiring out of the money, as well as the probability of touching, which estimates the likelihood a stock will reach a strike price before expiration.

Where to find it: In thinkorswim, right click on the P/L Open number on either the Position Statement of the Monitor page, or the Profits and Losses section of the Account Statement page, to see the trade prices of the positions in your account. If you're long stock, the trade price will be your cost basis.

4—Cost Basis

What a book says: The original cost of an acquired asset, adjusted for depreciation and capital improvements.

What a trader says: 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. And, 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've probably heard of the 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.

5—Return on Capital

What a book says: A financial ratio derived by dividing operating income by the value of an invested capital.

What a trader says: There's a number on the thinkorswim trading platform called “return on capital” (ROC), seen on the Trade page. It's available for short puts, and short verticals. ROC takes the mid-price of the put, or call, or put vertical, and divides it by the capital required to take the position. (To learn about the capital requirements for positions, read the Margin Handbook. ROC shows you the percentage return if the position makes a maximum profit at expiration. (The number is not annualized, and shows only a theoretical best-case scenario.) If the position loses money, or has a profit less than the max, you won't earn that ROC. But, ROC lets you compare two strategies to see how effectively they might use capital. ROC quantifies a received credit, and compares it to the required amount of capital.

For example, if there are two out-of-the-money puts on the same stock with adjacent strike prices, the ROC lets you compare the potential return for a given probability. Even though the probability might be higher for the further out-of-the-money put, the ROC might be lower.

Traders bullish on a stock might balance the probability of expiring worthless on a short put with its ROC.

Where to find it: Return on capital, and return on risk, are columns available on the Trade page of thinkorswim, where you can see them for short puts and short verticals.

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