If the writer creates and sells an option without owning the underlying asset, this is called a naked call. Uncovered call and short call are both synonyms to naked call.
A naked call comes with great risk for the writer, because the underlying asset might have increased significantly in value when the holder of the option decides to exercise the option. There is really no limit for how expensive an underlying asset can become, which means that it can be very expensive for the writer to honor this obligation. Because of the inherently high risk, most exchanges, brokers and clearinghouses will require a lot of collateral to be placed in the margin account by anyone wishing to write uncovered options.
The opposite of a naked call / short call / uncovered call is the covered call, where the writer of the option owns the underlying asset.
Open outcry is the traditional way of making purchases and sales on the exchange floor. Traders gather and communicate bids, offers, acceptances and other trading information with each other by shouting and using hand signals.
Today, most exchanges do not have pits for open outcry. Electronic trading systems are used instead.
In finance, the option contract is a financial instrument that gives the holder a right, but not an obligation to carry out a certain transaction on or before a certain date.
- A call option gives the holder the right to purchase a specific amount of a specific asset for a predetermined price (the strike price). This asset is the call option’s underlying asset.
- A put option gives the holder the right to sell a specific amount of a specific asset for a predetermined price (the strike price). This asset is the put option’s underlying asset.
When you can carry out the transaction depends on the type of option. The two most common option types are the American style option and the European style option. A European style option can only be exercised on its expiry date (also known as maturity date). An American style option can be exercised on any day until it has expired.
The creator of an option is called the writer. The writer is the original seller of the option and is the one that must honor the option should the holder of the option chose to exercise the option.
Trading over-the-counter (OTC) is to carry out a trade outside any of the exchanges. Many financial instruments can only be traded OTC, since they aren’t listed on any exchange. There are also financial instruments that are traded both on exchanges and OTC.
In finance, physical delivery is when a contract (e.g. an option) is settled by actual physical delivery of the underlying asset.
Today, physical delivery is unusual, since it is easier to just trade out instead, using offsetting contracts. One exception is situations where the underlying asset is a commodity, e.g. crude oil, coffee, rubber, gold, sugar, etc.
A put option gives the holder a right, but not an obligation, to sell a specific asset to the writer of the put option for a predetermined price.
The opposite is a call option, which gives the holder a right to buy instead.
Selling short is when you borrow an asset and sell it, hoping that it will have decreased in market value by the time you must return the borrow asset.
Example: You borrow 100 shares in company TTT from your broker. Their current market value is $10 a share, so you sell 100 shares for $1000 to a third party. Two weeks later, it is time for you to return 100 shares in TTT to your broker. The market value for shares in TTT is now $8. You purchase 100 shares for $800 and give them back to your broker. If we disregard transaction fees etc, you have made a $200 profit.
Selling short is risky. If the market value for shares in TTT had not decreased, but instead increased from $10 to $25, it would have cost you $2500 to purchase 100 shares when it was time to return 100 shares in TTT to your broker. You would have made a $1500 loss.
Since there is no limit for how high the market value for an asset can go, there is no limit to how much you can lose when selling short.
Settlement price in derivative markets
The settlement price in derivative markets is the average price for which a certain contract trades during a predetermined period of the day. The settlement price is used for determining profit or loss for the day, and for calculating margin requirements.
On the Chicago Mercantile Exchange, the predetermined period of the day is 15:14:30 – 15:15:00 CDT (Central Daylight Time), and the settlement price for an equity is determined by a volume weighted average of trading activity.
See naked call
A spot market is a market where assets are sold for cash and delivered right away. The payment for the asset can be made right away, or within a few bank days.
When it comes to commodities, the commodity is normally not delivered right away since that may be logistically impossible or prohibitively expensive. Instead, spot market purchases of commodities will typically require the commodity to be delivered within one month.
Spread (Bid – Offer)
The spread (bid – offer) is the difference between the bid (buyers) and offer (sellers) on a quote. The difference is shown in price or points.
Straddle is an options transaction where the investor is in a long position in a put and in a call at the same time. The put and the call must have the same exercise price and the same expiration for it to be considered a straddle.
A strangle is a long put + a long call, where the exercise price of the long put is lower than the exercise price of the long call.
Strap is an options transaction consisting of two long calls + one long put. All three have the same expiration and the same exercise price.
Strip is an options transaction consisting of two long puts + one long call. All three have the same expiration and the same exercise price.
The swap is a derivative where two counterparts agree to temporarily exchange cash flow streams. Each stream is called a leg.
In many swaps, at least one of the legs will be a cash flow stream that is highly affected by the price of a certain commodity or the exchange rate of two particular currencies.
Swaps were developed for risk mitigation (hedging) but is today traded by speculators as well. Swaps are usually traded over-the-counter, since there are few exchanges that lists swaps. Exceptions include the Chicago Mercantile Exchange, the Chicago Board Options Exchange, the Intercontinental Exchange and the Eurex AG.
In finance, synthetics are customized hybrid instrument. An underlying bond or note is amalgamated with either an options contract or with a futures contract.
Synthetic futures are created by combining a long call and a short put.
Traditionally, an exchange would have an area on the trading floor designated for trading with voice and hand signals. This was called the trading pit. The trading pit was usually an octagon.
The brokers would gather in the trading pit to carry out their respective clients’ buy and sell orders. The brokers would wear special jackets and badges to show each trader’s brokerage affiliation.
Outside the pit, there would be clerks to which the clients could send their orders throughout the day. A runner would bring the information from the clerk to the broker in the pit.
To improve visibility in large exchanges, the trading pit would consist of several tiers.
Today, electronic trading platforms have replaced the traditional trading pit at most exchanges.
See naked call
A classic warrant will give its holder the right, but not the obligation, to purchase the underlying asset at a predetermined price. A classic warrant is issued in conjunction with a bond, a so called warrant-linked bond. They underlying asset of a classic warrant is stock in the entity that issued the warrant-linked bond.
Today, there are many other warrants available in addition to the classical warrant. There are for instance naked warrants (warrants issued without being attached to any bond) and put warrants (warrants that give the holder the right to sell).