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February 6, 2014

Option Prices and Earnings

With earnings season in full gear and major players like Priceline.com and Tesla ready to announce soon, it is probably a good time to review how option prices are influenced.

Perhaps the most easily understood of the options price influences is the price of the underlying. All stock traders are familiar with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but it is sufficient to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.

The price influence of time is easily understood in part because it is the only one of the forces restricted to unidirectional movement. The main reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.

The third price influence is perhaps the most important. It is without question the most neglected and overlooked component; implied volatility. Because we are in the midst of earnings season, it can become even a greater influence over the price of options than usual. Implied volatility taken together with time defines the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to price of the underlying

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and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can ebb and flow as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).

New traders beginning to become familiar with the world of options trading should spend a fair amount of time learning the impact of each of these options pricing influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over an

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earnings announcement.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 2, 2014

A Few Pennies Can Make a Difference

One of the more difficult problems with which to deal for an options trader has historically been the broad bid-ask spreads quoted for options. I often refer to them in class and depending on how large the spread, it may keep me out of a potential trade. Experienced traders have routinely negotiated the bid-ask spreads downward with varying success when trading individual positions, but the non-economic price has been the significant effort and time required to achieve these negotiated results.

Beginning in January 2007, Chicago Board Options Exchange (CBOE) initiated a Pilot Program to reduce bid-ask spreads to as

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low as 1¢. As of the beginning of this year, there are currently around 360 in the series (including such big names as Apple (AAPL), Google (GOOG) and more) quoted in these penny increments. CBOE maintains an Excel file of option series currently included within this “Penny Pilot” program.

Because option positions are frequently constructed with several individual legs, the impact of the ability to trade with tighter bid-ask spreads can

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have significant impact on the aggregate slippage of positions. Combined with the falling commission rates resulting from the increasingly intense competition among brokers specializing in options, significant trading efficiencies have resulted. Looks like a great situation for an option trader to be in.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 11, 2013

Options and Math

One of the greatest advantages of options trading is its extreme flexibility in both the initial construction of positions and in the ability to adjust a position to match the new outlook of the underlying. The trader who limits his or her world to that of simply trading equities and ETF’s can only deal in terms of short or long. A change in an outlook often requires starting a new position or exiting the old one. The

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options trader can usually accommodate the newly developed outlook with much more fluidly, often with minor adjustments on the position in order to achieve the right fit with the new outlook.

One concept with which the trader needs to be familiar in order to construct the necessary adjustments is that of the synthetic relationships. Most options traders neglect to familiarize themselves with the concept when learning to trade options. This concept arises from the fact that appropriately structured option positions are virtually indistinguishable in function from the corresponding long or short equity/ETF position. One approach to remembering the relationships is to memorize all of the relationships. It may be easier to do this by remembering the mathematical formula and modifying as needed.

For those who remember high school algebra, the fundamental equation expressing this relationship is S=C-P. The variables are defined as S=stock, C=call, and P=put. This equation states that stock is equivalent to a long call and a short put.

Using high school algebra to formulate this equation, the various equivalency relationships can easily be determined. Remember that we can maintain the validity of the equation by performing the same action to each of the two sides. This fundamental algebraic adjustment allows us, for example, to derive the structure of a short stock position by multiplying each side by -1 and maintain the equality relationship. In this case (S)*-1 =(C-P)*-1 or –S=P-C; short stock equals long put and short call.

Such synthetic positions are frequently used to establish positions or to modify existing positions either in whole or part. You might have not liked algebra when you were in school, but applying some of the formulas can help an options trader exponentially!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 10, 2013

What Makes a Great Trader Part II

A few weeks ago we talked about traders really being committed to reaching their trading goals. This time we’ll go over why an options trader needs a trading plan and a few general guidelines. If you really want to improve your trading in heading into this fall trading season, you should absolutely to do this but be forewarned; this is the part nobody wants to do. Most options traders think that their trading plan is in their head and that all they need is a proper options education. “I know what I need to do when I need to do it” most beginning and some veteran options traders will exclaim. If it was just that easy, everyone would be a great options trader. Unfortunately it is not. That is specifically why you need a written options trading plan. Just because you know what to do doesn’t mean you will do it. And that is the key!

Before you even begin to write your options trading plan, you must take an inventory of yourself. What are your strengths and weaknesses? You must take the time to truly examine yourself and be honest about whom you are. Your options trading plan must match your personality. You will probably discover more about yourself that you were bargaining for.

The first thing you need to do to start your options trading plan is to write down your goals like we talked in a previous blog. Once you do this, it brings everything into perspective. The same reason you need to write down your goals is the same reason you need to write down your options trading plan-so your thoughts are transformed from the subconscious to the conscious. It does not matter if you write the plan on a nice piece of paper or a cocktail napkin. It just needs to be written down in your own words.

The next section of your options trading plan will be money management. This is one of the most crucial and often overlooked components of successful options trading. How much are you going to risk per trade? What are your weekly or monthly profit targets? What are the maximum losses you are comfortable with on a daily, weekly or monthly basis? All of these questions need to be answered right in this section. A great tip for this money management section is to not worry about monetary goals at first. Concentrate on taking and managing the best possible trades and then after some consistency has been established goals can be set.

Strategies will be the next component of your options trading plan. This will be the meat and potatoes of the plan so to speak. A thing to consider is to start with relatively a few simple strategies (long calls

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and puts) and master them before you write in more complex option strategies into your plan. You need to describe in as much detail as possible the strategy you intend to use. You will probably be making constant changes to this part until you get exactly what you want.

The last section will be the follow up and review. This is when an option trader needs to print out the charts and the option chains and review them. Did I follow my written options trading plan like I said I would? This needs to be done when the market is closed so all your attention can be on the review. You must keep a trading journal and must always acknowledge your winners and more importantly learn from your losing trades. Understanding and watching how the options change in regards to time and the underlying is a big bonus that can be also gained by observing past trades. This in my opinion is invaluable for progressing as an options trader.

Feel free to use this as a general outline of an options trading plan to get you started. If you need more help or more direction, feel free to contact me.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 18, 2013

Earnings and Other Influences of Option Prices

With earnings season in full gear and major players like Apple and Netflix ready to announce soon, it is probably a good time to review how option prices are influenced.

Perhaps the most easily understood of the options price influences is the price of the underlying. All stock traders are familiar with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but  it is sufficient to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.

The price influence of time is easily understood in part because it is the only one of the forces restricted to unidirectional movement. The main reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.

The third price influence is perhaps the most important. It is without question the most neglected and overlooked component; implied volatility. Because we are in the midst of earnings season, it can become even a greater influence over the price of options than usual. Implied volatility taken together with time defines the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can ebb and flow as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).

New traders beginning to become familiar with the world of options trading should spend a fair amount of time learning the impact of each of these options pricing influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over an earnings announcement.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 14, 2013

Baseball, Buying a Car and Iron Condors

With spring training right around the corner, traders should ask themselves this question; have you ever noticed a baseball player warming up before a game? Or watched footage of a baseball player at practice? What are they doing? Swinging a bat. Throwing and catching balls. Running bases. Working on the fundamentals. To be good at anything requires learning the fundamentals and constantly working on them throughout your career.

Option trading is no different. Even traders who have traded for years, who trade complex strategies return to the fundamentals to make their trading decisions. Take trading iron condors. Trading iron condors requires utilizing the fundamentals. Traders who are trading iron condors are trading a fairly complex, four-legged option strategy. They need to be able to visualize the strategy in order to analyze it and ultimately decide whether or not they should be trading iron condors or something else.

Traders trading iron condors should consider the spread from several different perspectives. Specifically, they should consider it as combinations of other spreads. When a trader is trading iron condors, the trader is in fact trading a pair of credit spreads. An iron condor is a put credit spread combined with a call credit spread. That’s one way to look at it.

Trading iron condors can also be considered from the strangle-trading perspective. An iron condor is a short strangle combined with a long strangle with wider strikes. The profit (and risk) comes from the short strangle, while the long one provides protection.

An iron condor can also be thought of as four individual option positions. Traders trading iron condors have a position in a long put, in a short put, in a short call and in a long call. Thinking of trading iron condors from this perspective, in particular, can help traders make adjustment and closing decision more effectively.

And, of course, an iron condor is, well, an iron condor! It is a single strategy in which the risk can be observed on a P&(L) diagram or through the greeks.

This strategy-break-down technique is not just suited for trading iron condors, but for trading all multi-legged strategies. It is an effective analysis technique akin to how car shoppers consider buying a car. They look at the front; then walk around to the side, then the back; they look under the hood and at the interior. All the while, they are considering this one purchase, but just from many different perspectives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 20, 2012

Great Trader Part I

With the holidays in full swing and trading volume falling off, it might be a good time to give yourself a mental break and reflect on your trading. Are you the great options trader you thought you would be by now or have you ever wondered what  truly makes a great options trader? I mean not a options trader that does pretty well, but one that you envy and want to be? Are great options traders just born that way? Does being smarter necessarily give you an advantage in options trading? Is studying charts until you are bleary-eyed from looking at them the secret; or is it just dumb luck on who succeeds and who fails? How does one learn to trade options?

The qualities that you will need to succeed in my opinion are a commitment to success, having a options trading plan and the most important, mastering your emotions—or the psychology of options trading. I believe that options trading is the hardest job in the world (quite possibly the best, but the hardest). That’s why it will probably take you a lot longer than you think before you really get a solid grip on it.

So let’s first talk about your commitment to success. This essentially sounds like the easiest of the three qualities to master doesn’t it? Why does anyone want to become a options trader in the first place? Probably, because they want to become wealthy and very successful. Who isn’t committed to that, right? All you need is some money, charts, and a platform and you are on your way. Almost everyone says they are committed but most people are not because when they find out options trading is work—and it is. They tend to lose their focus and their original goals when the going gets though.

If you are committed to success then you must be committed to reaching your goals. The most important part of having goals is to write them down. If you never write them down they are simply just dreams. We don’t want to dream we are a great trader we want to realize that we are! Only about 2% of Americans write down their goals. Is it really shocking to know that most people never achieve what they want out of life? As “corny” as it may seem, when you write something down no matter what, your thoughts are transformed from the subconscious to the conscious and are now tangible. Your goals have become something you can see and say out loud. If you never write them down they never exist outside of your thoughts.

Let me leave you with this before I end this introduction on how we are going to build a great options trader out of you. I think everyone can agree whether you are a beginning options trader or a more experienced options trader that there are several key components you will need to do to become a standout. Having said this I also know that most of you will not be committed to do this at first. I know I wasn’t. I thought to myself I am too smart and I know how to options trade. I knew it would not be easy but I was unprepared for the results that followed. I’ll give you a hint, they weren’t good. After I decided to fully commit myself and write down my goals did my results finally change. Let’s face it; options trading is a realm like no other. Options trading looks easy and which in turn makes you lazy to work at it. Be committed to your success and write down your goals right from the start will only help you achieve the success you are after that much quicker.

Enjoy the holidays!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 12, 2012

Volatility Events, Predictions and a Piece of Cake

Option trading is easy. Well, let me qualify that statement just a bit. To be fair, options are more complicated than more simple, linear assets like stocks. But there are some elements to options’ pricing that actually make them a little easier to trade from a valuation standpoint. To find out more about this feel free to visit the options information section of our website.

The most important thing to consider is predictability. You probably receive many unsolicited emails telling you how so-and-so can predict the market with 100% certainty and make you a billionaire overnight. On the other side of that coin, there is not a professor alive who will tell you that it is possible to predict the direction of the stock market with any statistical significance. The truth probably lies somewhere in the middle. But one thing for sure: predicting the direction of a stock is though, and you’ll be wrong often.

But, aside from directional implications of the underlying stock, there is an important pricing factor to options that is much more predictable: volatility shifts resulting from expected volatility events. All options have an imbedded component to their pricing relating to expected-future volatility. This is called implied volatility. It can be thought of as the expected future volatility implied by the market.

Sometimes volatility is quite predictable, and therefore, fluctuations in option prices resulting from implied volatility changes can be likewise predictable. So-called volatility events include earnings, Fed announcements, CPI, PPI, Retail Sales, Payrolls, GDP and more. Volatility events are often scheduled far in advance. Just google a financial calendar and see when CPI is scheduled to be released six months from now—you’ll easily find that information. Unemployment figures are always the first Friday of the month. And so on.

When volatility events are imminent, options get more expensive. Why? Hedgers and speculators brace for a potential move by buying options, creating price-pressuring demand. Look at a chart of implied volatility for a typical stock option class and take a look at its value in the few days leading up to earnings. Typically, it will increase right before earnings. Then afterwards, it tends to fall right back to its normal range.

Scheduled volatility events help option traders analyze the ebb and flow of option premium levels with the precision of predicting the moon cycle. But all volatility events are not predictable—only those that are regularly scheduled. Sometimes, volatility events come out of nowhere. Takeovers, CFOs cooking the books, these sort of things can take a trader by surprise.

Though not all volatility events are predictable, the fact that some are provides great value to option traders. Imagine knowing that a stock

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would almost always rise at a certain date every quarter! This makes option trading a little easier than stock trading in my opinion. Maybe not quite a piece of cake; but still advantageous over trading stocks.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 19, 2012

Maximizing Fade Plays With AAPL and Others

Do you feel like you’ve seen this movie before? Trouble in the Europe especially Spain. People in the streets; panic in the market. Is this recent wave of trouble going to last forever? Not likely. Perhaps there is an opportunity to fade this fall. But how should an option trader play the fade to maximize chances of success and maximize option-trading returns? Trade ideas like this are discussed weekly in the MTE newsletter.

The obvious starting point for a trader to fade this fall is to take a positive-delta position. This is fancy options speak for a bullish trade. There are lots of different ways to take a bullish stance given all the various types of option-trading strategies out there. So, the question really is: Which is best?

There are a few major considerations here. First, traders must strive to maximize reward by minimizing risk. In order to do so, option traders must define their expectations. Am I looking for an extreme turn around? A mild retracement? A dead-cat bounce? The more a strategy can be tailored to expectations, the more risk can be controlled and reward can be maximized.

Next traders need to consider implied volatility. This is where option traders can get an edge in their options positions. If implied volatility is high (overpriced), option traders should consider option-selling strategies. If implied volatility is low (underpriced), option traders should consider option-buying strategies.

In the current market scenario we have a situation where if the turmoil in the Europe and Spain subsides, the market should rally somewhat, but it’s not likely to go to the moon. Further, with the levels and implied volatility of individual stocks at inflated levels, it’s easy to find overpriced options. Any clever fader trader should be looking for put credit spreads to sell. Put credit spreads have positive delta and take a short position on implied volatility. Great candidates for this sort of play are AAPL, GOOG, PCLN, et. al. Traders are best off staying away from bank stocks and precious metals that might be adversely affected by European instability.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 18, 2011

If I’d Meant That, I’d Have Said That

To the new option trader, it often seems as if he has entered into the terra incognita of the derivatives world through Alice’s looking glass. Engaging the natives in conversation quickly results in encountering colorful characters who appear not to recognize the same reality from which the traveler has arrived. For those who have chosen to enter this new world, Alice’s conversation with Humpty Dumpty seems particularly familiar wherein he declares: `When I use a word,’ Humpty Dumpty said, in rather a scornful tone, `it means just what I choose it to mean — neither more nor less.’

The nomenclature of options is boundlessly confusing.  While the casual visitor may only notice the broad categories of puts and calls, the serious student soon will come to realize that the detailed nomenclature is confusing and results from the inescapable fact that options have more moving parts than do stocks.   When initiating a stock position, the choices are two:  buy or sell the issue. When initiating an options position, the choices are numerous and not mutually exclusive. The selection of the particular series to trade and the anatomic structure in which to place it is often nuanced.

An individual option’s value is a function of three main factors: price of the underlying, time to expiration, and implied volatility. Furthermore the individual options can be combined into complex spreads composed of multiple positions in an almost limitless variety. It is from this abundance of choice that the word salad of option terminology arises.

I find the terminology paradoxically to find its maximum point of obfuscation when used to describe one of the basic building blocks of options, the vertical spread. Verticals represent a two-legged category of spreads in which one option is bought and an option of a different strike is sold; both positions are taken in the same series month and in the same type, either puts or calls. Strike selection determines the directional bias of the trade as well as the credit or debit status.  Bullish and bearish trades are easily constructed in both puts and calls.

This simple spread results in a chaotic and confusing panoply of names including: bull call spread, call debit spread, bear call spread, call credit spread, bear put spread, put credit spread, bull put spread, bull call vertical, bear call vertical, bull put vertical, and bear put vertical. As if this collection of a dozen names describing four basic trades were not sufficiently opaque, many traders use an implied shorthand description. For example, they may refer to opening a call credit spread as “selling a call vertical”; conversely opening a call debit spread is often referenced as “buying a call vertical”.  The directional bias of the trade is apparent to those having been shown the “secret handshake” by the spread type, call or put, used and the credit or debit status of the opening cash flow.

Unfortunately there is no easy resolution to this nomenclature nightmare.  Various traders use the terms inconsistently and variably for no apparent logical reason.  Such is everyday life in the world of options.

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