  1: Options Terminology Equity, stock, shares - All three of these refer to actual ownership in the underlying company. This gives you the right to vote at meetings, and receive dividends the company pays from time to time. Equity option, stock option, option - Owning an option gives you the right (but not the obligation) to buy or sell shares of the underlying company at a fixed price by a certain date. All equity options have three important characteristics. One, each option is related to only one "underlying company". Two, each option has an expiry date, after which it becomes worthless if not exercised or sold. And three, each option has an exercise price - the price at which the owner has the right to buy or sell the shares at. Owning an option in a company does not give you any ownership rights to the company itself. You cannot vote at meetings and you do not receive dividends. Each option usually represents 100 shares of the underlying company. If you buy 1 option, you are usually buying the right to buy or sell 100 shares of the underlying stock. Call option - Gives the owner the right (but not the obligation) to buy shares of stock at a fixed price by a certain date. Put option - Gives the owner the right (but not the obligation) to sell shares of stock at a fixed price by a certain date. Long - Indicates that you bought something. If you are "long 100 shares of IBM", you are saying you own 100 shares of IBM. If you are "long 1 IBM call option", you own 1 call option on IBM. Short - Indicates that you sold something you didn't own. If you are "short 100 shares of IBM", you are saying you borrowed 100 shares of stock from your broker and sold those shares, hoping to buy them back later at a lower price. If you are "short 1 IBM put option", you wrote an IBM put option, giving someone else the right to sell IBM in exchange for a premium. Premium - The money you receive for selling options. Or the price you pay for purchasing options. Strike, Strike price - The fixed price at which an option may be exercised. If you buy an IBM call option with a strike of 55, that means you have the right but not the obligation to buy IBM at $55 per share any time up until expiration. Intrinsic Value - For call options, its the amount the strike price is below the current market price. If the strike price is above the current market price, a call option has zero intrinsic value. For put options, its the amount the strike price is above the current market price. Again, put options with strikes below the current market price of the underlying stock have no intrinsic value. Time Value, TV - The difference between an options price and its intrinsic value. On expiry day, there is theoretically no time value in an option, so an option is only worth its intrinsic value. Time value is generally large for options with far away expiry dates and decreases slowly as an option gets closer to expiry. In the Money, ITM - Options with intrinsic value greather than 0. Or, put another way, call options whose strike price is below the current market price for the stock and put options whose strike price is above the current market value. At the Money, ATM - Options at or near the current market value of the stock. For instance, if the stock is at $49 1/4. then you could say that options with a 50 strike price are "at the money". Out of the Money, OTM - Any options with no intrinsic value are out of the money. Call options with strike prices above the current market, or puts with strikes below. If options are out of the money on expiration day, they are worthless. Expiration date - Every option has an expiration date. Usually, this date is only expressed as either the month (ie: Dec), or a month and year combination (Jan 2002). The actual date of expiration is the Saturday after the third Friday of the month. Exercising options - If you own an option, you may exercise it at any time between the current date, and the expiration date (see above). If you own an IBM Call option with a 55 strike price, and wish to purchase IBM at $55 a share, you normally inform your broker that you wish to exercise that option. He will deduct $55 x 100 = $5,500 plus comissions from your account and you will be the proud owner of IBM at $55 a share. Of course, if IBM is trading at $100 a share at the time, you will have an instant profit of 81% on those shares. If IBM was trading at only $50 a share at the time, you probably wouldn't want to exercise your option in the first place, as it would be cheaper to buy IBM on the stock market directly! If IBM was $50 at expiration of your option, your option would not be worth anything. Spread - It is using offsetting option positions to limit you risk. Debit Spread - A spread which you pay money to initiate. Your maximum loss is generally the amount you paid for the spread. Credit Spread - A spread which is initiated for a credit - puts money in your account. Your maximum profit is generally the money received for the spread. Bull Spread - A spread in which you profit if the underlying stock goes up in value by expiration. Usually implemented as a vertical spread (see below). Bear Spread - A spread in which you profit if the underlying stock goes down in value by expiration. Usually implemented as a vertical spread (see below). Volatility Spread - A spread in which you profit regardless of if the underlying stock goes up or down, as long as it doesn't stay the same. Vertical Spread - Selling an option for one strike price, and purchasing an option on same stock and the same expiration date at a different strike price. Calendar Spread, Time Spread - Selling an option for one strike price, and purchasing an option on same stock and the same strike price at a different expiration date. Straddle - A trading position involving Puts and Calls on a one-to-one basis in which the Puts and Calls have the same strike price, expiration, and underlying stock. A long straddle is when both options are owned and a short straddle is when both options are written. Strangle - A Straddle where the Put and Call options have different strike prices. The call options are generally bought above the current stock price (out of the money), and the put options are generally bought below the current stock price (also out of the money). ©2001 xguru, Inc. A Cardinal Factor Company. All rights reserved. |
