Because options deal with (1) the underlying security, (2) a strike price, (3) a premium, and (4) a limited time, and because they are often traded in groups (combinations) that are described with special names, the vocabulary of options becomes important. So we start there.

ALWAYS REMEMBER, HOWEVER, THAT THE OPTION IS A BUNDLE OF RIGHTS IN AND OF ITSELF - NOT AN APPENDAGE TO THE UNDERLYING STOCK. THINK OF AN OPTION AS IF IT WERE REPRESENTED BY ITS OWN �CERTIFICATE� WHICH FLUCTUATES IN PRICE LIKE STOCK CERTIFICATES DO.

Understanding the Terminology: 12 Key Terms

The following discussion is very basic and certainly not thorough. More complete discussions of option writing are available in many publications, including the pamphlet distributed by the Chicago Board of Options Exchange to everyone who opens an options account with a member firm. Brokers also have access to discussions in their company�s procedure manuals. But the following brief summary is all one needs to understand options. It is presented in accordance with my personal views of what the important concepts of option writing are, and how they should be conceptualized. Reading definitions is no fun, but a basic understanding of the vocabulary is essential to further understanding of the concepts.

I classify options into four categories: STOCK CALLS, STOCK PUTS, INDEX CALLS, and INDEX PUTS. Some texts on options that I�ve seen properly define PUTS and CALLS and then assume that a Put and a Call on an index fits the same definition and a stock Put or a stock Call. Because I think that the risks and strategies involved in Puts and Calls on stocks are very different than those on indices, I recommend thinking about these four kinds of options as if they were four different pieces of paper, like stock certificates, each representing a different kind of investment.

When talking about an option, the option should be designated by the underlying security, its termination month, its strike price, and its type. For example - one Ford Jan 35 CALL is an option to buy 100 shares of Ford Motor Co. At $35 per share until the end of the third trading Friday next January (Figure I.) With that basic information in mind, here is a brief definition of the dozen basic option terms for repeated reference:

Figure 1: This figure shows an option listing from the Wall Street Journal. The listing is one line of the options on the XYZ Motor Company. The day preceding this listing, XYZ stock closed at $32 per share. The strike price illustrated is $35 per share. Call options with a strike price of $35 for October last traded at 0.125^. This means that an XYZ October 35 call would cost 100 times 0.125 or $12.50 plus commission. The November XYZ 35 Call option last traded at 0.25 and the January at 0.625. Note that the November Put is not priced�it is restricted.

1. CALL

One stock Call is a right to buy 100 shares of stock at a particular price until a specified time. We saw the Call in action with our friend the wine producer. He bought a Call to be sure he could acquire his grapes at a maximum of $1,000 per acre.

If I own one Ford January 35 Call, I have the right to buy 100 shares of Ford Motor stock at $35 per share through the close of the business day of the third Friday of the following January. Alternatively I can sell the Call itself. If I own such a Call, someone sold it to me. That person has committed to sell 100 shares of Ford stock to me if I exercise my option. If I exercise my option, the stock is said to be �called away� from the seller.

The seller of the call is obligating himself to sell the stock at the strike price. This seller might already own Ford stock and have sold a Call against it, or the seller, if called, may have to go into the open market and buy the stock to �cover� the position. If the stock has moved up significantly above the strike price, this �uncovered� seller will lose the spread between $35 and the price he has to pay to acquire the stock and deliver it to the holder of the call.

There is no certificate issued to represent the option. It is merely an entry on your broker�s books. Only the �confirm� you receive from your broker, and your broker�s credit, guarantee you the option rights.

2. PUT

One stock Put is a right to sell 100 shares of stock at a particular price until a specified time. In our wine story, this would exist if the grower paid the producer $100 per acre for the right to sell the producer the grapes produced for $1,100 per acre. The grower would thus have protected himself from a price decline below $1,000 per acre, and the producer would have collected $100 per acre in exchange for the contingent promise to purchase at a price he can afford to pay.

Similarly, if I own one Ford January 35 PUT, I have a right to sell 100 shares of Ford Motor stock at $35 per share at any time through the expiration date. The person that sold the PUT to me has become obligated to buy the stock. As with the CALL, I can also sell the PUT itself at any time during its life (Figure 1.) I may already own the 100 shares, and have bought the PUT to protect its value. Alternatively, if I do not own the stock and if the stock price goes down during the option period, it will pay me to purchase the stock and then �put it� (sell the stock by implementing the PUT) to the buyer at the higher ($35) price. The result of the transaction will be that I sold high, then bought low, which never hurts! On the other hand, if I SOLD the put at 35, I guaranteed to buy it at that price. Thus, if the stock goes down during the option period and does not recover, if exercised (and you can bet it will be) I will have to buy the stock at 35 even if the market price is below that figure.

3. INDEX CALL

The S&P 100 index is described below. For the moment it is sufficient to understand that an index CALL gives the buyer the right to collect a varying sum of money until a specific time, as the index rises above a specific number. For example, if I buy one index CALL at $300, and the index goes up to $310 before the CALL expires, I instruct my broker to exercise the CALL and my broker will put $1,000, less transaction costs, into my account. This is because one call is equal to 100 shares, the price of each share went up $10, and therefore �10 times 100 shares equals $1000. Alternatively, if the index goes to $290, nothing happens: I bought the CALL, and paid my premium to the seller who took the risk. Since the index did not go up, I just lose the premium that I paid for owning the option. Because it is an index, I do not in fact buy or sell the actual stocks that make up the index. I am only dealing in money.

The index call seller is betting the other way. If the index goes up during the period of the option, this seller is liable for the increase. But if the index declines, he just keeps the premium he acquired in the sale.

4. INDEX PUT

An index PUT gives the buyer the right to collect a varying sum of money, until a specified time, as the index falls below a specific number. Thus, if I buy an index 300 PUT, and the index goes up, I lose my premium. If the index goes down, I make $100 for each point it goes down upon exercise or expiration. I can exercise my option at any time until it expires. If I wish, I can �close out� the position before it expires. If I own the position I can sell it at the market price, and if I have sold the position I can �buy it back� at market price at any time, unless market liquidity is affected by special events, as happened during the crash of 1987. Then you might not be able to buy or sell for some period of time.

The person on the other side of the trade, the seller of the index put, is in a reverse position (but with more risk, as we�ll see below). This seller is liable for $100 for each point that the index declines. If the index goes up, this seller just keeps the premium he collected from the sale.

Figure 2: This figure illustrates at-the-money, in-the-money, and out-of-the-money calls and puts on a $20 stock.

5. STRIKE PRICE

We have talked about the �strike price� in the previous examples. The �strike price� is either the dollar value of the stock, or the number of the index, specified in the option. Thus, in the examples above, when we talked about a Ford 35 CALL, the strike price is $50. When we talked about an index option at 300, the strike price is $300.

6. TERMINATION DATE

The �termination date� is the date on which, at the close of business, the option rights expire unless exercised. Most options expire at the end of the third Friday of the designated month. Note that you can exercise an option (or be put or called, if you are the seller) at any time during the life of the option - not only at the end of the period. Also note that you must initiate some action through your broker, or else the option may expire worthless even if it still has value!

7. AT-THE-MONEY

An option is �at-the-money� when the actual present dollar value or index number is the same as the strike price specified in the option. The option is �in-the-money� when the stock or index price goes past the strike price in the direction of profit for the holder; and the option is �out-of-the-money� when the current price is not yet at the strike price, in the direction of the loss for the holder. These terms are illustrated in Figure 2.

8. COMBINATION

A �combination� is a strategy where more than one set of related option rights is held at the same time. A �spread� is a particular type of combination. In addition to spreads, one common combination for option traders is to buy or sell an out-of-the-money CALL and an out-of-the-money PUT on the same security at the same time. This combination is described in greater detail in Part IV below.

9. TIME VALUE PREMIUM

�Time value premium� is the market value of the option excluding �intrinsic value� as illustrated in Figure 3. Time value premium is what the conservative option seller is trying to capture. Time value premium is really what the market thinks the underlying option rights for the future are worth. Thus, when an option is �out-of-the-money� the market price is 100% time value premium. This is covered in more detail below.

Figure 3: This figure illustrates a Time Value Premium (T.V.P) for an out-of-the-money call with a strike price of $30. The Time Value Premium goes up as the price of the stock gets closer to the strike price ($30), but declines with time.

10. INTRINSIC VALUE

�Intrinsic value� is the amount of money, excluding �time value premium,� which could be realized from the sale of an option at a specific point in time as illustrated in Figure 4. Another way to look at intrinsic value is that it is the value than can be realized today, before any additional value is added for the possible profits in the future.

For example, if Ford Motor stock is at 35, and the 34 call is selling at $3, the intrinsic value is $1 and the time value premium is $2. This is because the owner of the call has a right to buy the stock at $1 below market value, but the option value is $2 higher than this price differential. If there is no other change in the market price, on the last day of the option, when there is no more �time value premium� because time has run out, the option will have a value of $1.

11. LONG AND SHORT

We speak of a holding as �long� when we own the position. To own a position means that you have purchased it, whether voluntarily or involuntarily. Accordingly, if you buy a Call you are long that Call. If you sell a Call, you are short that position., If I say �I am long the Ford 55's and short the Ford 50's,� that means that I bought the Ford Calls at a strike price of 55, and sold the Ford calls with a strike price of $50. I would then have to specify the termination date to fully describe my position. If I also own the Ford stock, I can be described as �long Ford.� If I own 1,000 shares I might describe it as �long 1,000 shares of Ford.�

When you sell calls, such as the Ford 50�s, we say that you are �short the Ford 50�s.� When you sell an option it is sometimes referred to as �writing� the option and the seller is referred to as an �option writer.�

Figure 4: Intrinsic Value and Time Value Premium for an in-the-money call with a strike price of $20. The Time Value Premium shrinks with time while the intrinsic value changes with the stock price. If the option were not so far in-the-money, the Time Value Premium would fluctuate more as the stock price approached the option strike price.

12. COVERED, HEDGED, AND NAKED

These are three terms that are related, and are easier to learn if learned at the same time. Naked is easy if you know the other two terms: it means that the position is not covered or hedged. For example, if you just sell a call, and you don�t have any protection against the unlimited potential loss of an increase in the underlying stock (just as owning the stock), you hold that call �naked.� Hedged is a very broad term that includes the condition of being covered. Hedged just means �protected.� Covering is one way to protect. If you sell a call, and you own 100 shares of the underlying stock, you are covered by the stock. That cover is a type of hedge. Another way to hedge your potential loss might be by buying a different call, creating a �spread��something we will discuss below. Hedging is a very broad term, and includes some very imperfect hedging devices, such as holding stock in a different company but which is in the same industry group.

REMEMBER: OUR EXAMPLES DEAL WITH 1000 SHARES OF STOCK, WHICH EQUATES TO 10 OPTIONS. IN REAL LIFE, HOWEVER, YOU CAN WRITE OPTIONS WITH AS LITTLE AS 100 SHARES (ONE OPTION) OR ANY OTHER AMOUNT THAT IS DIVISIBLE BY 100.