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Options Trader Glossary

Opening Transaction: Let's start with a blank page, because that's what an opening transaction implies! An opening transaction can involve either the purchase or sale of an option contract. If you have no position and you buy five Microsoft calls, you have an opening transaction. The options you've purchased must be closed out one of three ways:

• You simply let the worthless option expire.
• You sell the five contracts in Microsoft.
• You exercise your right to convert the five call contracts into 500 shares of Microsoft (MSFT) stock.

The investor who has no position in Microsoft and sells five Microsoft calls has opened a position from the short side. The options you've sold must be closed out one of three ways:

• You simply let the worthless option expire.
• You buy back the five contracts in Microsoft.
• You get assigned and your five short contracts convert into 500 shares short of Microsoft stock.

Call Options: A call option gives the owner the right to buy a stock at a specific price on or before a certain date. Call options increase in value as the value of the underlying stock increases in value.

When you buy a call option, the price you pay for it (called the option premium) secures your right to buy that certain stock at a specified price, called the strike price (or exercise price). If you decide not to use the option to buy the stock -- and, as an option buyer, you are not obligated to do so -- your only cost is the option premium.

Put Options: A put option gives the owner the right to sell a stock at a specific price on or before a certain date. Put options increase in value as the value of the underlying stock declines.

When you buy a put option, the price you pay for it (called the option premium) secures your right to sell that certain stock at a specified price, called the strike price (or exercise price). You do not have to own the underlying stock to buy a put, as you can simply close the option trade directly without exercising the option. If you decide not to use the option to sell the stock -- and you are not obligated to do so -- your only cost is the option premium.

Closing Transaction: A transaction by which a person reduces, or cancels out previous position, either as the buyer or the seller of that option. In the examples above, the option buyer executes a closing transaction by selling his or her calls, while the option seller, also known as a writer, executes a closing transaction by purchasing his or her shorted calls back.

Long and Short: Long refers to a position as the option holder or buyer. Short refers to a position as the option seller, which is also known as the writer.

At-the-money: The current market value of the underlying stock is the same as the exercise price of the option. For instance, if the current price of IBM (IBM) is $130, the IBM 130 Call (strike price of $130), is "at-the-money." This works the same for calls and puts, so the IBM 130 Put would also be the at-the-money option.

In-the-money: A call option is said to be "in-the-money" if the current market value of the underlying stock is above the option's exercise price. A put option is in-the-money if the current market value of the underlying is below the exercise price (for calls) or above it (for puts). For instance, if IBM is trading for $130 a share, then the IBM 125 Call (strike price is $125) and IBM 135 Put (strike price is $135) are in-the-money.

Out-of-the-money: A call option is said to be "out-of-the-money" if the current market value of the underlying stock is below the option's exercise price. A put option is said to be out-of-the-money if the current market value of the underlying shares is above the exercise price; a call is out-of-the-money if the strike price is higher than the market value. For instance, if IBM is trading for $130, the IBM 135 Call (strike price is $135) and the IBM 125 Put (strike price is $125) are out-of-the-money.

Intrinsic Value: The premium of an option contract basically consists of two components -- intrinsic value and time value. The intrinsic value reflects the amount, if any, by which an option is in-the-money. In my in-the-money example above, the IBM 125 Call is $5 in-the-money (because the stock is trading at $130). Thus, that $5 represents the intrinsic value of that $125 Call.

Time Value: Time value is the premium of the option, in addition to its intrinsic value. For instance, if IBM is trading for $130 and the S125 Call (strike price is $125) is trading for $6.50, the intrinsic value is $5, and the remaining $1.50 is the time value of that $125 Call.