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Part One: The Vocabulary of Options Trading

This publication is the property of the National Futures Association.

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These are some of the major terms you should become familiar with, starting with what is meant by an “option.”

Option An investment vehicle which gives the option buyer the right—but not the obligation—to buy or sell a particular futures contract at a stated price at any time prior to a specified date. There are two separate and distinct types of options: calls and puts.

Call A call option conveys to the option buyer the right to purchase a particular futures contract at a stated price at any time during the life of the option.

Put A put option conveys to the option buyer the right to sell a particular futures contract at a stated price at any time during the life of the option.

Strike Price Also known as the “exercise price,” this is the stated price at which the buyer of a call has the right to purchase a specific futures contract or at which the buyer of a put has the right to sell a specific futures contract.

Underlying Contract This is the specific futures contract that the option conveys the right to buy (in the case of a call) or sell (in the case of a put).

Option Buyer The option buyer is the person who acquires the rights conveyed by the option: the right to purchase the underlying futures contract if the option is a call or the right to sell the underlying futures contract if the option is a put.

Option Seller (Writer) The option seller (also known as the option writer or optiongrantor) is the party that conveys the option rights to the option buyer.

Premium The “price” an option buyer pays and an option writer receives is known as the premium. Premiums are arrived at through open competition between buyers and sellers according to the rules of the exchange where the options are traded. A basic knowledge of the factors that influence option premiums is important for anyone considering options trading. The premium cost can significantly affect whether you realize a profit or incur a loss. See “The Arithmetic of Option Premiums”.

Expiration This is the last day on which an option can be either exercised or offset. See definition of “Offset”. Be certain you know the exact expiration date of any option you have purchased or written. Options often expire during the month prior to the delivery month of the underlying futures contract. Once an option has expired, it no longer conveys any rights. It cannot be either exercised or offset. In effect, the option rights cease to exist.

Quotations Premiums for exchange-traded options are reported daily in the business pages of most major newspapers, as well as by a number of internet services. With an understanding of terms previously defined—call, put, strike price and expiration month—it is easy to determine the premium for a particular option.Take a look at the following quotation for gold options:

___________________________________________________________
            Gold (100 troy ounces; $ per troy ounce)
Strike         Calls-Settle                         Puts-Settle
Price     Jan     Feb       Apr                   Jan     Feb     Apr
285     10.50 10.70    14.80                  .20    1.00    2.50
290      5.70   7.20    11.40                  .30    1.80    4.10
295     1.60    4.30     7.90                 1.10    3.80    5.70
300       .40    2.00     5.40                 4.90    6.50    8.30
305       .20    1.20     3.80                 9.60   10.60  11.30
310       .10     .60      2.60                14.50  15.10  15.00
Est.Vol.: 4,400 Mn   2,687 calls   5,636 puts
Op Int Mon: 273,658 calls    121,133 puts
___________________________________________________________
The premium for a February gold call option
with a strike price of $295 an ounce is $4.30
an ounce. Therefore, for the 100 ounce option,
the option buyer would pay a premium of
$430 and the option writer would receive a
premium of $430.

Exercise An option can be exercised only by the buyer (holder) of the option at any time up to the expiration date. If and when a call is exercised, the option buyer will acquire a long position in the underlying futures contract at the option exercise price. The writer of the call to whom the notice of exercise is assigned will acquire a short position in the underlying futures contract at the option exercise price. If and when a put is exercised, the option buyer will acquire a short position in the underlying futures contract at the option exercise price. The writer of the put to whom the notice of exercise is assigned will acquire a long position in the underlying futures contract at the option exercise price.

Offset An option that has been previously purchased or previously written can generally be liquidated (offset) at any time prior to expiration by making an offsetting sale or purchase. Most options investors choose to realize their profits or limit their losses through an offsetting sale or purchase. When an option is liquidated, no position is acquired in the underlying futures contract.

In-the-money An option is said to be “in the money” if it is worthwhile to exercise. A call option is in-the-money if the option exercise price is below the underlying futures price. A put option is in-the-money if the option exercise price is above the underlying futures price.

Example: The current market price of a particular gold futures contract is $300 an ounce. A call is in-the-money if its exercise price is less than $300. A put is in-the-money if its exercise price is more than $300. The amount that an option is currently in-the-money is referred to as the option’s intrinsic value.

At-the-money An option is said to be “at-themoney” if the underlying futures price and the option’s exercise price are the same.

Out-of-the-money A call option whose exercise price is above the underlying futures price is said to be “out-of-the-money.” Similarly,a put option is “out-of-the-money” if its exercise price is below the underlying futures price. Neither option is currently worthwhile to exercise, and has no intrinsic value.