Getting Started in Options

average up a strategy involving the purchase of stock when its market value is increasing. The average cost of shares bought in this manner is consistently lower than current market value, enabling covered call writers to sell calls in the money when the basis is below the striking price. (See Figure G.2.)

bear spread a strategy involving the purchase and sale of calls or puts that will produce maximum profits when the value of the underlying stock falls.

beta a measurement of relative volatility of a stock, made by comparing the degree of price movement to that of a larger index of stock prices.

Binary Option an option based on an underlying index, which pays a fixed amount if the index is higher than a call’s strike or lower than a put’s strike at expiration.

binomial model an option valuation formula developed in 1979 and based on selection of various times between valuation date and expiration. The formula is risk neutral but also assumes that the efficient market theory applies in all cases.

Black-Scholes model a formula used to estimate a fair price for an option contract, originated in 1973. The calculation takes into account the elements of time value, stock price variation, an assumed market interest rate, and the time left until expiration.

book value the actual value of a company, more accurately called book value per share; the value of a company’s capital (assets less liabilities), divided by the number of outstanding shares of stock.

box spread the combination of a bull spread and a bear spread, opened at the same time on the same underlying stock.

breakeven price (also called the breakeven point) the price of the underlying stock at which the option investor breaks even. For call buyers, this price is the number of points above striking price equal to the call premium cost; for put buyers, this price is the number of points below striking price equal to the put premium cost.

breakout the movement of a stock’s price below support level or above resistance level.

Broad-Based Index an index with a larger number of components and involving many different market sectors.

bull spread a strategy involving the purchase and sale of calls or puts that will produce maximum profits when the value of the underlying stock rises.

butterfly spread a strategy involving open options in one striking price range, offset by open positions at higher and lower ranges at the same time.

buyer an investor who purchases a call or a put option; the buyer realizes a profit if the value of stock moves above the specified price (call) or below the specified price (put).

calendar spread (also called time spread ) a spread involving the simultaneous purchase or sale of options on the same underlying stock, with different expirations.

call an option acquired by a buyer or granted by a seller to buy 100 shares of stock at a fixed price within a specified time period.

called away the result of having stock assigned. Upon exercise, 100 shares of the seller’s stock are called away at the striking price.

candlestick charts technical charts for stocks summarizing a stock’s daily trading range, opening and closing prices, and price direction. The candlestick is used in many trading systems, including swing trading.

capital gains profits from investments, taxed the same as other income if the holding period is less than one year, and at lower rates if investments were owned for one year or more.

capitalization-weighted description of the procedure used to calculate an index value, based on current market value for each of the components in the index.

capped-style option an option that can be exercised only during a specified period of time; if the option’s value reaches the cap level prior to expiration, it is exercised automatically.

carryover capital losses sums of capital losses from prior years that exceeded annual loss limitation levels; the annual maximum capital loss deduction is $3,000, and all losses above that level have to be carried over and applied in future tax years.

cash settlement a method for settling exercise of an index option, in which cash is paid rather than shares of stock being bought or sold.

chartist an analyst who studies charts of a stock’s price movement in the belief that recent patterns can be used to predict upcoming price changes and directions.

class all options traded on a single underlying stock, including different striking prices and expiration dates.

closed position the status of a position when an initial opening transaction has been offset and the position is no longer open.

closing purchase transaction a transaction to close a short position, executed by buying an option previously sold, canceling it out.

closing sale transaction a transaction to close a long position, executed by selling an option previously bought, closing it out.

collar a spread strategy combining long stock, a covered call, and a long put, with both options out of the money. The collar limits potential gains and potential losses.

combination any purchase or sale of options on one underlying stock, with terms that are not identical.

condor spread a variation of the butterfly spread using different striking prices in the short positions on either side of the middle range.

confirmation a signal providing support for another signal, reinforcing the belief that a trend is ending and about to reverse.

constructive sales status when investors buy and sell in separate transactions, but involve substantially identical property; the holding of offsetting long and short positions may be taxed as a constructive sale even when no physical sale has occurred.

contingent purchase a strategy involving the sale of a put and willingness to accept exercise, which will result in purchasing 100 shares of stock. The strategy makes sense when the individual believes the striking price is a reasonable price for the stock.

contract a single option, the agreement providing the buyer with the terms that option grants. Those terms include identification of the stock, the cost of the option, the date the option will expire, and the fixed price per share of the stock to be bought or sold under the rights of the option.

contrarian an investor who recognizes the tendency for the majority to be wrong more often than right, who invests opposite popular opinion.

conversion the process of moving assigned stock from the seller of a call option or to the seller of a put option.

cookie jar accounting the practice of banking revenue or earnings in exceptionally high-volume years and booking them in later periods, to even out results consistently and to reduce fundamental volatility.

core earnings as defined by Standard & Poor’s, the after-tax earnings generated from a corporation’s principal business.

cover the ownership of 100 shares of the underlying stock for each call sold, providing sellers the ability to deliver shares already held, in the event of exercise.

covered call a call sold to create an open short position, when the seller also owns 100 shares of stock for each call sold.

credit spread any spread in which receipts from short positions are higher than premiums paid for long positions, net of transaction fees.

current market value the market value of a stock at any given time.

cycle the pattern of expiration dates of options for a particular underlying stock. The three cycles occur in four-month intervals and are described by month abbreviations. They are (1) January, April, July, and October, or JAJO; (2) February, May, August, and November, or FMAN; and (3) March, June, September, and December, or MJSD.

day trader an individual who trades within a single day, usually closing positions before the end of the trading day, and often making such trades on high volume.

debit spread any spread in which receipts from short positions are lower than premiums paid for long positions, net of transaction fees.

FIGURE G.3 Deep in/deep out.

FIGURE G.4 Delta.

debt investment an investment in the form of a loan made to earn interest, such as the purchase of a bond.

debt ratio a ratio used to follow trends in debt capitalization. To compute, divide long-term debt by total capitalization; the result is expressed as a percentage.

deep in condition when the underlying stock’s current market value is five points or more above the striking price of the call or below the striking price of the put. (See Figure G.3.)

deep out condition when the underlying stock’s current market value is five points or more below the striking price of the call or above the striking price of the put. (See Figure G.3.)

deferred credit an account listed under the liabilities section of a balance sheet, representing income to be recognized in future years.

delivery the movement of stock ownership from one owner to another. In the case of exercised options, shares are registered to the new owner upon receipt of payment.

delta the degree of change in option premium in relation to changes in the underlying stock. If the call option’s degree of change exceeds the change in the underlying stock, it is called an up delta; when the change is less than in the underlying stock, it is called a down delta. The reverse terminology is applied to puts. (See Figure G.4.)

diagonal spread a calendar spread in which offsetting long and short positions have both different striking prices and different expiration dates.

discount the reduction in the basis of stock, equal to the amount of option premium received. A benefit in selling covered calls, the discount provides downside protection and protects long positions.

dividend yield dividends paid per share of common stock, expressed as a percentage computed by dividing dividend paid per share by the current market value of the stock.

dollar cost averaging a strategy for investing over time, either buying a fixed number of shares or investing a fixed dollar amount, in regular intervals. The result is an averaging of overall price. If market value increases, average cost is always lower than current market value; if market value decreases, average cost is always higher than current market value.

downside protection a strategy involving the purchase of one put for every 100 shares of the underlying stock that you own. This insures you against losses to some degree. For every in-the-money point the stock falls, the put will increase in value by one point. Before exercise, you may sell the put and take a profit, offsetting stock losses, or exercise the put and sell the shares at the striking price.

downtrend in swing trading, a series of three or more days consisting of lower highs and lower lows.

Dow Theory a theory that market trends are predictable based on changes in market averages.

early exercise the act of exercising an option prior to expiration date.

earnings per share a commonly used method for reporting profits. Net profits for a year or for the latest quarter are divided by the number of shares of common stock outstanding as of the ending date of the financial report. The result is expressed as a dollar value.

EBITDA a popular measurement of cash flow, an acronym for earnings before interest, taxes, depreciation, and amortization.

efficient market hypothesis a theory stating that current stock prices reflect all information publicly known about a company.

equity investment an investment in the form of part ownership, such as the purchase of shares of stock in a corporation.

European-style option an option that can be exercised only during a specified period of time immediately preceding expiration. Some index options are European style.

exchange-traded funds (ETFs) types of mutual funds that trade on public exchanges like stocks, and consist of portfolios of predetermined, related securities known as the “basket of stocks.”

exercise the act of buying stock under the terms of the call option or selling stock under the terms of the put option, at the price per share specified in the option contract.

exercise cut-off time the specific deadline for exercise of index options, imposed by brokerage firms on traders, varying by index and by class of option.

expiration date the date on which an option becomes worthless, which is specified in the option contract.

expiration time the latest possible time to place an order for cancellation or exercise of an option, which may vary depending on the brokerage firm executing the order and on the option itself.

expected return the likely return from an option strategy, based on analysis of a range of possible outcomes, used to identify the most reasonable return a trader should expect to realize.

extrinsic value the portion of an option’s premium generated from volatility in the underlying stock and from market perception of potential price changes until expiration date; a nonintrinsic portion of the premium value not specifically caused by the element of time.

FLEX option a type of option whose terms—including expiration date, striking price, and exercise terms—can be modified during the period a position remains open.

fundamental analysis a study of financial information and attributes of a company’s management and competitive position, as a means for selecting stocks.

fundamental volatility the tendency for a company’s sales and profits to change from one period to the next, with more erratic change representing higher volatility.

futures contract a contract to buy or sell a pre-established amount of a commodity or other instrument (agricultural, energy, livestock, precious metals, imports, or financial instruments), at a set price and by or before a specific date (delivery date). Like options, futures are rarely exercised, but are more likely to be closed prior to settlement or rolled forward.

GAAP acronym for generally accepted accounting principles, the rules by which auditing firms analyze operations, and by which corporations report their financial results.

gamma a measurement of the speed of change in delta, relative to price movement in the underlying stock.

gap a trading pattern in which the range between days includes a gap in price, with the second day’s trading range opening above the highest price of the previous day, or below the lowest price of the previous day.

Greeks a series of analytical tests of option risk and volatility, so called because they are named for letters of the Greek alphabet.

hedge a strategy involving the use of one position to protect another. For example, stock is purchased in the belief it will rise in value, and a put is purchased on the same stock to protect against the risk that market value will decline.

hedge ratio alternate name for the delta, the measurement of changes in option value relative to changes in stock value.

Holding Company Depositary Receipts (HOLDRs) forms of beneficial ownership issued by trusts, providing investors with ownership in shares of predetermined stocks in a single industry or sector or sharing other attributes in common.

horizontal spread a calendar spread in which offsetting long and short positions have identical striking prices but different expiration dates.

incremental return a technique for avoiding exercise while increasing profits with written calls. When the value of the underlying stock rises, a single call is closed at a loss and replaced with two or more call writes with later expiration dates, producing cash and a net profit in the exchange.

index option any option traded on a market index as the underlying, rather than on an individual stock.

FIGURE G.5 In the money.

FIGURE G.6 Intrinsic value.

in the money the status of a call option when the underlying stock’s market value is higher than the option’s striking price, or of a put option when the underlying stock’s market value is lower than the option’s striking price. (See Figure G.5.)

insider information any information about a company not known to the general public, but known only to people working in the company, or with nonpublic knowledge about matters that will affect a stock’s price.

intrinsic value that portion of an option’s current value equal to the number of points that it is in the money. One point equals one dollar of value per share; so 35 points equals $35 per share. (See Figure G.6.)

iron condor the combination of a long strangle and a short strangle on the same underlying stock. The cost is reduced due to offsetting premium payments and receipts; and it is practical as long as short position exercise costs do not exceed long position profits.

know your customer a rule requiring brokers to be aware of the risk, knowledge level, and capital profile of each client, designed to ensure that recommendations are suitable for each individual.

last trading day the Friday preceding the third Saturday of the expiration month of an option.

LEAPS long-term equity anticipation security, a long-term option contracts that work just like standardized options, but with expiration up to three years.

leverage the use of investment capital in a way that a relatively small amount of money enables the investor to control a relatively large value. This is achieved through borrowing—for example, using borrowed money to purchase stocks or bonds—or through the purchase of options, which exist for only a short period of time but enable the option buyer to control 100 shares of stock. As a general rule, the use of leverage increases potential for profit as well as for loss.

liquid market a market in which buyers and sellers are matched to one another, and the exchange absorbs any imbalances between the two sides. listed option an option traded on a public exchange and listed in the published reports in the financial press.

lock in to freeze the price of the underlying stock by selling a covered call. As long as the call position is open, the writer is locked into the striking price, regardless of current market value of the stock. In the event of exercise, the stock is delivered at the locked-in price.

long hedge the purchase of options as a form of insurance to protect a portfolio position in the event of a price increase; a strategy employed by investors selling stock short and needing insurance against a rise in the market value of the stock.

long position the status assumed by investors when they enter a buy order in advance of entering a sell order. The long position is closed by later entering a sell order, or through expiration.

long straddle the purchase of an identical number of calls and puts with the same striking prices and expiration dates, designed to produce profits in the event of price movement of the underlying stock in either direction, adequate to surpass the cost of opening the position.

long-term capital gains profits on investments held for 12 months or more, which are taxed at a rate lower than other income.

loss zone the price range of the underlying stock in which the option investor loses. A limited loss exists for option buyers, since the premium cost is the maximum loss that can be realized.

lost opportunity risk (options) the risk that covered call writers will lose profits from increased prices in stock, because they are locked in at a fixed striking price.

lost opportunity risk (stock) the risk stockholders experience in tying up capital over the long term, causing lost opportunities that could be taken if capital were available.

lower shadow on a candlestick formation, the line defining the extent of a day’s trading range. The line extends below the opening or closing prices for the day.

margin an account with a brokerage firm containing a minimum level of cash and securities to provide collateral for short positions or for purchases for which payment has not yet been made.

margin requirement the maximum amount of outstanding risk investors are allowed to hold in their portfolio, or the maximum unfunded dollar level allowed when trading on margin.

market value the value of an investment at any given time or date; the amount a buyer is willing to pay to acquire an investment and what a seller is also willing to receive to transfer the same investment.

married put the status of a put used to hedge a long position. Each put owned protects 100 shares of the underlying stock held in the portfolio. If the stock declines in value, the put’s value will increase and offset the loss.

money spread alternate name for the vertical spread .

multileg options order a type of ordered allowed by some brokerage firms in which a strategy involving several options is opened for a single transaction fee, rather than for separate minimum fees on each option.

FIGURE G.7 Naked option.

multiple the P/E’s outcome, the number of times current price per share is above annual earnings per share; for example, if the P/E is 10, then current price per share is 10 times higher than the latest reported earnings per share.

mutual funds investment programs in which money from a large pool of investors is placed under professional management. For a fee, management invests in stocks and bonds. Mutual funds may be set up to pay a sales loan to salespeople, often called financial advisers; or they may be no-load, meaning investors can buy shares directly and not pay commissions.

naked option an option sold in an opening sale transaction when the seller (writer) does not own 100 shares of the underlying stock. (See Figure G.7.)

naked position status for investors when they assume short positions in calls without also owning 100 shares of the underlying stock for each call written.

narrow-based index an index using a small number of components rather than a larger or broader basis for its calculations.

narrow-range day (NRD) in a candlestick chart, a trading day with an exceptionally small trading range.

net basis the cost of stock when reduced by premium received for selling covered calls; the true net cost of stock after discounting original cost.

net investment income an individual’s taxable income from interest, dividends, and capital gains, distinguished from ordinary income by tax rate or potential tax exclusions.

net return the percentage return on an investment, based on dollar amounts going in and coming out, after transaction fees.

odd lot a lot of shares that contains fewer than the more typical round lot trading unit of 100 shares.

offsetting positions in tax law, a straddle which creates a substantial diminution of risk; when positions are classified as offsetting, tax restrictions are applied on deductibility of losses or treatment of long-term gains.

opening purchase transaction an initial transaction to buy, also known as the action of “going long.”

opening sale transaction an initial transaction to sell, also known as the action of “going short.”

open interest the number of open contracts of a particular option at any given time, which can be used to measure market interest.

open outcry A method of trading futures contracts and options on futures, in which buyer and seller in a commodity exchange trading pit shout bids back and forth; in comparison, options on stocks are traded using electronic bid and ask systems.

open position the status of a trade when a purchase (a long position) or a sale (a short position) has been made, and before cancellation, exercise, or expiration.

option the right to buy or to sell 100 shares of stock at a specified, fixed price and by a specified date in the future.

orderly settlement the smooth process of buying and selling, in full confidence that the terms and conditions of options contracts will be honored in a timely manner.

ordinary income noninvestment income, subject to the full tax rate an individual pays and not qualified for exclusions or lower rates applicable to some forms of net investment income.

out of the money the status of a call option when the underlying stock’s market value is lower than the option’s striking price, or of a put option when the underlying stock’s market value is higher than the option’s striking price. (See Figure G.8.)

paper profits (also called unrealized profits) values existing only on paper but not taken at the time; paper profits (or paper losses) become realized only if a closing transaction is executed.

paper trading online “mock trading” of stocks and options using a hypothetical sum of cash, to test strategies in a realistic environment but without placing real money at risk.

parity the condition of an option at expiration, when the total premium consists of intrinsic value and no time value.

FIGURE G.8 Out of the money.

pattern day trader any individual executing four or more transactions on the same security within five consecutive trading days; these traders are required to maintain no less than $25,000 in their brokerage accounts.

PM settlement valuation of an index option based on the value of the index components at the close of trading on the day of exercise or expiration.

premium value the current price of an option, which a buyer pays and a seller receives at the time of the transaction. The amount of premium is expressed as the dollar value of the option, but without dollar signs; for example, stating that an option is “at 3” means its current market value is $300.

price/earnings ratio a popular indicator used by stock market investors to rate and compare stocks. The current market value of the stock is divided by the most recent earnings per share to arrive at the P/E ratio.

price-weighted description of the procedure used to calculate an index value, based on current price and adjusted for all stock splits, for each of the components in the index.

profit margin the most commonly used measurement of corporate operations, computed by dividing net profits by gross sales.

profit zone the price range of the underlying stock in which the option investor realizes a profit. For the call buyer, the profit zone extends upward from the breakeven price. For the put buyer, the profit zone extends downward from the breakeven price.

pro forma earnings “as a matter of form” (Latin), a company’s earnings based on estimates or forecasts with hypothetical numbers in place of known or actual revenues, costs, or earnings.

prospectus a document designed to disclose all of the risk characteristics associated with a particular investment.

pump and dump action by an individual holding shares of a company. It involves spreading false rumors in order to get people to buy shares and increase the price of stock, and then selling shares at a profit.

put an option acquired by a buyer or granted by a seller to sell 100 shares of stock at a fixed price within a specified time period.

put to seller action of exercising a put and requiring the seller to purchase 100 shares of stock at the fixed striking price.

qualified covered call a covered call that meets specific definitions allowing an investor to claim long-term capital gains tax rates upon sale of stock, or to retain long-term holding period status. Qualification is determined by time to expiration, and by the price difference between current market value of the stock and striking price of the call.

qualified retirement plans those plans qualified by the IRS to treat current income as deferred and free of tax in the year earned and, in many cases, also exempting annual contributions to the plan from current taxes.

quality of earnings a measurement of the reliability of financial reports. A high quality of earnings means the report reflects the real and accurate operations of a corporation and may be used reliably to forecast likely future growth trends.

quarterlys specialized options issued on the last day of each calendar quarter, that expire at the end of the following quarter.

random walk a theory about market pricing, stating that prices of stocks cannot be predicted because price movement is entirely random.

rate of return the yield from investing, calculated by dividing net cash profit upon sale by the amount spent at purchase.

ratio calendar combination spread a strategy involving both a ratio between purchases and sales and a box spread. Long and short positions are opened on options with the same underlying stock, in varying numbers of contracts and with expiration dates extending over two or more periods. This strategy is designed to produce profits in the event of either price increases or decreases in the market value of the underlying stock.

ratio calendar spread a strategy involving a different number of options on the long side of a transaction from the number on the short side, when the expiration dates for each side are also different. This strategy creates two separate profit and loss zone ranges, one of which disappears upon the earlier expiration.

ratio write a strategy for covering one position with another for partial rather than full coverage. A portion of risk is eliminated, so that ratio writes can be used to reduce overall risk levels.

ready market a liquid market, one in which buyers can easily sell their holdings, or in which sellers can easily find buyers, at current market prices.

realized profits profits taken at the time a position is closed.

Regulation T a Federal Reserve Board (FRB) rule defining customer cash account minimum levels based on strategies employed.

relative volatility the degree of volatility in comparative form, such as between portfolios or between a specific stock and other stocks or markets.

resistance level the highest trading price, under present conditions, above which the price of the stock is not likely to rise.

retender a notice issued by a commodities broker to cancel an obligation by a short option trader to take actual physical delivery of the underlying commodity.

return if exercised the estimated rate of return option sellers will earn in the event the buyer exercises the option. The calculation includes profit or loss in the underlying stock, dividends earned, and premium received for selling the option. (See Figure G.9.)

return if unchanged the estimated rate of return option sellers will earn in the event the buyer does not exercise the option. The calculation includes dividends earned on the underlying stock, and the premium received for selling the option. (See Figure G.10.)

return on capital employed (ROCE) in stock and options trading, net return based on cash left on deposit in a margin account, to include all forms of net return minus transaction costs and interest charged on the balance financed; leveraged return combining minimum margin requirements with borrowed funds.

reverse hedge an extension of a long or short hedge in which more options are opened than the number needed to cover the stock position; this increases profit potential in the event of unfavorable movement in the market value of the underlying stock.

FIGURE G.9 Return if exercised.

FIGURE G.10 Return if unchanged.

rho a calculation of the effect of interest rate trends on option valuation; a long-term analytical tool rather than one of immediate value.

risk tolerance the amount of risk that an investor is able and willing to take.

roll-down the replacement of one written call with another that has a lower striking price.

roll-forward the replacement of one written call with another with the same striking price, but a later expiration date.

roll-up the replacement of one written call with another that has a higher striking price.

round lot a lot of 100 shares of stock or of higher numbers divisible by 100, the usual trading unit on the public exchanges.

sales load a commission charged when a financial adviser places a client’s capital into a load mutual fund.

sector a specific segment of the market defined by product or service offered by a company. Factors affecting value (cyclical, economic, or market based) make each sector distinct and different from other sectors, also affecting option valuation.

seller an investor who grants a right in an option to someone else; the seller realizes a profit if the value of the stock moves below the specified price (call) or above the specified price (put).

sensitivity the degree of change in an option’s value based solely on the time remaining until expiration.

series a group of options sharing identical terms.

setup in swing trading, a signal indicating that a stock has reached a short-term high level (a sell setup) or a short-term low level (a buy setup). By taking action upon recognizing a setup, swing traders make small but consistent profits.

settlement date the date on which a buyer is required to pay for purchases, or on which a seller is entitled to receive payment. For stocks, settlement date is three business days after the transaction. For options, settlement date is one business day from the date of the transaction.

share a unit of ownership in the capital of a corporation.

short hedge the purchase of options as a form of insurance to protect a portfolio position in the event of a price decrease; a strategy employed by investors in long positions who need insurance against a decline in the market value of the stock.

short position the status assumed by investors when they enter a sale order in advance of entering a buy order. The short position is closed by later entering a buy order, or through expiration.

short selling a strategy in the stock market in which shares of stock are first sold, creating a short position for the investor, and later bought in a closing purchase transaction.

short straddle the sale of an identical number of calls and puts with identical striking prices and expiration dates, designed to produce profits in the event of price movement of the underlying stock within a limited range.

short-term capital gains profits on investments held for less than 12 months, which are taxed at the same rate as other income.

sideways strategies option strategies designed to produce maximum gains when the underlying stock is expected to exhibit lower than average volatility.

speculation the use of money to assume risks for short-term profit, in the knowledge that substantial or total losses are one possible outcome. Buying calls for leverage is one form of speculation. The buyer may earn a very large profit in a matter of days, or could lose the entire amount invested.

spread the simultaneous purchase and sale of options on the same underlying stock, with different striking prices or expiration dates, or both.

straddle the simultaneous purchase and sale of the same number of calls and puts with identical striking prices and expiration dates.

strangle a strategy in which an equal number of long calls and puts are bought (long strangle) or sold (short strangle). These terms include different striking prices but the same expiration date, and it will be profitable only if there is a large price movement in the underlying stock.

strap an option strategy, also called a triple option, involving purchase of one put and two calls (hoping the stock’s price will rise) or the purchase of one call and two puts (anticipating a stock’s price decline).

striking price the fixed price to be paid for 100 shares of stock, specified in the option contract; the transaction price per share of stock upon exercise of that option, regardless of the current market value of the stock.

suitability standard by which a particular investment or market strategy is judged. The investor’s knowledge and experience with options represent important suitability standards. Strategies are appropriate only if the investor understands the market and can afford to take the risks involved.

supply and demand the market forces that determine the current value for stocks. The number of buyers represents demand for shares, and the number of sellers represents supply. The price of stocks rises as demand increases, and falls as supply increases.

support level the lowest trading price, under present conditions, below which the price of the stock is not likely to fall.

swing trading a system based on a two- to five-day cycle, involving buying and selling positions based on predictable price movements and in response to buy and sell setup signals.

synthetic position a strategy in which stock and option positions are matched up to protect against unfavorable price movement. When you own stock and also buy a put to protect against downward price movement, it creates a synthetic call. When you are short on stock and buy a call, it creates a synthetic put.

tangible book value per share the net value of a company, computed by subtracting all liabilities from all assets, and further reducing the net by all intangible assets. The net of tangible assets is then divided by the number of outstanding shares of common stock.

tau a measurement of an option’s premium value in relation to the underlying stock’s changes in volatility.

tax put a strategy combining the sale of stock at a loss—taken for tax purposes—and the sale of a put at the same time. The premium received on the put offsets the stock loss; if the put is exercised, the stock is purchased at the striking price.

technical analysis a study of trends and patterns of price movement in stocks, including price per share, the shape of price movements on charts, high and low ranges, and trends in pricing over time.

terms (also called standardized terms) the attributes that describe an option, including the striking price, expiration month, type of option (call or put), and the underlying stock.

theta a measurement of an option’s value based on time until expiration.

time value of money the concept observing that earnings potential adds value to a sum of money. As long as money is put to use earning profit, the present discounted value of the future fund relies on (1) the interest rate, (2) compounding method, and (3) time involved until the final result can be achieved.

triple option alternative name for the strap.

time value that portion of an option’s current premium above intrinsic value. (See Figure G.11.)

total capitalization the combination of long-term debt (debt capital) and stockholders’ equity (equity capital), which in combination represents the financing of corporate operations and long-term growth.

total return the combined return including income from selling a call, capital gain from profit on selling the stock, and dividends earned and received. Total return may be calculated in two ways: return if the option is exercised, and return if the option expires worthless. (See Figure G.12.)

FIGURE G.11 Time value.

FIGURE G.12 Total return.

trading range the price range between support and resistance; the current price area where stock purchase and sale levels occur.

uncovered option the same as a naked option—the sale of an option not covered, or protected, by the ownership of 100 shares of the underlying stock.

underlying stock the stock on which the option grants the right to buy or sell, which is specified in every option contract.

upper shadow on a candlestick formation, the line defining the extent of a day’s trading range. The line extends above the opening or closing prices for the day.

uptrend in swing trading, a series of three or more days consisting of higher highs offset by higher lowers.

value investing an approach to picking stocks based on actual value of the company rather than on price or price targets.

vega a name sometimes applied to the calculation of tau.

variable hedge a hedge involving a long position and a short position in related options, when one side contains a greater number of options than the other. The desired result is reduction of risks or potentially greater profits.

vertical spread a spread involving different striking prices but identical expiration dates.

volatility an indicator of the degree of change in a stock’s market value, measured over a 12-month period and stated as a percentage. To measure volatility, subtract the lowest 12-month price from the highest 12-month price, and divide the answer by the 12-month lowest price. (See Figure G.13.)

volume the level of trading activity in a stock, an option, or the market as a whole.

wash sale rule a provision in the tax code prohibiting the deduction of a loss if the security position is reopened within 30 days from the date of the sale.

FIGURE G.13 Volatility.

wasting asset any asset that declines in value over time. An option is an example of a wasting asset because it exists only until expiration, after which it becomes worthless.

weeklys specialized options issued each Friday, which expire the following Friday.

whipsaw a price trend in stocks when the price moves in one direction and then reverses and moves in the opposite direction.