The Motley Fool

“Options Edge” Handbook

BY JE FF FISC H E R
 “O p t i o n s E d g e ” H a n d b oo k

Table of Contents
w e lco m e . .................................................................................. 3
from M o t l e y Fo o l Pre s i d e n t , S co t t S c h e d l e r

W h y O p t i o n s ?. .......................................................................... 4

W h at a r e O p t i o n s ?.. ................................................................. 4

B u y i n g C a l l s ................. ........................................................... 5

B u y i n g p u t s .............................................................................. 5

S e l l i n g Co v e r e d c a l l s ............................................................ 5

S e l l i n g p u t s ............................................................................. 6

8 t i p s f o r w r i t i n g ( o r s e l l i n g ) p u t s ...................................... 7

w h at c a n g o w r o n g . ............................................................... 8

m a k e p u t w r i t i n g w o r t h w h i l e ............................................... 9

C lo s i n g e a r ly a n d r o l l i n g f o r wa r d ..................................... 9

b otto m l i n e .. ................. ........................................................... 9

B r o k e r r e q u i r e m e n t s ... ........................................................... 9

o p t i o n s g lo s s a r y ......... ......................................................... 11

the motley fool | “Options Edge” Handbook | page 2­

 “O p t i o n s E d g e ” H a n d b oo k

Welcome
from Motley Fool President,
Scott Schedler
Dear Fellow Investor,
You’re in a very fortunate position...
The market gyrations of the last year or two are creating some unique opportunities.
That’s why I’ve arranged for Jeff Fischer (the superstar trader behind one of our most
successful advisory services, Motley Fool Pro priced at $1999 per year) to reveal for you
some of his most powerful, and widely useful, options trading strategies in this special
“Options Edge” handbook.
Jeff is a long-time Fool who co-managed the original Rule Breaker portfolio from 1994
to 2003 with Motley Fool Co-Founder David Gardner. Together they helped investors
earn more than 20% per years. More recently, Jeff turned to options trading to take
advantage of moments of unprecedented volatility. And of his last 42 trades -- 39 have
generated a serious profit. That’s a staggering 93% rate of success.
And what’s truly exciting are the profits that are still to come!
Because Jeff recently returned to The Motley Fool, and now has access to all the Fool’s
resources -- all the research and coverage from our newsletter teams, and all the com-
munity intelligence of CAPS -- to zero in on short-term price moves and leverage his
considerable trading expertise.
And this special “Options Edge” handbook is a perfect primer. Inside Jeff will give you
the tools to make money in shorter periods of time, generate income, and squeeze out
some of your portfolio risk. In short, this handbook is your first step to building wealth
faster and more assuredly than at any point in recent history.
It’s all part of The Motley Fool’s ongoing commitment to empowering you, the indi-
vidual investor!
Kindest regards,

Scott Schedler
President, The Motley Fool

the motley fool | “Options Edge” Handbook | page 3­

 “O p t i o n s E d g e ” H a n d b oo k

Why Options?
Options are ideal for generating income, protecting profits, and most importantly, earning
outsized gains! They can generate returns in flat markets, cushion the blow of down
markets, and be outstanding performers in decent markets. So basically, whatever your
investment goals, options can be a powerful addition to your portfolio.
And it’s important for you to know that I advocate trading options as an investor, not as
a speculator. In other words, every option trade we make should be based on thorough
analysis of the underlying stock and its value. That way, the option is simply a way tol
everage what we know about a stock.

What Are Options?

Stock options formally debuted on the Chicago Board Options Exchange in 1973,
although option contracts (the right to buy or sell something in the future) have been
around for thousands of years.
Applied to stocks, an option gives the holder the right, but not the obligation, to buy or
sell an underlying stock at a set price (the strike price) by a set date (the expiration date).
The option contract allows you to profit if a stock moves in your favor before the contract
expires. Not all stocks have options -- only those with enough interest and volume.
There are only two types of options: calls and puts. A call appreciates when the underly-
ing stock rises, so you buy a call if you are bullish on that company. A put appreciates
when a stock declines. You buy a put if you believe a stock will fall or to hedge a stock
that you already own. One way to remember this is: “call up” and “put down”...
By the way, there’s an options glossary in the back of the handbook for you to use at any
point!
Next, let’s walk through the most common options trades: buying calls, buying puts,
selling covered calls, and selling puts.

Strategy Why

When you believe a stock will rise significantly over time and
Buy Calls
you want to leverage your returns or minimize capital at risk

To short a position, or to hedge or protect a current long

Buy Puts
holding

Sell Covered Calls To earn income on shares you already own while waiting for
(sell to open) your desired sell price

Sell Puts To get paid while waiting for a lower share price (your desired
(sell to open) buy price) on a stock you would be happy to buy

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 “O p t i o n s E d g e ” H a n d b oo k
Buying Calls
Investors often buy call options rather than buying a stock outright
to obtain leverage and potentially increase returns several-fold.
Call options work as “controlled” leverage, enhancing your pos-
sible returns while limiting your potential losses to only what
you invest (which is usually a much smaller amount than a stock
purchase would be). Because each option contract represents 100
shares of stock, an investor can control -- and benefit from -- many
shares of stock without putting a lot of capital at risk. When you
make the right call, you’ll enjoy higher returns than you would
have if you had used that money to buy the actual shares.
Let’s look at an example. Imagine that a stock that you know well
has been hit hard and now trades at $27 per share. You believe
the shares will rebound in the coming months or year. The market
offers $30 call options on the stock that expire in 18 months for
$1.50 per share. Therefore, 10 contracts, representing 1,000 shares
of the stock, will cost you $1,500 plus commissions. This option
contract gives you, its owner, the right to buy 1,000 shares of the
stock at $30 any time before expiration.
If your stock starts to rise again, your options will increase in
value, too. Suppose the stock recovers all the way to $32 after a
few months. Your option’s value would likely at least double to $3
or higher per contract. You’ve made 100% in a few months. If you
had simply bought the stock, you’d only be up 18.5%.
Of course, there is a flip side. Suppose your stock continues its
decline to the abyss. Even 18 months later, it’s below $20, so your
options expire worthless -- though hopefully you sold them at
some point along the way to recoup part of your investment.
I like to buy longer-term call options on well-valued stocks that I
believe will pay off handsomely over the coming months or years.
It’s a way to take more meaningful positions in stocks I believe
in -- without risking mounds of capital. This is useful if you’re
lacking capital or just don’t feel like risking it all in a stock.
As with any investment, you should only invest what you can
afford to lose, since a stock can easily work against you in a set
amount of time and make your call worthless. Where real oppor-
tunity can be lost is when your timing is wrong. Your options
might expire before the stock rebounds, causing you to lose your
option money and miss the stock’s eventual rebound. Thus, we
aim to buy longer-term calls in positions in which we have high
confidence and that have near-term catalysts.
Buying Puts
Next up, the antithesis to call options: puts.
Buy put options when you believe that the underlying stock will
decline in value. Buying puts is an excellent tool for betting
the motley fool | “Options Edge” Handbook
against highly priced or troubled stocks, or even entire sectors!
With put buying, your risk is again limited to the amount that you
invest in stark comparison to traditional short selling, where your
potential losses are unlimited. Ouch!
Aside from betting against a position with puts, you can also buy
puts to protect an important position in our portfolio, one that you
don’t want to sell yet for any number of reasons. When a stock
being protected -- or hedged -- in this way declines for a while, the
puts will increase in value, smoothing out returns.
I tend to buy puts on stocks that I believe are due to decline over
the coming months or even years. You may also use puts to hedge
long positions that you own, or to short sectors and indexes in a
small portion of your portfolio. I almost always buy puts rather
than short something outright to limit my risk.
Selling Covered Calls
Now our overview moves from the act of buying options to,
instead, selling them to others.
Any qualified investor can “sell to open” an option contract. When
you do so, you don’t pay the premium; instead, as the contract
writer, you get paid. All cash generated from your option selling
is paid immediately and is yours to keep.
“Covered” simply means that we own the underlying stock at the
same time. Writing covered calls is one of the most conservative
options strategies available. In fact, most retirement accounts
allow you to write covered calls. They’re generally used to gener-
ate income on stock positions while waiting for a higher share
price at which to sell the stock.
Here’s an example of a covered call. Suppose you own 1,000
shares of a stable, blue-chip stock. It’s trading at $56, but you
think it is fairly valued around $60 and you would be happy to sell
at that price. So you write $60 call options on the stock expiring a
few months ahead, and you get paid up front to do so.
If the stock does not exceed $60 by your option’s expiration, you
keep your shares and you’ve made money on the call options.
You could then write more calls if you wanted to. If the stock
is above $60 by expiration and you haven’t closed out your call
option contract, you’d sell your stock at $60 via the options. Your
actual proceeds on the sale would include the option premium you
were paid. So you sold your shares at the price you wanted to and
received some extra cash for doing so. That’s pretty sweet.
So, write covered calls when:
• You would sell a stock that you own at a higher price, and
you’re not worried about it declining too much in the mean-
time. Write calls at your desired sell price, collect the dough,
and then kick back and wait. Rinse and repeat, month after
month, when you can.
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When to write Covered calls
• You would sell a stock that you own at
a higher price, and you’re not worried
about it declining too much in the
meantime. Write calls at your desired
sell price, collect the dough, and then
kick back and wait. Rinse and repeat,
month after month, when you can.
• You believe a stock you own is going to
stagnate for a while, but you don’t want
to sell it right now. Write calls to make
the stagnation more profitable.
• You want to cushion a stock that is in
decline, but that you’re not ready to sell
yet. Tread carefully here so you don’t
get sold out at too low a price.
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“O p t i o n s E d g e ” H a n d b oo k
• You believe a stock you own is going to stagnate for a while, but you don’t want to
sell it right now. Write calls to make the stagnation more profitable.
• You want to cushion a stock that is in decline, but that you’re not ready to sell yet.
Tread carefully here so you don’t get sold out at too low a price.
When you write covered calls, you must be prepared to give up your shares at the strike
price. Approximately 80% to 90% of options are not exercised until expiration, but they
can be exercised early, so the call writer has to be prepared to deliver the shares at any
moment.
That means that if the $56 stock in the example above suddenly soars to $70, you’d still
have to sell at $60. This is the biggest downside to covered calls -- lost potential if a stock
price rises. The other risk is that a stock may fall sharply after hovering around your
desired sell price for a while, forcing you to wait longer for your sell price.
Even though covered calls are low risk, you should use them only on stocks you know
well. You could even set up some covered call-only positions -- buying a stock just to
write calls on it.
Selling Puts
Note: to sell puts, you must have a margin account. You won’t actually need to use margin
-- which entails high risk -- but you must be margin-approved, have ample buying power
(cash, in our margin-free strategy), and have full options permission from your broker.
Selling puts -- also referred to as selling naked puts -- is a favorite strategy of mine to
seed a portfolio. There may be plenty of stocks that I’d like to buy at the start, but I’d
prefer to snag them at lower prices. Put options are an excellent way to potentially buy
a stock at your desired, lower share price and get paid an option premium while waiting
for that price, whether it arrives or not.
Let’s turn to an example: A top-rated stock we found on Motley Fool CAPS and researched
thoroughly is trading at $39, but our analysis suggests that we shouldn’t buy it above $35.
The $35 put options expiring four months out are paying $3 per share. We “sell to open”
the put contracts and get paid $3 per share to make the trade, giving us a potential net
purchase price of $32 before commissions. A few things could happen here.
Scenario 1: The stock could stay above our $35 strike price; the options we
sold would expire. We didn’t get to buy the stock at the price we wanted, but at
least we made money on the options we sold.
Scenario 2: The stock could fall below $35 by expiration. In this situation,
our broker would automatically buy the stock for our account, giving us a start
price of $32 before commissions -- even lower than our $35 desired buy price!
Scenario 3: The stock may tank to $29 soon after we sell the puts, but then
climb back above $35 by expiration. In this case, we most likely would not
have had the shares sold to us during this brief decline because about 80% of
options are exercised only at expiration, not before. So we won’t own the shares,
and we’ll have missed our buy price and the stock’s rebound -- but we did get
paid the premium, at least, and can try again.
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 “O p t i o n s E d g e ” H a n d b oo k

Scenario 4: The company’s CEO flees to Bermuda

and the stock is only at $16 by our option’s expiration.
We didn’t have the heart to close our losing option posi-
tion, and we still have hope, so we wait and the shares are
“put” to our account at $35 (minus our option premium)
upon expiration. This is the worst-case scenario -- we’re
down 50% to start. But we own the stock now and can
hope it rebounds. Of course, assuming that we would
have bought the stock outright when it hit our $35 buy
price, as we had considered, we would be down even
more than we would be with this strategy.
You should most often sell puts when a stock you follow closely
and want to own is, alas, above your desired buy price. You should
sell puts on it at lower strike prices, prices that you believe are great
levels at which to buy. Either you eventually get to buy the stock at
your desired price via the puts, or you keep writing puts if the situa-
tion merits it. You may also sell puts when a stock you already hold
a partial position in is above the price where you’d like to buy more.
You can write puts as you wait to average in at lower prices. This is
a great tool for allocation and averaging into a position.
Writing puts on stocks you know well and want to own at lower
prices can be an excellent tool for income and for securing lower
buy prices, but you must be prepared to buy the stock should it fall
below your strike price. At all times, you must maintain the cash
or margin (for us it’s always cash and we recommend you follow
that rule, too) to buy shares if they are put to you.
It’s important that you only write puts on stocks that you under-
stand well and will be happy and ready to buy at the prices you’re
targeting. The risks of writing puts include the fact that the stock
could soar away without you. In many cases, it’s better to just buy
a great stock once you’ve found it. The other risk, of course, is
that a stock falls sharply and you’re stuck owning it. The biggest
risk with selling puts, as with all options, is when investors rely on
margin instead of cash. That can quickly wipe out a portfolio.
Let’s review...
  Call Option Put Option
The right, but not obli- The right, but not obliga-
gation, to buy a stock
at a set price (the strike tion, to sell a stock at a set
Option buyer price (the strike price); puts
price); calls appreci- appreciate as the stock falls
ate as the stock rises
(remember: “put down”)
(remember: “call up”)
The obligation to sell a The obligation to buy a
stock at the strike price; stock at the strike price;
Option writer must hold the stock must have the buying
(or seller) in the account. This power at the ready (pref-
is called a “covered” erably in cash) in case the
position. stock declines
Believes the underly- Believes the underlying
Option buyer ing stock will rise stock will fall
If the stock rises, is
If the stock falls, is
ready to sell shares ready to buy it at the
Option writer at the strike price, strike price, keeping the
(or seller) keeping the premium
paid for writing the premium received for
writing the option
option
8 Tips for Writing (or Selling) Puts
• Always choose a strike price at which you’d be happy to
buy the stock.
• Focus on strong businesses that you’d be excited to own
for the long term.
• Write “out-of-the-money” puts, meaning your strike
price is below the stock’s current share price.
• Verify that the option premium payment makes the trade
worthwhile.
• Remember, you often won’t get to buy the stock; you’ll
just get option income. That’s why we sometimes write
puts on stocks in which we already own partial posi-
tions.
• Put writers do not collect dividends paid by the underly-
ing stock.
• Never overextend yourself by writing too many puts.
Brokers allow put writing on margin, but we write puts
when we have the cash to buy the stock.
• Vary the expiration dates among your individual option
holdings so they don’t all fall in the same month -- this
staggers your risk.
• You may write “in-the-money” puts with strike prices
above the current share price when you’re especially
bullish on a stock and want to capture more upside
potential with its options. This strategy also increases the
odds that you get to buy the stock. When you write in-
the-money puts, the guidelines in our table don’t apply.
Put writing is a bullish, or at least neutral, strategy. When you
write a put, you’re saying you believe the underlying stock
will eventually increase in price (hopefully after you’ve bought
shares), or at least hold steady -- meaning you’ll earn income on
your puts when they expire.
Let’s use an example: Assume you’re bullish on the health-care
company, Kinetic Concepts (NYSE: KCI). The stock increased
from $20 to $25, so you’re not as anxious to buy it. If the shares
fell to $22 or so, however, you’d be happy to buy. Rather than just

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When to write puts
• You’re ready and willing to buy a stock
at a lower price and
• You don’t believe the stock will soar
away from you in the meantime
(otherwise you’d just buy the stock), or
• You just want to make income writing
puts. You don’t believe a stock will drop
to your buy price, but if it does, you’d
still be happy to buy it.
the motley
“O p t i o n s E d g e ” H a n d b oo k
sit and wait, you can write (remember, that’s “sell to open”) the $22.50 strike price put
options. You’ll get paid while you wait, and you’ll potentially get that lower buy price.
Before placing this trade, make sure you have the cash (or, for experienced investors,
ample buying power) in your account to buy a minimum of 100 shares of Kinetic. You
can then write $22.50 puts that expire in a few months. Let’s say the puts pay you $1.50
per share, and you write two contracts representing 200 shares of Kinetic. You’re paid
$300 (minus commissions) up front. And now you wait (cue the Jeopardy theme).
If Kinetic Concepts ends this time period above $22.50, your options simply expire,
and you keep the $300. You can then write new puts if you’d like. If Kinetic dips below
$22.50 at the option’s expiration, the puts you wrote will be exercised, and you’re on
the hook to buy 200 shares of Kinetic at a strike price of $22.50. Including the option
premium you received, your start price is actually $21. Nice! Now you own shares at an
attractive start price and can wait for appreciation.
So, you write puts when:
• You’re ready and willing to buy a stock at a lower price and
• You don’t believe the stock will soar away from you in the meantime (otherwise
you’d just buy the stock), or
• You just want to make income writing puts. You don’t believe a stock will drop
to your buy price, but if it does, you’d still be happy to buy it.
What Can Go Wrong?
Sounds perfect, doesn’t it? You’re paid to potentially buy a stock you wanted to buy
anyway -- and at a price you like. That’s beautiful.
But every investing strategy has some risk. In this case, assume Kinetic Concepts doesn’t
fall below $22.50 by the time your option expires, but instead jumps to $30 over the next
few months. You miss out on a $5 stock gain for only a $1.50 gain in the put options, and
you still don’t own shares. Now what do you do? It might be a tough call.
Kinetic could also drop to $22 soon after you write your puts, but then climb back to
$25 just as your puts hit their expiration date. Because almost all options are exercised
only at expiration, you won’t get the shares, and you will have missed your buy price.
Of course, you keep the $1.50 option premium and can write new puts, but what if you
miss your buy price again?
There’s also the scenario that the stock drops and doesn’t come back up for a long time.
If Kinetic fell to $17, your options would be far underwater. In this case, you must be
ready to just buy the stock at your net price of $21 and hope for a rebound. At least you’re
getting a much lower start price than if you had simply bought the stock outright at $25
on day one.
But if you no longer wanted to own Kinetic even at $17 -- say there’s a fundamental
change in the business -- you would need to buy back your puts (“buy to close”) early
-- and at a large loss. So, Fools, whenever you write puts, be confident that you want to
own the stock for the long haul.
Make Put Writing Worthwhile
When you like a stock enough to want to own it, be as certain as possible that it’s a good
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 “O p t i o n s E d g e ” H a n d b oo k

strategy to write puts rather than just buying the shares outright.
In general, don’t write puts when you believe a stock is greatly
undervalued and about to take off -- just buy the stock. Write
puts when you believe a stock is a good buy at a certain price yet
is unlikely to leave you in the dust if you don’t buy it anytime
soon.
Once you’ve identified a put contender, calculate whether the
options are paying you enough to make the risks worthwhile. Weigh
both the risk of waiting to buy the stock instead of buying today
(missing potential upside) and the risk if the stock falls sharply.
You want a large enough cushion on your puts to ensure a much
better valuation on the stock you’ll potentially buy. At the same
time, you want enough payment from the options to make the
trade worth your wait. The table below shows what to generally
seek on options expiring in four months or longer versus those that
expire in a few months:
These numbers are great, especially for an inexpensive-looking
stock and options that expire in less than three months. Even if
you don’t get the shares at expiration, you’ll earn $2.20 per share
in two months, or nearly 10% on the cash you have set aside for
this trade.
Closing Early and Rolling Forward
If you no longer want to potentially buy the underlying stock, or
if you’ve made most of your potential profit on the options, you
can close your puts early. Just “buy to close” the puts you sold
earlier; you’ll pay the going market price, resulting in a gain or
loss dependent upon what you were paid for the puts at the start.
In most cases, we won’t close a put early at a loss unless we’re
certain that we don’t want to own the underlying stock anymore --
which would mean our analysis was mistaken from the beginning
or something drastically changed at the company.

Now let’s apply these guidelines to a real-life scenario. As of Nov. You can also choose to close your put-writing strategy early to
11, 2008, Kinetic Concepts was trading at $24.35 per share -- but write new puts that expire in a later month, paying you a higher
option premium. You might do this if you’ve made most of the
money you can possibly earn on the trade (about 85% is our guide-
Options Options line); if you want more time for your strategy to play out; or if you
Factor to Expiring in 4 Expiring in 3
Consider Months or Months or simply want to be paid more now for keeping the strategy in place,
More Less for any reason. This is called “rolling forward.” Just make sure you
can find attractive new puts to write before closing your old ones.
Strike price should Strike price should
Strike price be at least 7% below be at least 4% below
current stock price. current stock price. Bottom Line
Target healthy businesses with attractively valued stocks, and your
Trade’s break-even
price (your strike At least 14% to 17% At least 8% to 9% put writing strategy  should leave you happy, whether it generates
price minus the below current stock below current stock income or you end up buying the stock. Write puts on stocks you’d
option premium price. price. like to own at cheaper prices, or on stocks that won’t likely decline
paid to you)
(but you’d happily own if they did) to generate income. If you really
At least 7% to 10% want to own a stock, though, buy at least some shares outright.
of your strike price.
(This is also your
Option premium At least 4% to 5% of
payment return on the cash your strike price. Broker Requirements
you’ll be keeping
aside for the pos- Applying for options trading permission with your broker involves
sible stock buy.)
filling out a form that they’ll give you when you ask. Simply say,
“I’d like to apply for full options trading permission, please.”
Target time frame No more than 9 For the above You’ll need to answer questions about your investing experience,
until option months; ideally, 6 figures, ideally, 3
expiration months or less. months or less. your assets, and a bit more. It can take a week or longer to get
approved. If you plan to follow along with our options trades,
you’ll want to apply for full permission right away.
let’s say you’d prefer to buy in the low $20s. The $22.50 January
options, which expire in just two months, are bidding at $2.20 per With most brokers, you can buy options even if you have very
share. The strike price of $22.50 is 7.6% below the stock’s current little money, say $5,000 or $10,000. The advantage of buying an
price of $24.35, and the option premiums pay a solid 9.7% of your option contract or two is that you can “control” many shares of
potential purchase price ($2.20 on a $22.50 strike price). Your the underlying stock for, typically, just a few hundred dollars. If
breakeven price if you get the shares is just $20.30 -- 16.6% below the stock rises, you’ll earn strong higher returns on your money.
the current share price. However, to make options worthwhile after spreads and commis-

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Bottom Line
Target healthy businesses with attractively
valued stocks, and your put writing
strategy  should leave you happy, whether it
generates income or you end up buying the
stock. Write puts on stocks you’d like to own
at cheaper prices, or on stocks that won’t
likely decline (but you’d happily own if they
did) to generate income. If you really want
to own a stock, though, buy at least some
shares outright.
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“O p t i o n s E d g e ” H a n d b oo k
sions, we suggest have at least $10,000 in your account.
To sell -- or write -- options, you should have a higher account balance and you’ll need
a margin account as well. Typically, a brokerage firm will require about $25,000 before
you can sell put options, less if you wish to sell covered calls (there, you only need to
own the underlying stock). If you’re not ready or able to sell puts yet, that’s perfectly fine.
It’s probably the strategy you should consider last if you’re new to options. We suggest
starting with the more practical (and less expensive) strategies of buying calls, buying
puts, or writing covered calls. As your account grows over time, you can try out more
involved options strategies.
When writing any options, the brokerage terminology used to start the position is “sell to
open.” To later close the position, you would use “buy to close.” Writing options -- put-
writing, specifically -- requires ample buying power in your account. Be sure to review
your cash and margin buying power before writing a put option. Meanwhile, buying
options is not unlike buying stocks. You can buy options with cash or partly on margin,
but margin is certainly not recommended.
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 “O p t i o n s E d g e ” H a n d b oo k

Options Glossary
Call option: A call option is the right to buy the underlying stock Put option: A put option is the right to sell a stock at a set price
at a set price (the “strike price”) at or before the option’s expira- at or before the option’s expiration date. A put’s value increases
tion date. A call rises in value as a stock rises and declines in value as a stock falls.
when the stock falls.
Strike price, expiration, and exercise: Every option has a strike
Delta: The amount that an option’s price will change with any price and expiration date (which is always the third Friday of
change in the underlying share price. a month, after the market closes). The strike price is the value
at which the underlying stock can be bought or sold. When an
Gamma: A measure of risk in an option based on the amount
option is converted into a stock transaction, the option has been
that the delta will change with a $1 change in the stock (we don’t
“exercised.”
concern ourselves much with delta or gamma, since we’re much
more concerned about the underlying value of the equity we’re Time-value premium: This is the price of an option above its
targeting, but they’re still good things to know). intrinsic value. It’s the value placed on an option purely to account
for unknowns and expected volatility between now and expiration.
In the money: This term is used when an option has intrinsic
Time value declines as expiration draws closer.
value. Call options are in the money when the underlying stock is
above the call’s strike price. Put options are in the money when Writing a contract: Selling a new option contract (opening a posi-
the underlying stock is below the option’s strike price (a stock is tion) is usually called writing a contract; the brokerage command
at $22 and the put option has a strike price of $30, allowing the to do so is usually “sell to open,” just as when you short a stock.
holder to sell the stock at $30). The new option seller is called the “option writer;” to close the
position, the trade command is called “buy to close.”
Intrinsic value: This is the value of an option if it were to expire
immediately. It’s an option’s value in direct proportion to the
underlying stock’s current price. If a call option gives the owner
the right to buy a stock at $10, and the stock is trading at $12, the
option’s intrinsic value is the difference: $2. The option may actu-
ally be priced at $3, with $1 of time value (see below) because it
doesn’t expire for a few months, and much could change by then.
LEAPS (Long-Term Equity Appreciation Securities): These
are simply stock options that, when first offered, expire at least
two years in the future. Most new LEAPS become available every
July. Although generally more expensive, we like LEAPS because
they give you a relatively long time for an investment thesis to
play out.
Option contract: Each option contract represents 100 shares of the
underlying stock. A contract is quoted at the price for just one share,
so you need to multiply it by 100 to get the full value. So, if you buy
two option contracts for $1.50 each, it actually represents 200 (2 x
100) shares of stock, and would cost you $300 ($1.50 x 200).
Out of the money: This is the opposite condition as “in the
money.” Here, an option has no intrinsic value, only time value.
This occurs when, for example, a stock is trading at $8 and a call
option has a strike price of $10.
Premium: Not unlike an insurance premium, the value paid for an
option contract is called the “premium.” The more volatile a stock
is, generally the higher the premium on its options. Also, all else
equal, the longer until an option expires, the higher the premium
it commands, accounting for more unknowns.

the motley fool | “Options Edge” Handbook | page 1 1­