When an investor purchases an option, he is
purchasing a contract to buy or sell a stock for a
preset amount at a certain time in the future. Most
option contracts have a finite life and will expire in
less than one year. Some large cap companies
have what are known as LEAPs, and these have expirations extending as far out as two years.

While options trading can offer quick and very handsome returns they do carry a high degree of risk. For more information on the associated risks please see the next page.

Perhaps one of the most important aspects of options is that holders of an option do not have to wait for expiration to realize gains. Each option contract can be traded freely before the expiration as if it were a stand-alone security.

The best way to begin understanding options is to learn what the various terms associated with them mean.

Call Option: A call option gives the buyer the right to purchase 100 shares of the underlying stock at a set price upon the options expiration. Purchasers of call options are bullish and believe the underlying shares will rise within the time frame of the contract.

Put Option: A put has the same definition of a call option except that a buyer of puts has the right to sell 100 shares at a preset price. Put buyers are bearish on the underlying stocks.

Strike Price: Each option has a strike price and this price is the amount the holder of an option will end up buying (call) or selling (put) each of 100 shares. Strike prices are usually in $5.00 increments.

Exercise: This term means the holder of an option will choose to buy or sell the one hundred shares when the options expire.

In the Money/Out of the money: An option is considered in the money when the underlying stock is trading above the strike price in the case of a call option and below the strike price in the case of a put option. The option table on the next page highlights various option contracts, both puts and calls. The highlighted option, the April 2004, 90 call (IBMDR) is currently in the money because the price of IBM is currently $91.79 or $1.79 over the $90.00 strike price. The next option on the table is the April 95 call. This is considered out of the money, as the stock, trading at $91.79, is $3.21 below the $95 strike price. Conversely, the April 90 put is out of the money, with the stock trading at $91.79, while the April $95 put is in the money by a total of $3.21.

Expiration: The expiration is usually the third Friday of each month.

Premium: The price of an option will almost never be equal to the exercise price due to the Premium. The pricing of options can be somewhat complex; in fact a successful mathematical formula was created known as the Black-Scholes model. This model won the creators a Nobel Prize in Economics. Without going into the complex details, the main idea is that the price of an option includes not only the conversion price (in the case the IBMDR example it would be $1.79) but also the underlying stocks volatility as well as time left to expiration. Also, to a lesser extent dividends come into play as well.

Volatility: Some stocks have greater volatility than others, meaning that price swings are greater over a set period of time. The greater the volatility the more expensive the option will be. The most common way of judging volatility is to look at a stock's Beta. If a stock has a Beta of 1.5 then its stock moves 1 ½ times more than the overall market, usually as measured by the S&P 500. For example: if the S&P 500 goes down or up down by 10% over the course of a year, a stock with a Beta of 1.5 would either increase or decrease by 15% over the same period. If a stock has a propensity to move 10-20% over a short period of time it stands to reason that the option will be priced high.