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By Philip Guziec, CFA | 07-25-07 | 06:35 AM | Email Article

Batting Average                                                                                                    Morningstar OptionInvestor editors' best estimate of the probability that a given investment will generate a break even or greater return over our three-year investment horizon.

Philip Guziec, CFA, is an alternative investing strategist. He covers alternative mutual funds and works on the alternative investing fund research team. Guziec joined Morningstar in 2003 after a career as an engineer and management consultant and has held numerous positions in equity and derivatives research within Morningstar.

Call
An option contract that gives its owner the right (but not the obligation) to buy a security at a specific price, known as the strike price, over a given period of time.

Delta
A measurement of the change in the price of an option resulting from a change in the price of the underlying security. Delta is positive for calls and negative for puts. Delta can be calculated as the dollar change of the option that an investor can expect for a one-dollar change in the underlying security. For example, let's say an option on a stock trading at \$50 costs \$1 and has a delta of \$0.50 per dollar of underlying stock price change. If the stock price rises to \$52, the price of the option will increase by \$1 (the \$2 price change times the \$0.50 delta). After the stock price movement, the option will be worth \$2 (\$1 initial cost plus \$1 delta). Delta can also be calculated as a percentage change in the option price for a one-percent change in the underlying security; this method of viewing the delta value is also known as "leverage."

Gamma
A measurement of the change in delta as the price of the underlying stock changes. As the underlying stock price changes, the delta of the option changes, too. Gamma indicates how quickly your exposure to the price movement of the underlying security changes as the price of the underlying security varies. For example, if you have a call with a strike of \$50 and the stock price is \$50, the delta likely will be approximately \$0.50 for a one-dollar movement of the stock. At a stock price of \$60, the delta will be greater, closer to \$0.75. At a stock price of \$40, the delta will be less, closer to \$0.25. In this example, if the stock price changes from \$50 to \$60, then the delta will change from \$0.50 to \$0.75. The \$10 change in stock price caused a \$0.25 change in delta, so gamma is approximately \$0.25/10, or \$0.025, in this case.

Implied Volatility
A measure of the "riskiness" of the underlying security. Implied volatility is the primary measure of the "price" of an option--how expensive it is relative to other options. It is the "plug" value in option pricing models (the only variable in the equation that isn't precisely known). The remaining variables are option price, stock price, strike price, time to expiration, interest rate, and estimated dividends. Therefore, the implied volatility is the component of the option price that is determined by the market. Implied volatility is greater if the future outcome of the underlying stock price is more uncertain. All else equal, the wider the market expects the range of possible outcomes to be for a stock's price, the higher the implied volatility, and the more expensive the option.

In the Money
A term that applies if the stock price is above the strike price for a call, or the stock price is below the strike price for a put. If exercising an option today would generate cash, the option is "in the money."

Intrinsic Value
The value that the option would pay if it were executed today. For example, if a stock is trading at \$40, a call on that stock with a strike price of \$35 would have \$5 of intrinsic value (\$40-\$35) if it were exercised today. However, the call should actually be worth more than \$5 to account for the value of the chance of any further appreciation until expiration, and the difference between the price and the intrinsic value would be the "time value."

Out of the Money
The opposite of "in the money." If the stock price is below the strike price for a call or the stock price is above the strike price for a put, the options are considered "out of the money."  If exercising an option today would yield no cash, the option is out of the money.

Open Interest
A measurement used to understand the total level of investment by the market in a given option. Open interest also indicates the liquidity in a given option, or the likelihood of being able to execute a large transaction quickly without changing the price of the option. A contract is "open" when it has been sold by a market maker to a customer, or sold by a customer to a market maker. If the seller reverses the transaction (an option owner sells the contract, or the option seller buys the contract back), that interest is "closed."

Option
The right, but not the obligation, to buy or sell the shares of a security (such as a stock) at a set price (the strike) for a given amount of time (the duration). There are two basic types of options, calls and puts.

Put
An option contract that provides the owner the right (but not the obligation) to sell a stock at a specific price (also called the strike price), over a given period of time.

Rho
The change in the value of an option for a change in the prevailing interest rate that matches the duration of the option, all else held equal. Generally rho is not a big driver of price changes for options, as interest rates tend to be relatively stable.

Strike/Stock
The strike price divided by the stock price. Strike/stock allows the comparison of options at different points in time and even across different companies with different stock prices. For example, a call that is at a strike/stock of 110% is 10% "out of the money," and the implied volatility or annualized premium for this call can be compared with another company's calls that are also 10% out of the money.

Theta
The change in an option's value that an investor can expect from the passage of one day, assuming nothing else changes. Theta can be calculated in two ways, as the dollar change of the option that an investor can expect for a one-day passage of time, all else remaining equal, or as a percentage change in the option price for a one-day passage of time, all else remaining equal. For example, if an option trades at \$1 on Monday morning and it has a theta of -\$0.10 per day, you can expect the option to trade at \$0.90 on Tuesday morning. Another way of measuring theta for that option is (\$0.90 - \$1)/\$1 or -10% per day.

Time Value
The value of an option that captures the chance of further appreciation before expiration. The value of an option can be broken down into intrinsic value, or the value of the option if it were exercised today, and time value, or the added value of the option over and above the intrinsic value. For example, if a stock is trading at \$40 and a call with a strike price of \$35 were trading for \$7, the call would have a \$5 intrinsic value (\$40-\$35) and a \$2 time value (\$7-\$5). Time value will decay by expiration assuming the underlying security stays at the same price.

Vega
The change in the price of an option for a change in the implied volatility of the option, all else held equal. In general, as the options market thinks it is more difficult to value a stock, implied volatility and therefore the price of the options will increase. For example, if an option is trading for \$1, the implied volatility is 20%, and the vega is \$0.05, then a one-percentage-point increase in implied volatility to 21% would correspond to an increase in the price of the option to \$1.05. In percentage terms, the vega in this case would be (\$0.05/\$1.00)/(1 percentage point) = 5%.

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