The Terms of an Option Contract

8/3/2019 The Terms of an Option Contract

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Adjustment An alteration to the terms of an option contract due to certain events such as a stock split ora stock dividend. In a 2-for-1 stock split, an option holder will own twice as many contracts at half thestrike price. An adjusted option may cover more than the usual 100 shares. For example, after a 3-for-2stock split, the adjusted option will represent 150 shares. The OCC publishes Contract Adjustmentmemos that spell out the specifics of such adjustments.

All-or-none orderAn order that must be completely filled or not filled at all.

American Stock Exchange (AMEX) One of six U.S. exchanges that trades options.

American-style option An option contract that can be exercised at any time between the date ofpurchase and the expiration date. Most exchange-traded options are American-style. All stock options are

American-style.

Arbitrage The process by which professional traders simultaneously buy and sell similar securities for aprofit at theoretically zero risk. Risk in arbitrage occurs when historical relationships that were expected tohold no longer apply, or when expected events like an announced takeover fail to materialize.

Asked price The lowest price a seller is willing to accept for a security (also called the "offer price").

Asset A resource that has economic value to its owner. Cash, accounts receivable, inventory, real estate,and securities are examples of assets.

Assignment The receipt of an exercise notice by an option seller (writer) that obligates him or her to sell(in the case of a call) or purchase (in the case of a put) the underlying security at the specified strikeprice.

At the money An option is "at the money" if its strike price is equal to or very near the market price of theunderlying security. Also called "on the money."

Automatic exercise A protection procedure whereby the Options Clearing Corporation (OCC) attempts

to protect the holder of an expiring in-the-money option on behalf of the trader by automatically exercisingthe option.

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Bearish An outlook that anticipates lower prices for a security.

Bearish credit spread An option strategy implemented by selling a lower-strike call and purchasing ahigher-strike call. This results in a net credit to the investor's account. The maximum profit is achieved aslong as the sold call stays out of the money by expiration.

Bearish debit spread An option strategy implemented by selling a lower-strike put and purchasing ahigher-strike put. This results in a net debit to the investor's account. The maximum profit is achieved ifthe underlying stock closes at or below the strike of the sold put.

Beta A measure of how a stock moves more or less than the movement of a broader market index.

Bid price The highest price a buyer is willing to pay for a security.


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Bid/Asked quotation The latest available bid and asked prices for a particular option.

Bid/Asked spread The difference in price between the latest available bid and asked quotations for aparticular option contract.

Black Scholes formula This version of the option pricing model is used most often in the standardized

pricing on the floors of the various options exchanges. It factors in the current stock price, strike price,time until expiration, level of interest rates, any dividends, and the volatility of the underlying security. Thecreators of the Black Scholes model won a Nobel Prize in 1997 for its contribution to the financialmarkets.

Bollinger Bands Well-known analyst John Bollinger developed Bollinger Bands, which are traditionallyplotted above and below the 21-day moving average of a stock's price. These upper and lowerboundaries factor in two standard deviations (about 95 percent) of the price movement over the previous21 days.

Boston Options Exchange (BOX) One of six U.S exchanges that trades options. The most-recentlyintroduced exchange, the BOX started trading in February 2004.

Break-even point The stock price at which a particular option strategy neither has a gain nor a loss atoption expiration.

Bullish An outlook anticipating higher prices in the underlying security.

Bullish credit spread An option strategy implemented by selling a higher-strike put and purchasing alower-strike put. This results in a net credit to the investor's account. The maximum profit is achieved aslong as the sold put stays out of the money by expiration.

Bullish debit spread An option strategy implemented by selling a higher-strike call and purchasing alower-strike call. This results in a net debit to the investor's account. The maximum profit is achieved if theunderlying stock closes at or above the strike of the sold call.

Butterfly spread A long butterfly spread is established by buying an in-the-money option, selling two at-the-money options, and buying an out-of-the-money option. A butterfly is typically entered anytime acredit can be received (i.e., when the premium received is greater than the premium paid).

Buy to close See Closing purchase.

Buy to open See Opening purchase.

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Calendar spread The sale of an option with a nearby expiration and the purchase of an option with thesame strike price, but a more distant expiration. The loss is limited to the net premium paid, while themaximum profit depends on the time value of the distant option when the nearby expires. This strategytakes advantage of time value differentials during periods of relatively flat prices.

Call An option contract that gives the buyer (holder) the right to purchase and gives the seller (the writer)the obligation to sell a specified number of shares (typically 100) of the underlying stock at the givenstrike price on or before the expiration date of the contract.


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Call ratio backspread A directional trade with a hedging component that allows a trader to book a smallprofit or break even in the event that the trade moves against them. The risk is limited while the reward isunlimited. Call ratio backspreads involve selling a call at one strike and then buying two more calls at ahigher strike price (other ratios can be used). The goal is to keep the ratio of calls sold to calls purchasedunder 0.67, allowing a credit to be received in order to profit from a strong move in either direction by theunderlying security. See also Put ratio backspread.

Called away The process by which a call option writer is obligated to surrender the underlying stock tothe option buyer at a price equal to the strike price of the written call. Similar toAssignment.

Cash-settlement option An option that is exercised by a cash payment rather than the delivery of theunderlying security. The amount of cash settlement is determined by the difference between the option'sstrike price and the price of the underlying security. Stock index and industry group options are usuallycash settled.

CBOE NASDAQ Volatility Index (VXN) VXN is an indicator of investor sentiment toward the futurevolatility of the Nasdaq 100 Index (NDX). VXN, which is derived from bid/ask quotes of NDX options,measures the implied volatility of a hypothetical NDX option that is always at the money with a constantone-month maturity. VXN is expressed as an annualized standard deviation of returns.

CBOE S&P 100 Volatility Index (VXO) VXO is an indicator of investor sentiment toward the futurevolatility of the S&P 100 Index (OEX). The VXO gauges expected market volatility over the next 30calendar days by calculating a weighted average of the implied volatilities of eight OEX calls and puts thathave an average time to maturity of 30 days. VXO measures the implied volatility of a hypothetical OEXoption that is always at the money with a constant one-month maturity. VXO is expressed as anannualized standard deviation of returns.

CBOE Volatility Index (VIX) The VIX gauges expected market volatility over the next 30 calendar daysby calculating a weighted average of S&P 500 Index (SPX) options with a constant maturity of 30 days toexpiration. Extreme high and low VIX readings can provide good contrarian signals, though it actuallydoesn't matter where the reading lies on an absolute basis if it is at an extreme relative to its recentreadings. Buy signals often occur as the VIX reverses lower after an extreme peak, while sell signals

occur as the VIX moves higher off an extreme bottom.

Chicago Board of Trade (CBOT) Established in 1848, the CBOT is the world's oldest derivatives(futures and futures-options) exchange. Futures and options on agricultural (wheat, corn, oats, etc.),financial (U.S. Treasury bonds and notes, etc.), and index (Dow Jones Industrial Average) instrumentstrade on the CBOT.

Chicago Board Options Exchange (CBOE) The CBOE is one of six U.S. options exchanges. In 1973,the CBOE created "listed options" that became the standard, and option prices were set in an auctionmarket nearly identical to the stock exchanges.

Chicago Mercantile Exchange (CME) CME is the largest futures exchange in the U.S. and the second-largest exchange in the world for the trading of futures and options on futures. The exchange offersfutures and options on futures in four basic product areas: interest rates, stock indexes, foreign exchange,and commodities. Founded as a not-for-profit corporation in 1898, CME became the first publicly tradedU.S. financial exchange in December 2002.

Class of options Options contracts of the same type (call or put) and style (American or European) thatcover the same underlying security.

Clearinghouse An agency associated with an exchange that guarantees all trades, thus assuringcontract delivery and/or financial settlement. The clearinghouse becomes the buyer for every seller and


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the seller for every buyer. In the case of listed equity option, the clearinghouse is the Options ClearingCorporation (OCC).

Closeout date The predetermined date an options trader chooses to close a position if it hasn't achievedits target profit. Using such "time stops" is a key component ofThe Option Advisor's overall risk/rewardmanagement strategy.

Closing price The price of a stock (or option) at the last transaction of the day.

Closing purchase (buy to close) A transaction in which an investor who initially sold an option intendsto liquidate his or her written position by buying, in a closing purchase transaction, an option having thesame terms as the option he or she wrote.

Closing sale (sell to close) A transaction in which an investor who initially bought an option intends toliquidate his or her purchased position by selling, in a closing sale transaction, an option having the sameterms as the one he or she purchased. This transaction will reduce the open interest for that option.

CollarA collar is an options strategy that involves the purchase of a put option and the sale of a calloption on the same pre-owned underlying stock. The call and put do not have the same strike price (the

call is always at a higher strike than the put), nor must they necessarily have the same expiration date.

Combination (position) A combination involves two different option positions and can take a variety offorms. This could involve buying both a call and a put on a given stock, e.g., a straddle (both options havethe same strike price) or a strangle (options have different strike prices). Options can also be used inconjunction with stock. A covered combination, for example, involves selling a covered call against stockalready owned and selling a put below the current stock price. This strategy enhances total returns in flat-to-rising markets, allowing one to buy more stock at lower prices and effectively lowering the net cost toacquire the stock.

Commission One of the costs associated with trading. This is a fee paid to a brokerage firm whenentering or exiting a position. Commissions vary widely, so we suggest searching for those withreasonable rates.

Confirmation statement After an option position has been initiated or closed, a statement must beissued to the customer by the brokerage firm. The statement contains the number of contracts bought orsold and the prices at which the transactions occurred. It is sometimes combined with a purchase andsale statement.

Consensus estimate When a stock reports earnings each quarter, the analysts who follow that stock willeach have their own earnings estimate for the company's quarterly results. The average of all theseforecasts is known as the consensus estimate. Actual earnings that come in above the consensusestimate are considered a positive earnings surprise. Earnings that are below the estimate areconsidered negative surprises. The stock's reaction to these earnings announcements typically confirmswhether expectations were high or low heading into the earnings report.

Contingency orderA type of order that specifies some parameters that must be met before an order isfilled. For example, stock traders betting on a breakout may want to buy only if a stock trades above acertain level and would place a "buy-stop" order to get in immediately after the stock trades at a definedprice. Options traders wanting to enter an option trade immediately may place a "fill or kill" order. Thismeans the order is either executed at the specified price as soon as it hits the trading floor or isimmediately canceled. Another type is an "all or none" order, which is filled only if all of the contractsrequested are received.


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Contract A call or put option issued by The Options Clearing Corporation.

Contract size The number of shares of the underlying asset covered by an options contract. This size isusually 100 shares for one stock option contract unless otherwise adjusted for a special event (such as astock split or stock dividend).

Contrarian theory Schaeffer's contrarian philosophy, which is based on Humphrey Neill's The Art ofContrary Thinking, is that the crowd is most likely to be right when it is supportive of the current pricetrend and is most likely to be wrong when it rejects the current price trend. Contrarian theory is not aboutbuying low prices or cheap stocks, i.e., value investing. True contrary opinion is about buying lowexpectations. Low expectations often accompany strong technicals and strong fundamentals. Contrarianstend to be attracted to stocks with low expectations that are generally avoided by the crowd. Similarly,they also look to avoid (or short) stocks or sectors that are overly loved by the crowd. Fundamentals andtechnicals are key to supporting these contrarian conclusions.

Convexity One of the benefits of buying options is convexity. When a stock drops one point, a call optionwith an initial delta of 50 percent will lose a half-point. But the option will now have a lower delta, suchthat the next point drop in the stock will result in a smaller loss for the option. This "positive curvature"helps reduce an option's price risk on each successive decline in the underlying shares, while the

stockholder continues to lose the same one point on each successive drop in the stock. This positivecurvature also works in the same manner as the stock moves up. A call option's delta will increase oneach successive gain in the stock, allowing the call holder greater upside participation with eachsuccessive gain in the underlying share price.

Convexity also refers to playing more dollars on successive trades during a winning streak and fewerdollars on successive trades in a losing streak (although the percentage allocated remains constant). Thispreserves capital during a string a losses and provides greater participation during a hot streak.

CoverIndicates the repurchase of previously sold contracts or shares, known as "covering" a shortposition. Short covering is synonymous with liquidating a short position.

Covered call writing A short option position in which the seller (writer) owns the number of shares of

underlying stock represented by the sold options. This strategy is less risky than outright long stockpositions and is equivalent in its profit/loss profile to naked put writing.

Credit spread See Bearish credit spread orBullish credit spread.

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Day orderAn order that automatically expires at the end of the session if not executed during the day it'sentered. All orders are assumed to be day orders unless otherwise specified.

Day traderStock or options traders (often active on the trading floor) who usually initiate and offset aposition during a single trading session.

Debit spread See Bearish debit spread orBullish debit spread.

Deep in the money An arbitrary term that describes an option that is so far in the money that it's unlikelyto move out of the money prior to expiration.


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Deep out of the money An arbitrary term that describes an option that is so far out of the money that it'sunlikely to move in the money prior to expiration.

Deep-discount brokerA broker offering stripped-down services in exchange for very low commissionrates.

Delta (also neutral hedge ratio) The percentage of price movement in the underlying stock that will betranslated into the price movement in a particular option. For example, a delta of 50 percent indicates thatthe option will move up (or down) by one-half point for each one-point rise (or decline) in the underlyingstock. Call options have positive delta and put options have negative delta. Delta increases as the stockprice rises and decreases as the stock price declines. It's also commonly used to approximate theprobability that an option will finish in the money.

Delta hedging The process of buying an increasing quantity of stock as it moves closer to the moneyrelative to a sold call position in order to remain delta neutral. Like short covering, this can result in deltahedging rallies that drive a stock price higher.

Derivative security A financial security whose value is derived in part from the value and characteristicsof another security, known as the underlying security. Options are a derivative securities.

Diagonal spread A strategy that utilizes options with different expiration dates and strike prices.

Discount brokerA broker whose commission rates are lower than typical full-service brokers. Discountbrokers usually provide a few additional services such as investment research and/or advice.

Diversification An investing or trading strategy in which positions are maintained in a variety ofunderlying stocks or stock options for the purpose of reducing risk and increasing bottom-line profits. Foroptions traders, diversification also refers to being invested in both calls and puts.

Dividend Compensation paid by a company on a regular basis to existing shareholders. Dividendsusually take the form of quarterly cash payments, which attract investors seeking regular income.

Dividends can also be paid in the form of additional stock or spin-offs of existing subsidiaries.

Double Top A double top is a technical formation in which a stock makes two sets of significant highs ata similar price level. Double tops are used for forecasting potential downside risk until their highs aretaken out. Once that occurs, all downside forecasts are negated and significant rallies can follow withoverhead resistance no longer in place.

Downtrend A process of successive downward price movements in a security over time.

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Efficient Market Hypothesis The EMH view of the markets believes that information is pricedinstantaneously into stock prices as soon as it is released to the public. The weak form of EMH suggeststhat technical analysis adds no value to the markets since all past market prices and data are fullyreflected in securities prices. The semi-strong form of EMH suggests that all publicly available informationis fully reflected in securities prices; thus, fundamental analysis cannot provide an edge in investmentselection. The strong form of EMH suggests that even insiders cannot make an above-average profit fromtheir knowledge since all information is fully reflected into the share price. EMH assumes the markets areefficient and thus random in the direction of future prices.


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Equity option See Stock option.

European-style option An option contract that can be exercised only during a specified period just priorto the expiration date.

Exchange An association of persons who participate in the business of buying or selling securities. A

forum or place where traders (members) gather to buy or sell economic goods.

Exchange-Traded Funds (ETFs) ETFs are investments that contain a pool of securities representing asector or specific index such as the Dow Jones Industrial Average or the S&P 500. Essentially, ETFs arebuilt like mutual funds but trade like stocks. They are priced continually and can be bought or soldthroughout the trading day. ETFs are attractive to both individual and institutional investors because theyprovide liquid, cost-efficient exposure to a broad range of asset classes. They can be shorted orpurchased on margin and many of them are even optionable, such as the Nasdaq-100 Trust (QQQQ).

Execution The actual completion of a buy or sell order on the exchange floor.

Exercise The process by which an option holder/owner invokes the terms of the option contract. Toexercise, call owners will buy the underlying stock, while put owners will sell the underlying stock under

the terms set by the option contract. Option sellers must be aware of this exercise risk when the optionthey sold goes deep into the money, and they must make sure they have the capital available to coverany such potential exercise.

Exercise price See Strike price.

Expectational AnalysisPioneered by Bernie Schaeffer, this is an investment analysis approach thattakes into account the beliefs of investors and speculators relative to the prevailing technical trends andfundamental facts. This methodology is used to best gauge the future direction of stock prices.

Expiration calendarA calendar showing when various option classes cease trading and/or expire. Clickhere to access our expiration calendar listing.

Expiration cycle A cycle related to the dates on which options on a particular underlying security expire.A stock's options (other than LEAPS) are placed in one of three cycles - the January cycle (with optionslisted in the January, April, July or October cycle months), the February cycle (with options listed in theFebruary, May, August or November cycle months) or the March cycle (with options listed in the March,June, September or December cycle months). At any point in time, a stock generally has options with atleast four expiration dates outstanding (not counting LEAPS) - in the nearest two expiration months and intwo longer-term cycle months.

Expiration date The date on which an option and the right to exercise it expire. For equity options, this isthe Saturday following the third Friday of the month.

Expiration Friday The last trading day prior to an option's expiration date that an option may be

purchased or sold. This is typically the third Friday of the month for equity options. If Friday is anexchange holiday, the final trading day will be the preceding Thursday.

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Fill The price at which an order is executed.


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Fill or kill order (FOK) A trading order that is canceled unless executed within a designated time period.

Flat price risk Taking a position either long or short that does not involve spreading.

Float The number of shares of a particular security available for public trading.

Foreign currency option An option that conveys the right to buy or sell a specified amount of foreigncurrency at a specified price within a specified time period.

Forward price The price at which a security is expected to be trading at a defined point in the future, as afunction of the expected interest rate environment during that time period.

Free market price The price established by buyers and sellers in the free market, with no restrictionsplaced on market participants. This price is a function of the level of demand versus the level of supply inthe market at any time.

Fronth month The next class of futures or options contract set to expire.

Full fungibility A right of options ownership in which an options buyer is free to sell his or her contract atany time on an options exchange, up to and including its expiration date.

Full-service brokerA broker who provides investment research, information, and advice, as well as theservices involved in purchasing and selling securities. Full-service brokers usually charge the highestcommission rates.

Fundamental analysis The study of specific factors, such as price-to-earnings ratios, earnings history,volume, and market capitalization that influence supply and demand and (consequently) prices in themarketplace.

Fundamental beta The product of a statistical model to predict the fundamental risk of a security usingnot only price data but other market-related and financial data.

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Gamma The unit change in the delta of an option for each point change in the price of the underlyingstock or index. For example, assume stock XYZ is at 60 and its 55-strike call option has a gamma of 0.05and a delta of 75. If the stock moves to 61, the new delta will be 80.

Gap A term used by technicians to describe an opening price that is substantially higher or lower than theprevious day's closing price. Significant gaps are usually related to market-moving news that occursovernight while a stock cannot be traded.

Good-til-canceled (GTC) A qualifier for any kind of order extending its life indefinitely until it is eitherfilled or canceled.

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Handle The whole-dollar price of a bid or offer. In other words, if a security is quoted at a bid of 101.10and an offer of 101.11, the handle is 101. Traders are assumed to know the handle.

Hedge A conservative strategy used to limit investment loss (or risk) by implementing a transaction thatoffsets an existing position.

Hedge fund A fund that may employ a variety of techniques to enhance returns, such as both buying andshorting stocks based on a valuation mode.

Hedged portfolio A portfolio consisting of the long position in the stock, and the short position in the calloption and long position in the put option, so as to be riskless and produce a return that equals the risk-free interest rate.

Historical volatility A statistical measurement of a stock's past price movement over a specific timeperiod.

HolderThe buyer or owner of an option.

Horizontal spread The simultaneous purchase and sale of two options that differ only in their expirationdate.

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Implied volatility The assumption of the stock's volatility that helps determine the option's price. Since allother factors in the options pricing model are assumed to be known, the implied volatility is calculated lastas a plug-in factor after other options pricing components are taken into account.

In the money An option is in the money when it has intrinsic value. A call is in the money when themarket price of the underlying stock is greater than the option's strike price. A put is in the money when

the market price of the underlying stock is lower than the option's strike price.

Index A statistical compilation of several stocks that are related in some manner into one number. TheS&P 500 Index is the most well-known index.

Index fund An investment fund designed to match the returns on a stock market index.

Index option An option whose underlying security is a stock index. This includes options on the overallmarket (such as the S&P 100 Index options) as well as options on narrower-based industry groups. Indexoptions are cash settled.

Initial margin See Margin requirement.

Initial public offering (IPO) A company's first sale of stock to the public. Securities offered in an IPO areoften, but not always, those of young, small companies seeking outside equity capital and a public marketfor their stock. Investors purchasing stock in IPO's generally must be prepared to accept very large risksfor the possibility of large gains.

Institutional investors Organizations that invest, including insurance companies, depository institutions,pension funds, investment companies, mutual funds, and endowment funds.


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International Securities Exchange (ISE) One of six U.S. exchanges that trade options. The ISE begantrading in May 2000 and is the nation's first entirely electronic options market.

Internet brokerA broker offering online trading over the World Wide Web. Commission rates are typicallyvery competitive, in line with deep-discount brokers.

Intrinsic value The difference between an in-the-money option's strike price and the current market priceof the underlying security.

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Kappa See Vega.

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Lambda The ratio of change in option price relative to a small change in option volatility.

Last sale price The price of a stock or option at the most recent transaction.

Last trading day The final day under an exchange's rules during which trading may take place in aparticular options contract. Contracts outstanding at the end of the last trading day must be settled bydelivery of the underlying financial instrument.

LEAPS An acronym for Long-term Equity AnticiPation Securities. LEAPS are put or call options withexpiration dates set as far as three years into the future. Like standard options, each LEAPS contractusually represents 100 shares of the underlying stock.

Leverage The control of a larger number of shares with a smaller amount of capital. A major benefit ofoptions, leverage provides an option buyer greater profit potential using fewer dollars compared toholding a long or short stock position. Thus, a 10-percent move in a stock can be leveraged into a 100-percent or more gain using an option.

Limit orders A customer sets a limit on price or time of execution of a trade (or both). For example, a"buy limit" order is placed below the market price. A "sell limit" order is placed above the market price. Asell limit is executed only at the limit price or higher (better), while the buy limit is executed at the limitprice or lower (better).

Limited risk A concept often used to describe the option buyer's position. Because the option buyer'sloss can be no greater than the premium paid for the option, the buyer's risk is limited.

Liquid or liquidity The ease with which a purchase or sale can be made without disrupting existingmarket prices. Liquidity is typically characterized by high volume and narrower bid/ask spreads.

Listed options Options traded on one or more of the optionsexchanges. Unlike over-the-counter orunlisted options, which must be exercised to have any value, listed options are fully fungible and have anactive secondary market on the options exchanges. Most traders in listed options close their positions inthis secondary market prior to exercise.


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Long position A position where a person's interest in a particular series of options is as a net holder (i.e.,the number of contracts bought exceeds the number of contracts sold). Also, an investor is "long" whenhe or she takes ownership of a stock in the anticipation that it will appreciate in value.

Longer-term option See LEAPS.

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Maintenance margin See Margin call.

Margin call A call from the clearinghouse to a clearing member (variation margin call), or from a broker toa customer (maintenance margin call), to add funds to their margin account to cover an adverse pricemovement. The added margin assures the brokerage firm and the clearinghouse that the customer canpurchase or deliver the entire contract or security, if necessary.

Margin requirement The amount an uncovered (naked) option seller (writer) is required to deposit and

maintain to cover his or her daily position valuation and reasonably foreseeable intraday price changes.

Market makerAn exchange member on the trading floor who buys and sells options for their ownaccount. Market makers have the responsibility of making bids and offers and maintaining a fair andorderly market.

Market observation Found at SchaeffersResearch.com, these daily columns focus on some of the morenotable stock and options activity of the day. Written by Schaeffer's analysts, market observations arepublished throughout each and every trading day.

Market orderAn order to purchase or to sell at the best available price. Market orders must be executedimmediately, and therefore take precedence over all other orders. Market orders to buy tend to beexecuted at the asked price, and market orders to sell tend to be executed at the bid price.

Market Recap After the market close, Schaeffer's reviews some of the day's outperforming andunderperforming sectors and provides a recap of the day's trading activity. This is published every markettrading day on SchaeffersResearch.com.

Market timing The process of buying and selling securities based on indicators that predict meaningfulswings in the price of the market or individual securities, targeting better results than the "buy and hold"approach.

Married Put The simultaneous purchase of stock and puts that represent an equivalent number ofshares. This is a hedging strategy as the put compensates for losses in the stock.

Maturity date See Expiration date.

MEP If you are buying to open a new position, "MEP" stands for "Maximum Entry Price." If you are sellingto open a new position, "MEP" stands for "Minimum Entry Price." By heeding the MEP, you avoidestablishing positions in options that have already made a significant move, which reduces the profitpotential below an acceptable level.

Money market fund A mutual fund that invests only in short-term securities, such as bankers'acceptances, commercial paper, repurchase agreements, and government bills. The net asset value per


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share is maintained at $1.00. Such funds are not federally insured, although the portfolio may consist ofguaranteed securities and/or the fund may have private insurance protection.

Moving average An average of prices over a specified time period (minutes, days, weeks, months, etc.).As a new price is added, the oldest price is dropped to recalculate the average. A three-day movingaverage, for example, is calculated by averaging the first three days of prices (days one, two, and three).

On the following day, the average is calculated using days two, three, and four. Moving averages areused by technicians to spot changes in trends.

Multiply listed options Options on the same underlying security traded on more than one optionsexchange.

Mutual fund inflows/outflows A measure of the amount of money investors put into or take out ofmutual funds during a given time period. Schaeffer's uses such flows to gauge sentiment on sectors orthe overall market.

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Naked call writing See Uncovered call options.

Naked put writing See Uncovered put options.

NASDAQ The largest U.S. stock market (in terms of listings) with nearly 4,000 companies listed.NASDAQ is an acronym for the National Association of Securities Dealers Automatic Quotation system,an electronic quotation system that provides price quotes to market participants about the more activelytraded common stock issues in the OTC market.

Nasdaq-100 Trust (QQQQ, or "cubes") A unit investment trust established to accumulate and hold aportfolio of equity securities that comprise the Nasdaq-100 Index. QQQQ is intended to provide

investment results that, before expenses, generally correspond to the price and dividend yieldperformance of the Nasdaq-100 Index. QQQQ's initial market value approximates 1/40th of the value ofthe underlying Nasdaq-100 Index. QQQQ options are among the most liquid available on any exchange.

Nasdaq-100 Trust Volatility Index (QQV) The QQV is an indicator of investor sentiment about the futurevolatility of QQQQ. QQV, which is derived from bid/ask quotes of QQQQ options, measures the impliedvolatility of a hypothetical QQQQ option that is always at the money with a constant one-month maturity.QQV is expressed as an annualized standard deviation of returns.

NAV Effect Asset growth in a particular mutual fund that's attributed to a change in the net asset value(NAV) of the fund. These changes have nothing to do with mutual fund inflows or redemption and,therefore, cannot be attributed to investor sentiment with any degree of certainty.

Neutral hedge ratio See Delta.

Neutral spread An option spread created to profit from little net price movement of the underlying stockin either direction. Neutral spreads are most often calendar spreads. See also Option spread andCalendar spread.

New York Stock Exchange (NYSE) Also known as the Big Board. More than 2,000 common andpreferred stocks are traded. Founded in 1792, the exchange is the oldest in the United States.


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No-load mutual fund An open-end investment company, shares of which are sold without a salescharge. There can be other distribution charges however, such as Article 12b-1 fees. A true "no-load"fund will have neither a sales charge nor a distribution fee.

Nominal price (or nominal quotation) The price quotation calculated for futures or options for a periodduring which no actual trading occurred. These quotations are usually calculated by averaging the bid

and asked prices.

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Offering price (also asked price) The lowest price any potential seller is willing to accept for a particularoption.

On the money SeeAt the money.

Open interest The number of outstanding options contracts on a given series for a particular underlying

stock.

Open Interest Configuration The number of outstanding contracts (or open interest) at all strikes for agiven underlying security.

Open trade equity The gain or loss on open positions that has not been realized.

Opening price The price of a stock or option at the first transaction of the day.

Opening purchase (buy to open) A transaction in which an investor becomes the holder of an option.This transaction adds to the investor's long position and increases open interest on that option.

Opening sale (sell to open) A transaction in which an investor becomes the writer of an option. Thistransaction adds to the investor's short position and increases open interest on that option.

Opportunity cost A factor in the pricing of an option, as a function of the prevailing level of interest rates.

Option A contract that entitles the holder to buy or sell a number of shares (usually 100) of a particularcommon stock at a predetermined price (see Strike price) on or before a fixed date (see Expiration date).

Option contract A contract that, in exchange for the option price, gives the buyer the right, but not theobligation, to buy (or sell) a financial asset at the exercise price within a specified time period, or on aspecified date (expiration date).

Option Exchange Any of the six markets where options are traded. These are the American Stock

Exchange, International Securities Exchange, Chicago Board Options Exchange, Pacific StockExchange, Philadelphia Stock Exchange, and Boston Options Exchange.

Option price Also called the option premium, the price paid by the buyer of the option contract for theright to buy or sell a security at a specified price in the future.

Option Pricing Model The conventional method to assess option prices. This model incorporates sixfactors into its pricing assumptions: the underlying security price, the strike price, the time until expiration,any dividends to be paid, the level of interest rates, and the volatility of the stock. This model assumes


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that stock price movement is random with no directional bias except for a slight upward bias related tocarrying costs equal to the interest rate. See Black Scholes formula.

Option spread A position that results from two different options on the same security. See also Creditspread, Debit spread, and Neutral spread.

Option writing Selling options in an opening transaction. See also Covered call writing, Uncovered calloptions, and Uncovered put options.

Options Clearing Corporation (OCC) Founded in 1973, the OCC is the world's largest equity derivativesclearing organization. OCC clears transactions for put and call options on common stocks and otherequity issues, stock indexes, foreign currencies, interest rate composites, and single-stock futures. TheOCC also offers clearing and settlement services for transactions in futures and options on futures.Operating under the jurisdiction of the Securities and Exchange Commission and the Commodity FuturesTrading Commission, OCC is jointly owned by the American Stock Exchange, Chicago Board OptionsExchange, International Securities Exchange, Pacific Exchange, and Philadelphia Stock Exchange.

Options specialized brokerA broker that focuses on options trading and strategies.

OrderAn instruction to purchase or sell an option, first transmitted to a broker office, and then submittedto the exchange floor for execution.

Oscillators Indicators of the movement of a stock's price relative to an assumed cycle of highs and lows.

Out of the money An option that has no intrinsic value. A call option is out of the money when the strikeprice is higher than the market price of the underlying security. A put option is out of the money when thestrike price is below the market price of the underlying security.

Overbought/oversold A condition where a stock has reached the top of its cycle (overbought) and isnow likely to turn down, or has declined to the point where the selling is exhausted (oversold) and buyerswill likely step in to push the share price higher.

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Pacific Stock Exchange One of six U.S. exchanges that trade options.

Philadelphia Stock Exchange One of six U.S. exchanges that trade options.

Position Established when an investor makes an opening purchase or sale of an option, or establishesan option spread.

Premium The price of an option contract, determined in the competitive marketplace, that the buyer(holder) of the option pays to the option seller (writer) for the rights conveyed by the option contract.

Put An option contract that gives the buyer (or holder) the right to sell, and gives the seller (or writer) theobligation to buy, a specified number of shares (typically 100) of the underlying stock at a given strikeprice on or before the expiration date of the contract.

Put ratio backspread A directional trade with a hedging component that allows a trader to book a smallprofit or break even in the event that the trade moves against them. The risk is limited while the reward is


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unlimited. Put ratio backspreads involve selling a near-the-money put (illustrated by a higher strike price)while purchasing two or more out-of-the-money puts. This strategy is designed for a bearish outlook onthe underlying stock. Sharp moves lower and increasing volatility are ideal for this strategy. See also Callratio backspread.

Put Writing (or Put Selling)A strategy that involves selling a put, which places upon the seller the

obligation to buy the shares at the strike price if the put is exercised. Put writers typically sell puts belowthe market to either acquire a stock at a price below current market prices or to get paid while they wait byretaining the option premium when the put expires worthless. Put writers should want to own the stocksthey sell puts on, as they are incurring the obligation to buy the stock at a certain price up until thatoption's expiration.

Put/Call ratio The number of puts divided by the number of calls, based on daily trading volume or openinterest. Such ratios are calculated on individual stocks, indices, or the overall market. Near market lows,the put/call ratio will rise as options traders become excessively worried about downside risk and seek tohedge their portfolios with puts or speculate on further downside activity. Near market peaks, interest incalls heats up to form a low put/call ratio. The put/call ratio is thus a contrary indicator when it reachesextreme highs or lows.

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QQV See Nasdaq-100 Trust Volatility Index (QQV).

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Ratio backspread See Call ratio backspread and Put ratio backspread.

Registered options principal A broker who has passed the NASD Series 4 exam, providing in-depthknowledge related to options.

Regression Channels A best-fit trendline through a given set of data points for a stock, with upper andlower channels that seek to contain the bulk of the price action in that stock's trend. Schaeffer'sInvestment Research seeks to find accelerations outside of these regression channels, and leveragesuch accelerations with options purchases.

Relative Strength Index (RSI) Developed by Welles Wilder, RSI is one of the most popular oscillatorsused by traders to measure the oversold or overbought nature of a security. Values range from zero to100 depending on how much up movement occurs relative to down movement. An indicator readingapproaching zero denotes an oversold condition, while a reading approaching 100 denotes anoverbought condition. Traditionally, values under 20 and over 80 mark the starting points for the zoneswhere oversold and overbought conditions begin to be felt. When stocks approach these zones, there isan increasing likelihood of a reversal in the trend.

Resistance A stock that tends to find significant selling pressure at a certain price point is said to haveoverhead resistance at that level. Technical indicators such as moving averages and overhead call openinterest can also provide resistance as downtrending stocks rally up to these trendlines or strike levels,thereby spurring sellers to take profits.


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Return if called The percentage gain that a covered writer would achieve if the underlying stock is calledaway (see Called away). The components of this return are the original option premium plus anydividends plus any appreciation by the stock to the strike price. This is the maximum return achievable bya covered writer. See Covered call writing.

Rho The sensitivity of an option to a change in interest rates. Normally this is expressed for a one-

percentage-point change in interest rates.

Rolling out Substituting an option of the same class and strike price with one of a later expiration.

Rolling up Substituting a call option of the same class and expiration with one of a higher strike price (ora lower strike price in the case of rolling down a put).

Rydex Nova/Ursa Ratio The Rydex family of mutual funds offers the bullish Nova fund (which targets 1.5times the performance of S&P 500 Index) and the bearish Ursa fund (which moves inversely to the S&P500 Index). A ratio of the NAV-adjusted assets in these funds provides an indication of sentiment towardthe broader market. More dollars pouring into the Ursa fund relative to the Nova fund results in a lowerratio that suggests pessimism (and a potential market bottom). Relatively more dollars going into theNova fund (i.e., a higher ratio) will signal a possible market correction or consolidation, as buying power is

close to being exhausted.

Rydex OTC/Arktos Ratio This is a ratio of the assets in the bullish OTC fund (which mirrors theperformance of the Nasdaq 100 Index) and the bearish Arktos fund (which moves inversely to the Nasdaq100 Index) This ratio provides an indication of sentiment toward the technology sector. More dollarspouring into the Arktos fund relative to the OTC fund results in a lower ratio that suggests pessimism (anda potential bottom in tech stocks). Relatively more dollars going into the OTC fund (i.e., a higher ratio) willsignal a possible tech correction or consolidation, as buying power is close to being exhausted.

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S&P 100 Index (OEX) This is a capitalization-weighted index that measures the overall change in thestock values of 100 of the largest U.S. companies. The S&P 100 companies are drawn from a variety ofindustry groups.

S&P 500 Index (SPX) One of the most widely watched indices, the SPX measures the overall change inthe value of 500 stocks of the largest firms in the U.S. Introduced in its current form in 1957, the SPX iscalculated using a base-weighted aggregate methodology.

Schaeffer's Put/Call Open Interest Ratio (SOIR) A ratio of open puts to open calls among options set toexpire within three months for a given underlying security. The SOIR is one of Schaeffer's primaryquantitative sentiment indicators.

SchaeffersResearch.com (SR.com) The website for Schaeffer's Investment Research, which preparesinvestors for success in options and stock trading. It includes free stock and options quotes, optionsresearch, strategies, market commentary, news, premium content, and other investment resources.SR.com is consistently ranked among the best in its field by several independent organizations.

Sell to close See Closing sale.

Sell to open See Opening sale.


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Sentiment The sum total of all bullish and bearish outlooks among all market participants on a particularstock, index or market.

Sentiment analysis The analysis of the opinions of a crowd of investors that seeks to find extremes inthe crowd's consensus opinion. When most investors expect a certain outcome in the markets, thatexpectation is likely to have already been factored into market prices. Schaeffer's Investment Research

measures sentiment among options traders, mutual fund traders, and various sentiment surveys.

Sentiment surveys Polls that measure the percentage of investors, analysts, or strategists who arebullish, bearish, or neutral on various financial markets. Sentiment surveys related to the stock marketinclude Investors Intelligence, the Consensus Index of Bullish Market Opinion, theAmerican AssociationofIndividualInvestors, and Barron's Roundtable.

Series All option contracts of the same class that have the same unit of trade, expiration date, andexercise price.

Short interest The number of shares of a particular stock that bearish traders and investors have soldshort. Shorting is a strategy that benefits from a stock's decline by selling borrowed shares in the openmarket and then buying those shares back later at a lower price. Short interest signals potential future

buying power, as the shares must eventually be repurchased.

Short position A position where one's interest in a particular series of options is as a net seller or writer(i.e., the number of contracts sold exceeds the number of contracts bought). Also, an investor is "short"when they sell a stock that they don't own in the anticipation that it will decline in value.

Short sellerAn individual who is betting on a decline in a stock's price by selling it short. In such cases,the individual borrows the stock first (usually from a brokerage firm) in order to sell it. The goal is to buythe security back at a lower price at a later date in order to collect a profit relative to the higher initialselling price.

Short squeeze This occurs when short sellers start to feel pressure from a rising stock, which causesincreasing losses as the stock price moves higher. This "squeeze" places pressure on the shorts byforcing them to buy back their bearish positions in order to limit losses. Short squeezes often result indramatic price gains over relatively small periods of time due to this spike of buying pressure.

Short-interest ratio One of the oldest and most popular measures of market sentiment, the short-interestratio represents the number of days it would take to cover all existing short positions at the stock'saverage daily trading volume for the previous month. The ratio is derived from the action of investors whohave borrowed stock and "sold it short" betting on a future decline that will enable them to buy theshares back at a lower price for repayment to the lender. As an indicator, short interest shows the degreeof negative sentiment among investors for a particular stock. It also suggests the amount of potentialbuying power that could be unwound.

Short-life option An option contract having from several weeks to a few months until expiration.

Slippage A cost to investors that results from buying at the asked price and selling at the lower bid price.

SPDR ("Spyders") Standard & Poor's Depositary Receipts (SPY) are instruments that trade like a stockand allow investors to mirror the performance of the S&P 500 Index (SPX). SPY are approximately 1/10ththe value of the SPX. If the SPX is at 1200, for example, SPY will trade at 120.


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Specialist One or more exchange members whose function is to maintain a fair and orderly market in agiven stock or a given class of options. This is accomplished by making bids and offers for their ownaccount in the absence of opposite market side orders.

Spread A position consisting of two parts, each of which alone would profit from opposite directional pricemoves. These parts are executed simultaneously to limiting risk. See Bearish credit spread, Bullish credit

spread, Bearish debit spread, and Bullish debit spread.

Stock option A contract to buy or sell a stock at a predetermined price (strike price) on or before a fixeddate (expiration date).

Stock split The creation of a lower share price with additional shares of stock. In a 2-for-1 stock split, 100shares at a pre-split price of 80 will become 200 shares at a price of 40 after the split. For options traders,stock splits must be monitored, as option contracts will be adjusted to reflect the split. SeeAdjustment.

Stop limitA contingency order that can be placed to trigger an entry or exit if a stock trades at a certainprice. If a stock is at 100, a stop-limit order to buy if the stock reaches 101 requires entering the trade at101 and no higher. This approach can work well as an entry signal on breakouts. It is not recommendedfor exit orders, however, as a stock could drop below the stop-limit price and never allow an exit if it keeps

plunging.

Stop loss A price threshold that triggers the exit of a position when reached. Many stock traders willplace a stop loss about eight or 10 percent below the initial price paid, while options traders often need awider stop-loss threshold of 25 or even 50 percent to account for the more volatile fluctuations in theoptions market. A stop-loss order can be placed in the market in advance of that level being reached or itcan be monitored by a trader as a mental stop-loss level.

Straddle The purchase or sale of an equivalent number of puts and calls on a given underlying stock withthe same exercise prices and expiration dates. The straddle purchaser seeks to profit from relatively largemovements in the price of the underlying stock, regardless of direction.

Strangle The purchase or sale of an equivalent number of puts and calls on a given underlying stock withthe same expiration date but different strike prices. The strangle purchaser seeks to profit from relativelylarge movements in the price of the underlying stock, regardless of direction.

Strike price interval The normal price differential between option strike prices. Equity options generallyhave $2.50 strike price intervals (if the underlying stock price is below $25), $5.00 intervals (from $25 to$200), and $10 intervals (above $200). Some indices and ETFs have one-point intervals (e.g., QQQQand SPY). LEAPS generally start with one at-the-money, one in-the-money, and one out-of-the-moneystrike price.

Strike price The stated price per share for which the underlying stock may be purchased (in the case of acall) or sold (in the case of a put) by the option buyer (holder) upon exercise of the option contract. Alsocalled exercise price.

Suitability A requirement that any investing strategy fall within the financial means and investmentobjectives of an investor or trader. There are several levels of suitability for options traders that covervarious option strategies.

Support A stock that tends to find good buying interest at a certain price level is said to have goodsupport at that price level. Technical indicators such as moving averages and heavy put open interest canalso provide support as stocks pulling back to these trendlines and strikes tend to induce buying behavior.


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Systematic risk The risk inherent in the general market due to broad macroeconomic factors that affectall companies in the market. Also known as market risk.

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Target exit point The predetermined price at which options holdings would be sold at a lucrative, yetachievable profit. This is a key component ofThe Option Advisor's overall money management strategy.

Technical analysis An examination of moving averages, standard deviation bands, and other price andvolume indicators to identify stocks in trending situations or in trading ranges and to predict future stockprices.

Theoretical value An estimated value of an option derived from a mathematical model, such as the BlackScholes formula.

Theta This represents the loss in value an option will experience due to the passage of time. As a

quantification of time decay, theta is usually expressed on a per-day basis. For example, if an option hasa theta of minus 0.25, it will lose about 25 cents per day provided that the underlying stock price andvolatility hold constant.

Tick Each trade in a security can be considered a tick. A tick that is higher than the previous one isconsidered an "uptick." A tick that is lower than the previous one is called a "downtick."

Time decay The nonlinear loss of value in an option over time when all other factors are constant. Timedecay is quantified by theta.

Time erosion See Time decay.

Time premium See Time value.

Time spread See Calendar spread.

Time stop Closing a position if it hasn't moved as expected within a predetermined period of time. A timestop is especially useful for options traders, as an option position can lose value even though theunderlying stock has not moved. A time stop seeks to minimize this risk if the position is not moving asexpected fairly quickly.

Time value The difference between the total cost of an option premium and its intrinsic value. Out-of-the-money options consist solely of time value.

Trading capital The portion of an investor's overall investment portfolio dedicated to a particular trading

strategy. Only a fraction of one's total trading capital should be committed to any one trade or transaction.

Trading floorThe location at the option exchanges where contracts are actually bought and sold.

Trendline See Moving average.

Truncated risk The ability of an investment to resist additional loss. Truncated risk is of particularrelevance to options, since an option buyer cannot lose more than the premium paid. Profits, however,are theoretically unlimited on an option purchase (technically a call purchase, as puts reach a maximum


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when the stock drops to zero) and are equal to the intrinsic value of the option less the premium paid(assuming there is no longer any time value remaining).

Type The classification of an option contract as either a put or a call.

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Uncovered call options A short call option in which the seller (writer) doesn't own an equivalent positionin the underlying stock represented by their call contracts.

Uncovered put options A short put option in which the seller (writer) doesn't have a corresponding shortstock position or has not deposited cash or cash equivalents in a cash account to cover the potentialexercise of the put.

Underlying stock or security The security that would be purchased or sold if the option is exercised.Underlying securities can include stock, futures, and indexes.

Unit of trading The minimum quantity or amount allowed when trading a security. The minimum foroptions is one contract, which generally covers 100 shares of the underlying stock.

Unsystematic risk The risk of an individual stock that is a function of that company's outlook forearnings, new products, or other company-specific news. Unsystematic risk has no relationship tosystematic risk, or risk inherent in the broader market. Also known as company-specific risk.

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Vega The change in an option's price based on the change in its implied volatility expressed in dollarterms. For example, if stock XYZ has an option with a vega of 0.25, the option's price will change by 25cents for each one-percentage-point change in the option's implied volatility.

Vertical Debit Spread A debit spread that utilizes options with the same expiration month. See Bearishdebit spread orBullish debit spread.

VIX See CBOE Volatility Index (VIX).

Volatility The propensity of the market price of the underlying security to change in either direction.

Volume For options, the number of contracts that have been traded within a specific time period, usuallya day or a week.

VXN See CBOE NASDAQ Volatility Index (VXN).

VXO See CBOE S&P 100 Volatility Index (VXO).

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Wasting asset An asset that has a limited life and tends to decrease in value over time (with all otherfactors being held constant). Options are wasting assets.

Documents

The Terms of an Option Contract