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.
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%.