OPTIONS TRADING:Options Started

OPTIONS

An option is a contract between two party, where one party gives to the other the right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed price. In return for giving the right, the party giving the right collects a payment from the other party. This payment collected is called the “premium” or price of the option.

TYPES OF OPTIONS

There are mainly two types of options:

Call Option: Call Option is the Options which give the right to buy.

Put Option: Put Option is the Options which give the right to sell.

Further option can be classified in two types based on exercising style:

American Option: American options are options that can be exercised at any time up to expiration date. In NSE all stock options are American type options.

European Options: European options are options that can be exercised at the time of maturity only. In NSE all indices options are European type options. These options are easier to analyze then American options.

OPTIONS TERMINOLOGIES

Spot price

Spot price is the current price at which a particular underlying can be bought or sold at a specified time and place.

Strike price

Strike price is the price at which a specific derivative contract can be exercised. Strike prices are mostly used to describe stock and index options, in which strike prices are fixed in the contract. For call options, the strike price is where the security can be bought, while for put options the strike price is the price at which shares can be sold (up to the expiration date).

The fixed price at which the owner of an option can purchase (in the case of a call), or sell (in the case of a put) the underlying. It's the price at which the stock will be bought or sold when the option is exercised. The strike price is often called the exercise price.

Maturity Date

The date on which all open future and option of that series gets settled.

Premium

The total cost of an option. This is the amount which option buyer pays to the Option Seller. The premium of an option is basically the sum of the option's intrinsic and time value.

Exercise and Assignment

Exercise is the term used when the owner of a call or put (i.e. someone who has a long position in a call or put) uses his right to buy (in the case of a call) or sell (in the case of a put) the stock. Assignment is the term used when someone who is shorts a call or put is forced to sell (in the case of the call) or buy (in the case of a put) the stock. Remember, for every option trade there is a buyer and a seller, so if you are short an option, there is someone out there who is long that option and who could exercise.

Intrinsic Value

Intrinsic value refers to the value of a security which is contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value. An option is said to have intrinsic value if the option is in-the-money. When out-of-the-money, its intrinsic value is zero.

Time Value

Time Value = Option Value - Intrinsic Value.

More specifically, an option's time value reflects the probability that the option will gain in intrinsic value or become profitable to exercise before it expires. This value depends on the time until the expiration date and the volatility of the underlying instrument's price. The time value of an option is not negative (because the option value is never lower than the intrinsic value), and converges towards zero with time.

In The Money Options (ITM):

A call options is said to be “In the Money Option” when spot price is higher than strike price (ITM Call = Spot Price > Strike Price). While a put option is said to be “In the Money Option” when Spot price is below Strike price (ITM Put = Spot Price < Strike Price). In the Money options lead to a positive cash flow if it were exercised immediately.

Intrinsic value of in-the-money call option = underlying product price - strike price

Intrinsic value of in-the-money put option = strike price - underlying product price

At The Money Options (ATM):

An option is said to be “At the Money Option” when spot price and strike price are equal.  (ATM Option = Spot Price = Strike Price). At the Money options lead to a zero cash flow if it were exercised immediately.

Out Of The Money Options (OTM):

A call options is said to be “Out of the Money Option” when spot price is below than strike price (OTM Call = Spot Price < Strike Price). While a put option is said to be “Out of the Money Option” when Spot price is higher Strike price (ITM Put = Spot Price > Strike Price). In the Money options lead to a negative cash flow if it were exercised immediately.