The trading community loves speculative trading in the form of options since it can generate enormous profits while also hedging the portfolio to protect it. However, when a novice enters the realm of options trading, they become perplexed by terms like Strike Price, Call/Put, ATM, ITM, OTM, and others.
In this article, we’ll examine some of the most important options trading terminology and attempt to explain what these terms (or jargon) imply. To comprehend 21 of the most crucial definitions in options trading, continue reading. But first, let’s go over the basics.
What is Optional trading?
Options trading are derivative financial products that allow buyers the right to purchase the underlying asset from the option seller at a predetermined price on or before an expiration date (also known as the expiry day).
However, in this case, the option buyer is merely allowed to purchase the asset; he is not required to do so when the contract expires. However, the Options Seller is required to uphold the agreement.
This is because the option seller is compensated by this charge (also called the premium) for waiving his claim to the underlying assets until the contract’s expiration. The buyer will forfeit the advance payment if he decides not to purchase the asset from the seller.
Buying or selling these options contracts is known as options trading.
21 essential definitions of options trading that every newbie should be aware of
Options Trader or Buyer
A trader or an investor who purchases an option from the seller is known as an option buyer. It means the buyer acquires the right to buy an underlying asset from the seller at a specific price on or before the option’s expiration date. The buyer purchases this right. Because the option buyer has paid a premium (also known as a fee or compensation) to the option seller for this contract, unlike the option seller, the option buyer is not required to put the option into action.
Options Seller or Writer
There is a buyer and a seller in every transaction. Options sellers are investors or traders who earn a premium from the buyer to enter the agreement and are obligated to honour the contract if the buyer decides to exercise the option before it expires. Option sellers are often referred to as Options writers.
The maximum profit for Options writers is until the premium is received, but they can incur a limitless loss.
Option Calls
A call option is a form of option that allows the buyer to purchase an underlying asset at a predetermined price at a future date. The buyer of a call option makes money only when the underlying asset’s value rises.
The fundamental reason for purchasing a call option is that the trader expects the underlying securities price to rise soon.
On the other hand, the trader who sells (or writes) a call option believes that the asset’s price will not rise over the predetermined level.
Put Alternatives
A put option is a form of option that allows the buyer to sell the underlying asset at a predetermined price at a later period. When the underlying asset’s value falls, the buyer of a put option profits.
In layman’s terms, a trader or investor purchases a put option when he believes the underlying asset price will fall soon. The trader who sells (or writes) a put option believes the asset’s price will not exceed the predetermined level.
Expiration of Options
The expiry date of an option contract is the last date on which the buyer or holder of the options may exercise their rights.
Options contracts in the Indian stock market typically expire at the end of business hours on the last Thursday of each month for weekly index expiry and on the last Thursday of each month for stock options.
Underlying cost
The Spot Price, also known as the underlying price, is the current market price of the asset from which the options are derived, and it can be purchased or sold for immediate delivery at this price.
Assume someone purchases a call option from ABC Company. If ABC Company is now selling at Rs 15 per share, the underlying price or spot price is Rs 15. The gap between the underlying and strike prices significantly impacts the option premium.
Price of a Strike
The Strike Price is the option contract’s predetermined and executable price at which the Options buyer and seller agree on a contract. Buyers of options receive options to purchase different strike prices based on their viewpoint.
If the spot price exceeds the agreed strike price when the call option expires, the holder profits. The Put option holder, on the other hand, profits if the spot price falls below the agreed-upon strike price.
Index Alternative
Indexes, like stocks, can be traded in options by investors and traders. Unlike stock options, index options are based on an index like the Nifty, Bank Nifty, or Finnifty.
Trading in Nifty and Bank Nifty options is prevalent in the Indian stock market.
ITM (In the Money)
Contracts in the Money (ITM) refer to something already profitable. ITM is an option contract in which the underlying asset’s spot price is more than the strike price for a call option and less than the strike price for a put option.
ATM (Automated Teller Machine)
An At Money Option contract is one in which the underlying asset’s spot and strike prices are the same. The options premiums are most important when the options contract is trading ATM.
For example, if the spot price of XYZ stock is Rs 75, then the XYZ 75 Call Option (CE) is in the money. ATMs provide XYZ 75 Put Options (PE). If the Nifty trades at 18,000 in the spot market and you buy an 18000 Call or 18000 Put option, you are trading At Money contracts.
OTM (Out of the Money)
When the strike price of a call option is more than the spot price of the underlying asset, the contract is referred to as OTM. When the striking price of the underlying asset is less than the spot price of an option contract, the contract is said to be Out of Money.
Intrinsic Worth
The Intrinsic Value of an option contract determines how profitable it is based on the difference between the strike price and the market price. It implies how much money the contract is currently ‘in the money’.
For example, if you purchased a call option contract with a strike price of Rs 300 and it currently trades at Rs 400 on the spot, the intrinsic value of the call option is Rs 100 (400-300).
Out of the Money (OTM), contracts have no intrinsic value and cannot have a negative intrinsic value.
The Time Value
Time value is the extra money that an option buyer is willing to pay on the premium over the intrinsic value based on the projected volatility of the underlying asset and the additional time before the expiration date.
If the contract has time and is close to expiration, it has the potential to be profitable, and the buyer must compensate for this time value. As the options contract expires, the time value approaches zero.
Premium Alternatives
The option premium is the charge paid by the option buyer to the option seller for the right to an underlying asset before it expires. It is thus the most significant loss the buyer of the option can experience and the maximum profit the seller can obtain.
Intrinsic Value + Time Value equals Options Premium.
If the option expires in the money, the option buyer is entitled to exercise the option and profit. If the option expires out of money, the option buyer will be unable to exercise his right and will forfeit the premium paid. If the contract expires at OTM, the premium is the income the option seller generates.
Options Settlement
An example will clarify. Last Thursday’s XYZ call option cost Rs 50. Market lots include 7,000 shares and cost Rs 4.
Trader A and Trader B. Trader A (Option buyer) and Trader B (Writer) desire to buy and sell this agreement, respectively.
How will money move?
Trader A must pay Trader B Rs 28,000 since the premium is Rs 4 per share.
If Trader A exercises his agreement, Trader B must sell 7000 XYX shares on January 30, 2020, because he obtained this Premium from him. Trader B should not have 7000 shares on 30 January.
India cash-settles options. Trader B must pay only the cash differential if Trader A exercises his option on the last day.
On January’s last Thursday (expiry day), XYZ trades at Rs.65. The option buyer (Trader A) will acquire 7000 XYX shares at Rs 50. He buys XYZ at 50 when trading at Rs 65 in the open market.
Option buyers profit Rs.15 per share (65-50). Because the option is cash-settled, Trader A would receive Rs 1,05,000 instead of 7000 shares from Trader B.
The option buyer invested Rs.28,000 to buy this privilege. His profit is Rs 77,000 (1,05,000-28,000). Options are appealing because of their enormous exponential return. Options are a trader’s preference because of this.
Option Chain
Option chains list all option contracts having Call and Put parts. NSE India hosts the options chain. Buyers and sellers must understand the Options Chain.
Greek options
Options Greeks assist traders in price options. Greeks help you understand options premium, volatility, risk management, etc. Options Greeks: Delta, Gamma, Theta, Vega, Rho. Options Greeks are used to analyze portfolios and understand option price sensitivity to underlying assets.
Delta
Delta is an Options Greek that compares premium change to underlying change. Delta ranges from 0 to 1 for call options and -1 to 0 for put options.
Theta
Theta influences option pricing. Time influences striking price premiums. As expiration approaches, option Premium decays. Theta is the rate at which option premiums erode as expiration approaches.
Gamma
Gamma compares Delta’s change to underlying’s change. Gamma calculates Delta gained or lost for a one-point change in underlying. Remember that Call and Put options have positive Gamma.
Vega
Volatility affects Greek Vega. Change is volatility. Vega is the change in option value for a 1% change in underlying asset price. Option prices increase with underlying asset volatility and decrease with lesser volatility.