InvestorQ : What are some of the most important options concepts I need to know?
Swati Naik made post

What are some of the most important options concepts I need to know?

Answer
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Ria Roy answered.
2 years ago


When you talk of options terminology, here are some basic concepts you need to fully comprehend so as to be able to trade options more fruitfully. Here are a few key concepts pertaining to options.

Index options: These options have the index as the underlying; and this could be a general index like the Nifty or a sectoral index like the Bank Nifty. In India, they have a European style settlement. E.g. Nifty options, Mini Nifty options etc.

Stock options: Unlike index options, stock options are options on individual stocks; which means the stock is the underlying asset and the value of the option depends on the price of the stock. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. In the past, stock options used to have an American style settlement but now they have also shifted to being European options.

Buyer of an option: The buyer of an option is the one who, by paying the option premium, acquires the right but not the obligation to exercise his option on the seller/writer.

Writer / seller of an option: The writer / seller of a call/put option are the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. His risk is unlimited compared to the buyer of the option.

Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price

Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium and it is a sunk cost

Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. All F&O contracts mature or expire on the last Thursday of the month.

Strike price: The price specified in the options contract is known as the strike price or the exercise price

American options: American options are options that can be exercised at any time up to the expiration date. Stock options were American options till 2011 after which they also shifted to being European options

European options: European options are options that can be exercised only on the expiration date itself. In India currently, all index and stock options are of European nature only

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price)

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price

Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0,K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.