InvestorQ : What exactly is an option in the stock markets?
Bhavik Nehru made post

What exactly is an option in the stock markets?

Answer
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Bhavik Nehru answered.
2 years ago


Before we understand in-the-money (ITM) and out of the money (OTM), let us first understand at-the-money (ATM) since the definition is the same for calls and puts. An option is said to be "at-the-money", when the option's strike price is equal to the underlying asset price. This is true for both puts and calls. What do we understand by in the money option? When an option can be exercised i.e. either it is resulting in profit or in reduction of premium loss, it is call in the month option or ITM option. A call option is said to be "in the money" when the strike price of the option is less than the underlying asset price. For example, a Tata Steel call option with strike of 550 is "in-the-money", when the spot price of Tata Steel is at 580 as the call option has a positive exercise value. The call option holder has the right to buy the Stock at 550, no matter by what amount the spot price exceeded the strike price. With the spot price at 580, selling Stock "A" at this higher price, one can make a profit. Let us complicate this further. What if the premium of Rs.10 was paid and the spot price was at Rs.555. It would still be in the money and will be exercised because it reduces the option loss from Rs.10 to Rs.5. On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Let us go back to the example of Tata Steel. Using the earlier example of Tata Steel if the market price falls to 520, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Tata Steel at 550 when the stock can be purchased in the open market at Rs.520. Hence he will allow the option to lapse and lose the Rs.10 premium that has been paid.

SUMMARY

CALL OPTIONS

PUT OPTIONS

In-the-money

Strike Price < Spot Price of underlying asset

Strike Price > Spot Price of underlying asset

At-the-money

Strike Price = Spot Price of underlying asset

Strike Price = Spot Price of underlying asset

Out-of the-money

Strike Price > Spot Price of underlying asset

Strike Price < Spot Price of underlying asset

How are ITM and OTM defined in case of put options? A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Tata Steel put at strike of 550 is in-the-money when the spot price of Tata Steel is at 530. When this is the case, the put option has value because the put option holder can sell the Stock at 550, an amount greater than the current Stock price of 530. Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Tata Steel put option won't exercise the option when the spot is at 570. The put no longer has positive exercise value because why should he sell at Rs.550 when it can be sold in the open market at Rs.570. Therefore in this scenario, the put option holder will allow his "option" right to lapse and take the loss of premium paid as a sunk cost


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Bhavik Nehru answered.
2 years ago


An option is a right to buy or sell an equity share or any other asset but without an obligation. That means you can buy the asset at a future data if the price is suitable can sell the asset at a predetermined price at a future date if it suits you. If the price is not suitable then you can just opt to forego the option and say that you don’t want to exercise the right to buy or sell the option. When you trade options in the stock market, you actually trade these rights without the obligation. Options need to be understood as distinct from futures because futures are a right and an obligation. Options on the other hand are a right without an obligation. When you buy an option in the market you get a right to buy or sell an asset without the obligation to do so. A right to buy is referred to as a call option while a right to sell is referred to as a put option