Basics of Derivatives
Previously, we have learned buying and selling Call or Put options. But before we start options trading, it is essential to get used to specific terminologies related to Options.
What are the various terms used in Options?
There are different terms that need to be understood with clarity regarding options. Let us understand this with the help of an example.
Let us assume that we are bullish on a stock, which is trading at ₹670/-. We buy a call option at a strike price of ₹750. By paying a premium of ₹50 per share. The contract would mature after one month.
It looks simple but there are a lot of terms associated with it that needs to be understood.
The right to buy a stock at a specified price on a certain specific predetermined date is known as a call option contract and the person who has this right is known as a call option buyer or holder.
The person who is having the obligation to sell the stock at the specified price on the predetermined date is known as a call option seller or writer.
The predefined specified price is known as the strike price or the exercise price, whereas the price at which the stock price is trading in the market at different points of time is known as the Spot price.
In our example, ₹670 is the spot price and ₹750 is the exercise price.
To enjoy the right to buy the stock, the option buyer pays a small amount to the option seller at the time of entering into the contract. This is known as the premium.
The time (i.e. one month in our example) when the contract would lapse is known as time to maturity.
Similarly a Put option, is the right to sell the asset at a predefined price at a predefined date.
A seller of a put option has the obligation to buy the asset at the strike price, and he also receives premium to do so.
We must remember that all option buyers pay a premium and option sellers receive premium.
One more concept with respect to options is its moneyness and intrinsic value. It basically tells us about the relationship of an options contract with respect to its spot price and exercise price.
It is a classification criterion which classifies each option strike based on how much money a trader will earn would exercise his option contract at this particular moment.
It basically tells us about the intrinsic value of an option. The intrinsic value of an option is the money the option buyer will make from the contract assuming he has the right to exercise that option now. Intrinsic Value is always a positive value and can never go below zero. There are three broad classifications on the basis of moneyness. They are:
- In the Money (ITM)
- At the Money (ATM)
- Out of the Money (OTM)
All In the money options are those options which have a positive intrinsic value. For call options, a contract is ITM when spot price is greater than the exercise price and for a put option a contract is ITM when spot price is lower than the exercise price.
OTM options are those whose intrinsic value is always 0. For call options, a contract is OTM when spot price is lower than the exercise price. and for a put option a contract is OTM when spot price is higher than the exercise price.
ATM options are those where the spot price equals the exercise price and intrinsic value is also zero.