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Options Basics


Options


What is 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.


Type of Options - Call and Put

Call Options


Call Option is an option where buyer gets the right to purchase the underlying but not any obligation. Buyer of the Call Option expects the price to go up and hence purchase right to buy at a specified rate by paying premium. Call Option buyer is getting the right to purchase from Call Option seller and pays the premium to Call Option seller. The Maximum loss to the buyer of the Option is limited up to premium paid. If price rises than Call buyer earns unlimited profit. The maximum profit to the call seller is up to premium received when market falls and he may make unlimited loss if market rises.


Put Options


Put Option is an option where buyer gets the right to sell the Underlying but not any obligation. Buyer of the Put Option expects the price to go down. The Maximum loss to the buyer of the Option is limited up to premium paid. If prices falls than Put buyer earns unlimited profit. Let us look at one example to make it clear.


What is Option 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.


Type of Options - ITM, ATM & OTM​​​​


ITM


A Call Options is said to be “In the MoneyOption” when spot price is higher than strike price (ITMCall = Spot Price > Strike Price). While a Put Option is said to be “In the Money Option” when Spot price is below Strike price (ITMPut = 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


ATM


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


OTM


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


Type of Option - American / European


American Options


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 than American options. 2.1.6 Options Terminology


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 Option, strike price is the price at which underlying can be bought, while for putoptions the strike price is the price at which underlying can be sold. 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.


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 upon the time period left for expiry 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.


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 has short 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 in any option, there is someone who is long in that same option and who could exercise.






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