Now that we have a clear understanding on what are options, lets us decode different terms associated with the world of options in this video.
We will continue with our example which was in our previous videos (Why are options better than futures) to get a better understanding.
In that video, we had assumed that we were bullish on a stock. The stock was trading at Rs.670/- currently.
We buy a call option at a strike price of Rs. 750, by paying a premium of Rs. 50 per share. The contract would mature after 1 month.
So now there are lot of terms associated with it. Isn’t it?
Now, let us understand them one by one:
The right to buy a stock at a specified price, on a certain specific predetermined date is known as a call option contract.
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.
So, in our example, Rs. 670 is the spot price, and Rs. 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 of the option. The time i.e., 1 month, when the contract would lapse, is known as the time to maturity.
Similarly, a Put option is the right to sell the asset at a predefined price at a predefined date.
So, 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 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, if he would exercise his option contract 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 0. There are 3 broad classifications in the basis of moneyness. They are:
- In the Money (ITM)
- At the Money (ATM)
- Out of the Money (OTM)
These terms have been discussed in our separate video on ITM, ATM and OTM.
So, with this, we conclude the basic terminologies related to option contracts.
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