What is Option in Trading?
An option in trading terms means a contract between two parties either to buy or sell a given amount of underlying assets at pre-specified price on or before a given timeline.
To understand it better we can take vehicle insurance as the best example:
Assume that you took a vehicle insurance of 10,00,000 by paying a premium of 20,000. If an accident occurs where your vehicle is destroyed, you receive most of the value of your vehicle, minus the premium i.e. 9,80,000. Incase your vehicle survives, then you lose only the premium paid i.e. 20,000.
More like the insurance payoffs which are asymmetric when it comes to upside and downside payments, so are the Options in Trading.
What are the different types of Options?
There are two types of Options:
i) Call Option: An option which gives the right to buy the underlying asset at a specific price on or before a specific date. ii) Put Option: An option which gives the right to sell the underlying asset at a specific price on or before specific date.
Buyer of an Option by paying Option Premium buys the right but not the obligation. Whereas the writer of Call/Put option receives the Option Premium and it becomes obligatory for them to sell/buy the underlying asset if the buyer wishes to exercise his option.
How to buy option?
* Buying of option requires premium to be paid
How to Sell Option?
* Selling of option requires margin to be paid.
What is Option Premium?
* The price which option buyer pays to option seller to acquire the rights is called an option premium.
What is Strike Price?
* The pre-specified price of an underlying assets is called as strike price and
What is an expiration date?
The date at which strike price is applicable is called expiration date.
What are underlying assets?
* The asset which is bought or sold is called underlying assets.
What Determines an Option Price? This includes a various factors such as spot price of the underlying asset, the strike price, annual volatility, expiration date and also interest rates.
What is an Option Value?
Actual Value of an option is the difference between the spot price and strike price of the underlying i.e.
For Call option it's Spot Price - Strike Price.
For Put option it's Strike Price – Spot Price.
What is the time value of an option?
Time value of an option is the difference between its premium and its actual value which equals to Premium – (Spot Price – Strike Price)
Only A Call ATM(At The Money) and OTM(Out of The Money) have time value. And mostly, the maximum time value exists when the Option is ATM.
At the Money Option(ATM): This an option that would lead to zero cash flow.
In this case Spot price = Strike price.
Out-of-the Money(OTM): This is an option that would lead to a negative cash flow.
In this case Call option = Spot Price < Strike Price, Put Option = Spot Price > Strike Price.
In-the-Money Option(ITM): An option that would lead to positive cash flow to the holder.
In this case a Call option becomes ITM when Spot price > Strike price whereas Put options becomes ITM when Spot price < Strike price