Navigating options trading jargon can be daunting for beginners. Terms like calls, puts, in the money, and out of the money may seem confusing at first glance. However, understanding these key definitions is essential for successful investing. By mastering these terms, you can establish a solid foundation of knowledge.
Ready to dive into the world of options? Here are some common options trading terms to familiarize yourself with.
| Strike Price |
| Index Option |
| Underlying Price |
| Exercising of an Options Contract |
| Option Expiry |
| Option Premium |
| Option Settlement |
| Stock Option Quotes |
| Options Buyer and Seller Terms |
| Option Greeks |
| Moneyness |
Strike Price
The strike price is more or less like the anchor price at which the buyer and seller agree to enter into an options contract. Let’s look at how it works in an actual scenario. Remember the property investor and landowner example? In that agreement, Rs.75 lakh is the anchor price, which is also the ‘Strike Price’. While the property investor was willing to pay Rs.75 lakh for the property in the next six months, the landowner also agreed to the proposed price.
We also went through another scenario by taking BANKNIFTY Call Option into account. In this Options Contract, Rs.44,200, the price at which the agreement was made, is the Strike price. Generally in Call Options contracts, the strike price denotes the price at which the stock can be purchased on the expiry day.
Let’s take a real-world example and see how the Strike Price works. Reliance is currently trading at Rs.2370. If a buyer is willing to buy Reliance’s Call Option for Rs.2400 in the near future, then it means that he is willing to pay a premium today to buy the right of ‘buying ITC at Rs.2400 on expiry’. However, the decision to buy or not buy at the time of expiry is up to the buyer.
Look at the below snap from NxtOption where the strike prices of Reliance are highlighted. You can also see the premium associated with the price there.
The above figure is the Option Chain feature in NxtOption. If you look at the image, you can view how the table lists down different strike prices available for a contract along with the premium for the same.
Beyond strike price and premium, the Option Chain feature has far more info like Open Interest, Theta, Delta, POP, implied volatility, OI change, etc. For now, it is better to just look at the highlighted information. Here is a summary of what they represent.
The blue highlight on the top right corner shows the spot price of Reliance, which was Rs.2368.05 at the time the snapshot was taken.
Meanwhile, the vertical red highlight showcases different strike prices that are available for Call Options. The strike price starts from Rs.2180 and goes all the way to Rs.2580 with Rs.20 intervals between each price.
When you get into an Options agreement for Rs.2400, you are supposed to pay a premium of Rs.11.65 to get the right to buy the Reliance stock at the agreed price by expiry.
Strike prices are independent of the other. Each strike price has its own premium and set of potential outcomes.
Index Option
In the realm of options trading, akin to stocks, investors and traders have the opportunity to engage in indices. Index options encompass contracts where the underlying asset is an index (such as Nifty, Bank Nifty, or Finnifty) rather than specific stock shares.
Nifty and Banknifty are a couple of famous Index Options popular in the Indian stock market.
Let’s take a look at the Option Chain of Banknifty to get a better understanding of how Index Options work.
Here is the summary of what the above image represents.
The spot price of Banknifty is Rs.43615.10 (highlighted in blue).
The vertical red nightlight represents the different strike prices of Banknifty. Starting from Rs.42600, the strike price goes all the way to Rs.44600.
If you are planning to get into an Index Options for Rs.43800, then you will have to pay a premium of Rs.211.40. Since Option Contracts have a lot size, your total premium paid will be lot size x premium for each stock. In this case, the total premium you’ll be paying is Rs.3171.
Underlying Price
The value of every derivative contract is based on an underlying asset. Such underlying price indicates the trading value of the underlying asset in the spot market. Any alteration in the underlying asset’s price directly affects the associated derivative asset’s price.
For instance, in the Reliance example we saw earlier, the spot price was Rs.2368.05. This is technically the underlying price of an asset. When you buy a call, you expect the underlying price to increase to profit from it.
Exercising of an Options Contract
Exercise (in Capital Markets) refers to implementing the right to purchase or sell the designated financial instrument specified in a contract. “Exercising” in Call Option trading signifies the act of implementing the privilege to buy the stock or index mentioned in the options contract.
Traders exercise an Options Contract only when the stock trades above its strike price. One more important thing to remember while entering an Options Contract is that you can exercise your right only on the day of expiry and not anytime before that.
Let’s bring back the Reliance Options Contract example. It is expiring on 30th November 2023 (13 days from now). Reliance’s current market price is Rs.2368.05 and you are buying a Call Option for Rs.2400, paying a premium of Rs.11.65. Once you make the purchase, by the end of the first week (7 days later), the stock price increases to Rs.2480. Although the price has gone up and you can’t ask for a settlement according to the norms. You can only exercise your option contract on the day of expiry (usually the last Thursday of the month).
Option Expiry
Both Futures and Options contracts come with an expiry date, and it is usually the last Thursday of the month. For example, if you buy an Options Contract on 15th November, the contract will expire on the last Thursday of the month, which is 30th November 2023.
The expiry date is exclusive to the F&O environment and is not applicable in equity trading. In case the last Thursday of the month happens to be a holiday, the last Wednesday of the month is considered the expiry date.
F&O contracts have the concept of current month, mid-month, and far month that defines their prices and expiry. The current month represents the ongoing month while mid-month represents the coming month and the far month represents the month after the next month. The below image shows the months and their expiry dates.
As you can see in the above image, there are three expiry options- 30th November 2023 (current month), 28th December 2023 (mid-month), and 25th January 2024 (far month). Traders will be able to buy or sell the Call and Put options for these three months and the strike price and premium will be at different levels for all three.
While we are elaborately discussing about the expiry of contracts, we would also like to let you know that NSE has recently changed the expiry dates for Banknifty F&O. The weekly contracts were announced to expire on Wednesday instead of Thursday while the monthly contracts will stay the same. If Wednesday is not a trading day, then the expiry will be on the previous trading day. Check the below image to get an idea of it.
Option Premium
You must’ve understood what an Option Premium is from the previous chapter. Let’s brush up your knowledge a little bit- Premium represents the cost paid by the option holder/buyer to acquire call contracts or put contracts at a predetermined rate upon contract expiration. Simultaneously, it signifies the compensation received by the option writer/seller for the commitment to buy or sell the asset should the contract holder choose to execute their right.
If you’ve understood the importance of Option Premium in an Option Contract, then it is time to learn more about how it works and the factors affecting Premium.
Two elements that directly influence Option premiums are:
- News flow
- Time
Remember the property investor and landowner example? We will take that scenario into account and determine how news flow and time define Option Premium.
In the property investor and landowner example, they both got into an agreement over a few expectations. These assumptions, which include News flow and Time, decide the Option Premium paid by the property investor. Let’s decode it one by one and see how it works.
News Flow: The property investor and landowner got into an agreement only after coming across speculations about the relocation of the city bus stand. Over the assumption, the property owner has put forward a deal that the landowner has accepted. The fact that the bus stand relocation is speculative increases the chance of benefitting from it. Based on the three outcomes that we analyzed in the previous chapter, the ratio of the landowner having the upper hand is 2:1. Out of the three outcomes, two came in favor of the landowner, purely based on the buzz around the bus stand relocation.
So think about how it directly relates to Option Premium. When the deal was made on 1st January 2023, the news about the bus stand relocation was purely speculative, hence the landowner accepted Rs.10 lakh as an upfront fee. What if the news was not just a speculation and there was some backing to it. Maybe the city corporation officer has already mentioned about the relocation of the bus stand to this area in an interview before the 1st of January. Now, there is an assurance that the relocation could most probably take place in the coming months. Do you think that the landowner will accept Rs.10 lakh as premium? Maybe not! He is already well aware of the potential bus stand relocation and might demand a higher amount as premium. However, there is still a risk associated with it. Since it is not an official announcement, there is a chance that it could get canceled or shifted to a different place. That being said, the landowner might demand a higher premium like Rs.15 lakh instead of Rs.10 lakh.
Time: There was a solid six-month gap between the agreement signing and execution date. This time gap plays a crucial role in deciding the premium. Both parties have six months to get clarity on the bus stand relocation.
Let’s look at a different scenario to understand this better. If you were to predict whether it would rain within the next 10 minutes or 24 hours, the likelihood of rain occurring within the next 24 hours is considerably higher than within the next 10 minutes due to the longer time frame.
Option Settlement
Option settlement refers to the process by which the obligations of an options contract are resolved between the buyer and the seller. It occurs at the expiration date of the option or when the option holder decides to exercise their right to buy or sell the underlying asset.
In India, settlements are cash-based, meaning the party pays a cash amount equal to the difference between the option’s strike price and the market price of the underlying asset.
Let’s understand this with an example. If you take a look at the image above, the Call Option to buy Reliance at Rs.3000 has been initiated with the expiry of 25th April 2024. The premium is Rs.41.40 and one lot has 250 shares.
So the total premium is 250 x Rs.41.40 = 10,350
Assume there are two traders- Trader X and Trader Y. Trader X intends to purchase this contract (option buyer) while Trader Y seeks to sell (write) it. Given that the contract involves 250 shares, Trader X is required to pay Rs.10,350 as a premium. Let’s outline the projected cash flow and explore how the Options Settlement is reached.
Since Trader Y has received a premium from Trader X for the contract, he is obligated to sell those 250 shares on the day of expiry, if Trader X decides to exercise his agreement. Nonetheless, this does not imply that Trader Y must possess 250 shares on April 25th. If Trader X decides to exercise his right, Trader Y is obligated to pay just the cash differential to Trader X.
Let’s look at an imaginary scenario to understand this better. Consider on 25th April, Reliance is being traded at Rs.3200. This means Trader X (Option Buyer) will exercise his right to buy 250 shares of Reliance at the pre-determined price of Rs.3000. In a nutshell, he is getting to buy Reliance stock at Rs.3000 when it is trading at Rs.3200 in the open market.
Technically, this is what the cashflow of a profit-making Call Option looks like:
Trader X exercises the right to buy 250 shares from Trader Y on 25th April 2024 (expiry day).
The strike price of the symbol is pre-determined as Rs.3000 on the day of expiry.
Trader X pays Rs.3000 (strike price) x 250 (one lot size) = Rs.7,50,000 to Trader Y to acquire the stocks.
Against the payment from Trader X, Trader Y releases the shares as promised.
After acquiring, Trader X immediately sells the shares in the open market at Rs.3200 per share and receives Rs.8,00,000.
The Option Buyer makes a profit of Rs.50,000 (Rs.8,00,000-Rs.7,50,000) on this transaction.
While this is the typical way to look at the cashflow, below is a simple way to understand this.
Trader X (Option Buyer) is making a profit of Rs.200 per share (Rs.3200-3000).
As the option is cash-settled, instead of delivering 250 shares to the option buyer, Trader Y provides them with the cash equivalent of the potential profit.
Through this, Trader X would receive Rs.200 x 250 = Rs.50,000 from Trader Y.
Since the Option Buyer has already spent Rs.10,350 as premium, he makes an overall profit of Rs.50,000-10,350 = 39,650.
In a nutshell, Trader X makes 383% profit from this trading. Options offer the potential for significant profits, making them appealing to traders. This popularity among traders is one reason why options are favored trading instruments.
Stock Option Quotes
A stock option quote provides essential information for investors and traders looking to engage in options trading for a particular stock. Options contract quotes are inherently complex due to the versions available for trading, differentiated by their type, expiration date, strike price, and other factors.
When accessing an options quote, you’ll see a table displaying available options contracts, known as Option Chain. This table provides essential information such as strike price, expiration date, and type of the contracts.
Strike Price: The predetermined price at which an option can be bought or sold if it is exercised.
Expiry Date: The predetermined date on which an options contract expires, marking the last day it can be exercised or traded.
VWAP: Volume Weighted Average Price calculates a stock’s average price based on its volume and the price at which it trades throughout the trading day.
Greeks: Option Greeks are financial metrics used to assess how changes in various factors, such as volatility or the price of the underlying asset, impact the price of an option.
Volume: The number of contracts traded on a particular day.
ITM-Prob: ITM probability refers to the likelihood that an option will expire in-the-money.
OI Interpretation: OI Interpretation helps analyze the OI data to understand market sentiment and potential price movements.
OI Change: The difference between the current day’s open interest and the previous day’s open interest, indicating changes in market positions.
POP: Probability of Profit is the likelihood of an option trade resulting in a profit at expiration.
PCR: Put/Call Ratio is a market sentiment indicator that measures the ratio of Put Options to Call Options traded on a particular underlying asset.
Implied Volatility: Implied Volatility (IV) plays a crucial role in determining the price of Options. Buying Options Contracts provides the opportunity for holders to buy or sell an asset at a set price within a pre-determined period of time. IV forecasts the potential value of the option, considering both its current value and anticipated future changes. Options with high IV typically command higher premiums, whereas those with lower IV tend to have reduced premiums.
LTP Change: The difference between the LTP of a security in the current session and its previous closing price.
Options Buyer and Seller Terms
Within the realm of options trading, the terms ‘holder’ and ‘writer’ delineate the roles assumed by investors, presenting a nuanced perspective that transcends the conventional buyer-seller diversification.
Holder: A Holder, as the name implies, embodies the investor who possesses an options contract. For instance, a call holder acquires the privilege to purchase the stock at a predetermined price, while a put holder secures the right to vend the stock under the same contractual conditions.
Writer: Conversely, a Writer signifies the investor who undertakes the sale of the options contract. In exchange for this commitment, the writer receives a premium from the holder. This premium serves as compensation for the obligation to either buy or sell the specified shares at the strike price, should the holder opt to execute the option.
The core of divergence between options holders and writers lies in their exposure to risk. While holders have the right to buy or sell the shares, they’re not obliged to do anything. They may opt to exercise the option, should it prove financially advantageous, or allow it to lapse upon expiration. In the latter scenario, their loss is confined to the premium paid for the option.
In contrast, writers lack the luxury of such flexibility. Upon the decision of a call holder to exercise the option, the writer becomes contractually bound to fulfill the transaction by selling the stock at the stipulated strike price. If the writer lacks the required stock holdings, they are compelled to procure shares at prevailing market rates, potentially incurring losses if these rates exceed the strike price.
Option Greeks
Option Greeks are crucial metrics in options trading, indicating the sensitivity of an option’s price to various factors related to its underlying asset. These measures play a vital role in analyzing options portfolios and assessing risk. The main Greeks include Delta, Gamma, Vega, Theta, and Rho.
- Delta assesses the probability of an option expiring in-the-money (ITM), relative to the underlying security’s market price and strike price.
- Gamma estimates Delta’s potential change with alterations in the stock price.
- Theta measures an option’s daily value loss as it nears expiration.
- Vega reveals an option’s sensitivity to significant price fluctuations in the underlying stock.
- Rho simulates the impact of interest rate fluctuations on an option’s value.
These Greeks help traders understand and manage risk effectively by providing insights into how options prices may fluctuate under different market conditions. By analyzing these metrics, traders can make informed decisions about options trading strategies and portfolio management.
Moneyness
When discussing options performance, simplistic terms like “up,” “down,” or “flat” are insufficient. At any juncture when an options contract is active, it falls into one of three categories:
In the Money (ITM): In the Money (ITM) contracts indicate options that are currently profitable. For a call option, ITM means the spot price exceeds the strike price, while for a put option, it’s the opposite.
ITM: Spot Price > Strike Price (Call Option)
ITM: Spot Price < Strike Price (Put Option)
For example, if XYZ’s spot price is Rs.100, then anything below that are considered ITM.
At the Money (ATM): At the Money (ATM) contracts have spot and strike prices identical. The premiums are crucial at this stage.
For instance, if XYZ stock is at Rs. 100, both the XYZ 100 Call Option (CE) and the XYZ 100 Put Option (PE) are ATM.
Out of the Money (OTM): Out of the Money (OTM) contracts have strike prices unfavorable compared to spot prices. For call options, the strike exceeds the spot; for put options, it’s the opposite.
OTM: Spot Price < Strike Price (Call Option)
OTM: Spot Price > Strike Price (Put Option)
For XYZ with spot price Rs.100, call options with strike prices above 100 are OTM.