OPTION
TERMINOLOGY
·
Index
options: These options
have the index as the underlying. In India, they have a European
style settlement. Eg. Nifty options, Mini Nifty options etc.
·
Stock
options: Stock options
are options on individual stocks. A stock option contract gives the
holder the right to buy or sell the underlying shares at the specified price.
They have an American style settlement.
buys
the right but not the obligation to exercise his option on the seller/writer.
·
Writer /
seller of an option: The writer
/ seller of a call/put option is the one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer exercises on
him.
·
Call
option: A call option
gives the holder the right but not the obligation to buy an asset by a
certain date for a certain price.
·
Put option: A put option gives the holder the right but not the obligation to sell
an asset by a certain date for a certain price.
·
Option
price/premium: Option price
is the price which the option buyer pays to the option seller. It
is also referred to as the option premium.
·
Expiration
date: The date specified in the
options contract is known as the expiration date, the exercise
date, the strike date or the maturity.
·
Strike price: The price specified in the options contract is known as the strike
price or the exercise price.
·
American
options: American
options are options that can be exercised at any time upto the expiration
date.
·
European
options: European
options are options that can be exercised only on the expiration
date itself.
·
In-the-money
option: An
in-the-money (ITM) option is an option that would lead to a positive
cashflow to the holder if it were exercised immediately. A call option on the
index is said to be in-the-money when the current index stands at a level
higher than the strike
price (i.e.
spot price > strike price). If the index is much higher than the strike
price, the call is said to be deep ITM. In the case of a put, the put is ITM if
the index is below the strike price.
·
At-the-money option: An at-the-money (ATM) option is an option that would lead to zero
cashflow if it
were exercised immediately. An option on the index is at-the-money when the
current index equals the strike price (i.e. spot price = strike price).
·
Out-of-the-money
option: An out-of-the-money (OTM) option is an option
that would lead to a negative cashflow if it were exercised
immediately. A call option on the index is
out-of-the-money
when the current index stands at a level which is less than the strike price
(i.e. spot price < strike price). If the index is much lower than the strike
price, the call is said to be deep OTM. In the case of a put, the put is OTM if
the index is above the strike price.
·
Intrinsic
value of an option: The option premium can be broken down into two
components - intrinsic value and time value. The intrinsic value of a
call is the amount the option is ITM, if it is ITM. If the call is OTM, its
intrinsic value is zero. Putting it another way, the intrinsic value of a call
is Max[0, (St — K)] which means the intrinsic value of
a call is the greater of 0 or (St — K).
Similarly, the intrinsic value of a put is Max[0, K — St],i.e.
the greater of 0 or (K — St). K
is the strike price and St is
the spot price.
·
Time
value of an option: The time
value of an option is the difference between its premium and its
intrinsic value. Both calls and puts have time value. An option that is OTM
or ATM has
only time value. Usually, the maximum time value exists when the option is ATM.
The longer the time to expiration, the greater is an option's time value, all
else equal. At expiration, an option should have no time value.