Option Basics

[Larry1234 10]

I would like to tell you about options. In my opinion, options are the most important financial instrument. Its really easy to make money using option strategies.

 

Let's understand the terminologies related to option -

 

There are two basic types of options, call options and put options.

 

• Call option: It gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

 

• Put option: It gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

 

• Option price/premium: It 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: These can be exercised at any time up to the expiration date.

 

• European options: These can be exercised only on the expiration date itself. European options are easier to analyze than American options and properties of an American option are frequently deduced from those of its European counterpart.

 

• In-the-money option: An in-the-money (ITM) option would lead to a positive cash flow 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 would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the cur- rent index equals the strike price (i.e. spot price = strike price).

 

• Out-of-the-money option: An out-of-the-money (OTM) option would lead to a negative cash flow 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 has two components - intrinsic value and time value. Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time.

 

The intrinsic value of a call is Max[0, (S — K)] which means that the intrinsic value of a call is the greater of 0 or (S— K). Similarly, the intrinsic value of a put is Max [0, K — S], 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. 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.

 

 

Happy Learning

[Larry1234 10]

This thread is created to discuss the basics of options. Lets talk more about this. I am awaiting the comments of option experts in this thread.

[henryduncan12 10]

Thanks for shared this information with details. I think an option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date.

[UrmaBlume 10]

I would like to tell you about options. In my opinion, options are the most important financial instrument. Its really easy to make money using option strategies.

 

What is really easy is to throw out a few definitions. What is missing is the definition of precisely how - - "Its really easy to make money using option strategies"

[Larry1234 10]

What is really easy is to throw out a few definitions. What is missing is the definition of precisely how - - "Its really easy to make money using option strategies"

 

Hello Urma,

 

Various option strategies can be framed using different combinations of Call, Puts and Futures, with different and similar strike price and with different and similar time to expiration.

These strategies can be framed in such a that we can easily minimize our loss, maximize our profit which is not possible in equity investment.

 

That is why I have mentioned in my earlier post that "Its really easy to make money using option strategies"