Options Terminology The Master List of Options Trading Terminology

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In the preceding chapter, we got familiar with the primary call option setup. The purpose was to understand a few core ‘Call Option’ ideas such as –

  1. Purchase of a call option is an efficient approach if you anticipate the value of the underlying asset to rise.
  2. If the price stays level or decreases, the purchaser of the call option will be at a loss.
  3. The buyer of the call option would be equal to the premium they paid to the seller/writer of the call option.

In the upcoming Call Option chapter, we will explore the call option in more depth. Before delving further into the topic, let’s decode a few basic terms associated with options. Explaining these jargons at this point in time will not just reinforce our understanding but also simplify our future discussion of this concept.

Let us now consider the following terms –

  1. Strike Price
  2. Underlying Price
  3. Exercising of an option contract
  4. Option Expiry
  5. Option Premium
  6. Option Settlement

Remember, we have only gone over the fundamentals of a call option. I suggest you only research these terms as they relate to that type of option.

  • Strike Price

The strike price serves as a reference point agreed upon by buyers and sellers when they engage in an options agreement.

Let’s take an example: 

By acquiring a XYZ Limited Call Option at Rs.250, the purchaser pays a premium today to obtain the right to potentially purchase the company’s stock at Rs.250 upon expiration. This will only happen if XYZ Limited is trading above this strike price at the end of the specified period. Here is a screenshot from the stock exchange’s website showing the option chain for XYZ Limited, displaying the different strike prices and their associated premiums.

The tabular representation provided above is commonly referred to as an “Option Chain,” which provides information about various strike prices and their corresponding premiums. For now, let’s focus on the highlighted data and ignore other details such as open interest, volume, bid-ask quantity, etc.

  1. The highlighted maroon area represents the spot price of the underlying asset, with XYZ Limited trading at Rs.230 per share.
  2. As seen in the blue highlight, there is a range of strike prices starting from Rs.200 with intervals of Rs.10, going up to Rs.300.
  3. It’s important to note that each strike price has a unique premium associated with it. If someone wants to enter an options agreement at a specific strike price, they must pay the corresponding premium.
  4. For example, a premium of Rs.5.50 (highlighted in red) can be paid to enter into a 240 call option.
  5. The buyer of this option has the right to purchase XYZ Limited shares at Rs.240 upon expiration. It is crucial to assess the circumstances under which it would be advantageous to buy XYZ Limited at Rs.240 as the contract expires.
  • Underlying price 

We understand that the value of a derivative contract is derived from an underlying asset. The spot market price of the underlying asset is referred to as the underlying price. In the case of XYZ Limited, as mentioned earlier, it is noted at Rs.230/-. This underlying price forms the basis of the call option, and a rise in the underlying price benefits the buyer of the call option.

  • Exercising of an option contract

Exercising an option contract refers to the act of utilising the right to buy the underlying asset upon the expiration of the contract. In the case of a call option, exercising involves the individual exercising their right to purchase the stock at the predetermined strike price. 

However, this can only be done if the current trading price of the stock is higher than the strike price. It is crucial to understand that exercising is only possible on the expiration day and not before.

Therefore, if someone purchases an XYZ Limited 240 Call option when the underlying asset is valued at Rs.230 in the spot market, and the price increases to Rs.250 the following day, they cannot execute the settlement against their option on that same day. The settlement will only take place at expiration, based on the spot market price at that time.

 

  • Option Expiry

Both options and futures contracts have expiration dates. Generally, they fall on the last Thursday of each month. Similar to futures contracts, options contracts are divided into different categories such as current month, mid-month, and far month.

This provides an overview of an option to buy ABC Corporation Ltd at a strike price of Rs.80, priced at Rs.4.50/-. There are three expiration options – current month, mid-month, and far month – with dates of 26th March 2023, 30th April 2023, and 28th May 2023, respectively. It may come as a surprise, but premiums can vary depending on the expiration date. However, it is essential to remember that all contracts have three expiration options, and premiums can differ among them. 

Options contracts, like futures contracts, have expiration dates. Typically, they fall on the last Thursday of each month. Like futures, options contracts are categorised into current month, mid-month, and far month.

This is a snapshot of an option to buy PQR Corporation Ltd at a strike price of Rs.90 for a premium of Rs.3.70/-. You can observe three expiration options – 26th March 2023 (current month), 30th April 2023 (mid-month), and 28th May 2023 (far month). Note that premiums may vary among different expirations, but don’t worry too much about this now as we can discuss it in more detail later. The main point to remember is that, like futures, there are three expiration options, and premiums can differ among them.

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