Options Terminology The Master List of Options Trading Terminology

Demystifying Fundamental Options Language

The previous chapter introduced us to the primary call option framework. Our objective centred on grasping several fundamental ‘Call Option’ principles, including:

Acquiring a call option represents an effective strategy when anticipating appreciation in the underlying asset’s value

Should prices remain static or decline, the call option purchaser incurs losses

The call option buyer’s maximum loss equals the premium remitted to the option seller/writer

In subsequent sections exploring call options, we shall examine these instruments more comprehensively. Before advancing, let’s clarify several basic terms associated with options. Explaining this terminology presently will reinforce our understanding whilst simplifying future discussions.

Consider the following terms:

Strike Price

Underlying Valuation

Contract Exercise

Option Expiration

Option Premium

Option Settlement

Remember, we’ve only covered call option fundamentals thus far. I recommend examining these terms exclusively as they relate to this particular option type.

Strike Price

The strike price represents a reference point mutually agreed upon by buyers and sellers when establishing an options contract.

Consider this illustration:

Through acquiring a DEF Industries Limited Call Option at Rs 275, the purchaser remits a premium today to secure the entitlement to potentially acquire the company’s equity at Rs 275 upon expiration. This occurs only if DEF Industries Limited trades above this strike price at the specified period’s conclusion. Below appears a screenshot from the stock exchange’s platform displaying DEF Industries Limited’s option chain, illustrating various strike prices alongside their associated premiums.

The tabular format presented above is termed an “Option Chain”, providing information regarding various strike prices and corresponding premiums. For now, let’s concentrate on the highlighted data whilst disregarding other details such as open interest, volume, bid-ask quantity, etc.

The highlighted burgundy section represents the underlying asset’s spot price, with DEF Industries Limited trading at Rs 255 per share

As shown in the blue highlight, strike prices range from Rs 225 at Rs 10 intervals, extending to Rs 325

Note that each strike price carries a unique premium. Someone wishing to enter an options agreement at a specific strike price must remit the corresponding premium

For instance, a premium of Rs 6.25 (highlighted in red) secures entry into a 265 call option

This option’s buyer possesses the right to acquire DEF Industries Limited shares at Rs 265 upon expiration. Assessing circumstances under which purchasing DEF Industries Limited at Rs 265 proves advantageous as the contract expires becomes crucial

Underlying Valuation

We understand that derivative contract values derive from an underlying asset. The underlying asset’s spot market price is termed the underlying valuation. For DEF Industries Limited, as previously mentioned, this stands at Rs 255. This underlying valuation forms the call option’s foundation, and increases in the underlying valuation benefit the call option buyer.

Contract Exercise

Exercising an option contract refers to utilising the right to acquire the underlying asset upon contract expiration. For call options, exercising involves the individual exercising their entitlement to purchase equity at the predetermined strike price.

However, this only occurs if the equity’s current trading price exceeds the strike price. Understanding that exercising is exclusively possible on the expiration date, not beforehand, proves crucial.

Therefore, should someone purchase a DEF Industries Limited 265 Call option whilst the underlying asset trades at Rs 255 in the spot market, and the price appreciates to Rs 280 the subsequent day, they cannot execute settlement against their option that same day. Settlement occurs only at expiration, based upon the spot market price at that time.

Option Expiration

Both options and futures contracts feature expiration dates. Generally, these fall on each month’s final Thursday. Similar to futures contracts, options contracts divide into categories such as current month, mid-month, and far month. Here’s an illustration:

This provides an overview of an option to purchase GHI Corporation Ltd at a strike price of Rs 70, priced at Rs 3.80. Three expiration options exist – current month, mid-month, and far month – with dates of 28th March 2024, 25th April 2024, and 30th May 2024, respectively. Surprisingly, premiums can vary depending upon expiration dates. However, remember that all contracts offer three expiration options, and premiums may differ amongst them.

Options contracts, like futures contracts, possess expiration dates. Typically, these fall on each month’s last Thursday. Like futures, options contracts categorise into current month, mid-month, and far month. Examine the following snapshot:

This snapshot displays an option to purchase JKL Corporation Ltd at a strike price of Rs 105 for a premium of Rs 4.50. You can observe three expiration options – 28th March 2024 (current month), 25th April 2024 (mid-month), and 30th May 2024 (far month). Note that premiums may vary amongst different expirations, though don’t concern yourself excessively with this presently as we can discuss it comprehensively later. The principal point to remember is that, like futures, three expiration options exist, and premiums can differ amongst them.

For those navigating the stock market through a stock broker or consulting with a financial advisor, understanding these fundamental terms proves essential for equity investment success. Whether evaluating trading calls or utilising a stock screener to identify opportunities, options contracts represent sophisticated instruments requiring solid foundational knowledge.

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