Options Trading Definitions - Must Know Terms for Beginners cover

Options Trading Definitions – Must Know Terms for Beginners

Options Trading Definitions: Options as the name would suggest, gives you the right but not an obligation to own a financial instrument. But, before going deep into the technicalities of this instrument, let’s have an understanding of some of the key terminologies (jargon) used while trading options. Today, we will be covering jargon like Strike price, Underlying price, In The Money, At The Money, Out Of Money, etc.

Options Trading Definitions – Must Know Terms for Beginners

— Strike Price

The strike is the exercisable price of the options contract. The call option holder makes money if upon expiry the spot price is above the agreed strike price. And similarly, put option holder makes money if the spot price is below the agreed strike price.

The strike price is fixed in the options contract. Say, a trader has bought a call option contract (assuming 1,000 shares in a lot) of ABC Company for Rs. 75 strike price. So, over the duration of the contract, the call option holder has the right to buy 1,000 shares at Rs. 75. If the price of the share goes to Rs. 125, the option holder stands to make Rs. 50,000 (=50*1000) on the trade. And Vice versa for the Put option holder.

Also read: Options Trading 101: The Big Cat of Trading World

— Underlying Price

Underlying price is the spot price of the underlying asset of a derivative. For example, if someone owns a call option to buy one lot of ABC Enterprises. If ABC Enterprises is currently trading at Rs 15 per share, the underlying price is Rs 15. The difference between the underlying price and strike price greatly influences the option premium.

— In The Money (ITM)

As the name would suggest, ITM would simply mean something which already is making money. In options terminology, ITM means an option contract whose spot price of the underlying asset is above the strike price for call option and below the strike price in case of the Put option.

For Example, if the spot price of the ABC Company is Rs 50 then the strike price of the ITM Put option will have to be Rs. 51 or more. The premium cost as a factor must also be considered.

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— At The Money (ATM)

An At The Money Option contract is one whose spot price and the strike price of the underlying asset are same. The options premiums are at their most crucial stage when the options contract are trading ATM. For example, if XYZ stock’s spot price is Rs.75, then the XYZ 75 call option (CE) is at the money and even the XYZ 75 put option (PE).

An ATM contract has no intrinsic value but has time value before expiry. For Example, on 10 April 2020, ABC share has a spot price of Rs. 100 and the 100 CE (for April Expiry) is trading ATM but still has a premium of 10. The reason for this is simply the fact that the contract still has 20 days to expiry. As and when the contract moves towards expiry, the premium erosion will happen in this contract because of less time available for the stock price to make a substantial move in any direction.

— Out of Money (OTM)

A contract is called OTM when the strike price of a call option is above the spot price of the underlying asset. In case of a Put option, a contract is called Out of Money when the strike of the underlying asset is below the spot price of an option contract. For example, if the spot price of the ABC Company is Rs. 70 then the strike price for the OTM call option will be Rs. 69 or less.

Relationship between various terminologies

For call options, the further away the strike price from the spot price, the economical the option. The following table shows the various strike price and the premiums and other factors for a stock trading at Rs 50.

Strike PriceMoneynessCall option premiumIntrinsic valueTime Value
35ITM15.5150.5
40ITM11.25101.25
45ITM752
50ATM4.504.5
55OTM2.502.5
60OTM1.501.5
65OTM0.7500.75

Conversely, for put options, the following table shows the various strike price and the premiums and other factors for a stock trading at Rs 50.

Strike PriceMoneynessCall option premiumIntrinsic valueTime Value
35OTM0.7500.75
40OTM1.501.5
45OTM2.502.5
50ATM4.504.5
55ITM752
60ITM11.25101.25
65ITM15.5150.5

— Moneyness

Moneyness in simple terms explains the amount of money the option holder was to make if he were to exercise his right immediately. It simply explains the intrinsic value (i.e., the amount received by the buyer) of an option.

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— Options Expiry

In financial terms, the expiration date of an option contract is the last date on which the holder of the option may exercise it. A call/put option will be in-the-money if the stock is above/below the strike price and will be executed by the option buyer upon expiration.

If the stock price is above the Put option strike price, the option expires worthless. The weekly options expire every Thursday in Indian Equity Market and the monthly options expire on the last trading Thursday of every month. If Thursday is a holiday, then the options expire the previous day.

options expiry buyer and seller

— Options Premium

The option premium is the fees paid to the option seller by the option buyer for having a right on an underlying asset before expiry. If the option expires In the Money then the option buyer has the right to exercise the option contract. If the option expires Out of money, then the option buyer stands to lose to money i.e., the premium paid. The premium is the income generated by an option writer/seller.

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Say, the stock price of XYZ Company on 10th April 2020 is Rs 500. An option buyer buys 530 call at Rs. 15 from option seller. Upon expiry, if the price of XYZ id 575, then the income made by the buyer is Rs 30 (Spot price – strike price – option premium).

Further, let’s assume upon expiry if the spot price of XYZ Company is Rs. 520, then the option will expire worthless for option buyer and the premium will be income earned by the option writer/seller.

Again if the price of XYZ shares upon expiry is Rs. 540, then the contract expires ITM for option buyer but he still stands to lose money. Following is the calculation to explain:

  • Strike Price: Rs 530
  • Option premium: Rs 15
  • Spot Price upon expiry: Rs. 540.

Here, the total Income of Option Buyer: Rs. (540- 530-15) i.e. Rs. -5. So the intrinsic value will be 0.

On the other hand, the total Income of Option Seller: Rs. (530+15-540) i.e. Rs. 5.

— Options Settlement

Let’s understand this with the help of an example: There is a call option to buy XYZ at Rs.50. The expiry is 30th Jan 2020 (last Thursday). The premium is Rs 4 and one market lot has 7,000 shares.

Assume there are two traders – Trader A and Trader B. Trader A wants to buy (option buyer) and trader B wants to sell (write) this agreement. Here is how the money movement will happen

Since the premium is Rs 4 per share, Trader A is required to pay a total of 7,000 * 4 = Rs 28,000 as a premium amount to Trader B.

Now because Trader B has received this Premium form Trader A, he is obligated to sell Trader A, 7000 shares of XYX on 30th Jan 2020, if Trader A decides to exercise his agreement. However, this does not mean that Trader B should have 7000 shares with him on 30th Jan. Options are cash-settled in India. This simply means on the last day if Trader A wants to use his right to exercise his option then Trader B is obligated to pay just the cash differential.

To help you understand this better, consider on the last Thursday (expiry day) of January XYZ is trading at Rs.65/-. This means the option buyer (Trader A) will exercise his right to buy 7000 shares of XYX at 50/-. In other words, he is getting to buy XYZ at 50/- when the same is trading at Rs.65/- in the open market.

Another way to look at it is that the option buyer is making a profit of Rs.15/- per shares (65-50) per share. Because the option is cash-settled, instead of giving the option buyer 7000 shares, the option seller directly gives him the cash equivalent of the profit he would make, which means Trader A would receive

= 15*7,000 = Rs 1,05,000/- from Trader B.

Of course, the option buyer had initially spent Rs.28,000/- towards purchasing this right, hence his real profit would be –

= Rs (1,05,000-28,000) = Rs 77,000 /-

The fact that one can make such a large exponential return is what makes options an attractive instrument to trade. This is one of the reasons why Options are one of the most favorite trading instruments amongst Traders.

Also read: What is Bank Nifty? The Index That Summarizes Economic Health

Key Takeaways

In this article, we discussed a few of the frequently used stock options trading definitions or jargon like Strike price, Underlying price, In The Money, At The Money, Out Of Money. Here are the key takeaways from this post:

  • It is advisable to buy a call option only when one anticipates an increase in the price of an asset.
  • The strike price should be as close as possible to the current price to avoid quick premium decay because of the time factor.
  • The underlying price is simply the spot price of the asset.
  • Weekly options contact expire every Thursday and monthly Option contracts expire on the last Thursday of every month. If Thursday is a holiday then it expires the previous day.
  • Options are cash-settled in India

In conclusion, a clear understanding of the complexity of the instrument goes a long way in making use of the financial instrument for meeting one’s own financial goals and financial independence.

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