The realms of investing and trading are packed with numerous sophisticated jargons to give the impression that only professionals or specialists can handle equities. Despite their frightening and confusing look, they are only a few simple ideas expressed creatively. Given the unique nature of options trading within the financial business, it is important to become familiar with the language used in options trading. Before beginning to trade options, it is critical to understand and be comfortable with the terminology. In following portions of the book, the terminology will be discussed one at a time.
 |
| SOME TERMINOLOGIES IN OPTION TRADING |
Option premium:
The option premium is the fee that an options buyer pays to an options seller in exchange for the right to purchase (in the case of a call option) or sell (in the case of a put option) an underlying asset at a certain price (strike price) within a specified time period. on other terms, the option premium is the price of an option contract on the open market. The premium is basically the option's cost, and it is decided by a variety of criteria, including the underlying asset's current price, the strike price, the time to expiry, and the projected volatility of the underlying asset. The premiums for Out-Of-The-Money (OTM) options are made up entirely of extrinsic value, while those for In-The-Money (ITM) options include intrinsic as well as extrinsic value.
The premium may be thought of as insurance since it protects the buyer from negative fluctuations in the price of the underlying asset. The seller, on the other hand, receives the premium and bears the risk that the buyer would exercise the option, resulting in a loss for the seller.
single trading transaction. A lot is the smallest number of stocks that may be acquired or sold in an options trading transaction. SEBI (Securities and Exchange Board of India) determines the lot size for F&O traders. It regulates market price quotations by using lot size. Because the lot size is fixed, traders are constantly aware of the cost of each unit. There will be no price standardisation or bulk uniformity if no specified lots are used.
To better understand lot size, consider the following example.
A lot for ITC is made up of 1,600 shares. As a result, traders may only buy it in multiples of 1,600. The value of the options contract is determined by the product of the number of units and their respective prices. As a consequence, if the ITC option price is 10 and a 1,600-lot amount is purchased, the transaction is worth 10X1,600, or ₹16,000.
SEBI determines the lot size for each stock and index that is allowed for derivative trading. It is crucial to recognise that lot sizes vary. Shares come in a variety of lot sizes.
The intrinsic value of an option is what the option would be worth if it were exercised immediately. In other words, it is the difference between the current market price of the underlying asset and the strike price of the option. The intrinsic value of any stock, is always positive and can never be negative.
The intrinsic value of an option acts as a minimum value or floor since the option's price should never be less than its intrinsic value. The remaining value of the option, if any, is known as the time value, and it indicates the potential rise in value if the price of the underlying asset changes before the option expires.
The time remaining before expiry, the predicted volatility of the underlying asset, and the level of interest rates all have an impact on extrinsic value. Changes in market conditions, such as changes in supply and demand for the option, shifts in market sentiment, or changes in the degree of implied volatility, can all have an effect on the extrinsic value of an option.
Extrinsic value is a variable amount that can change over time, as opposed to intrinsic value, which is a fixed amount based on the current market price of the underlying asset and the option's strike price. All else being equal, an option's extrinsic value tends to decline as it approaches expiration. This is because there is less time for the option to benefit the buyer and, as a consequence, less ambiguity about its potential value.
A variety of factors, including the strike price, affect the intrinsic value of an option, which is the difference between the current market price of the underlying asset and the strike price. If the option is in-the-money (ITM), suggesting that it has intrinsic value, the option buyer might exercise it to profit. If the option was out-of-the-money (OTM), the buyer would not exercise it since it has no intrinsic value and would result in a loss.
The strike price is often specified when the option is issued, and it is one of the elements that determines the option's premium, along with the
current market price of the underlying asset, the time to expiry, and the predicted volatility of the underlying asset.
In the context of equities, for example, the spot price of SBIN is the current market price of SBI share price that may be purchased or sold for immediate delivery, in contrast to a futures price, which is the price at which the stock can be bought or sold for delivery at a future date.
Numerous factors, including supply and demand dynamics, geopolitical happenings, changes in interest rates or currency rates, and the overall state of the economy, can all have an influence on spot pricing. Spot pricing may be used as a benchmark or point of reference to determine the worth of other financial instruments or contracts on occasion.
At any given time, the bid price is the highest price that a buyer is willing to pay for a security. It shows the market price at which a buyer can sell the securities. In other terms, it is the amount of money a buyer is willing to pay to obtain an asset from a seller.
In contrast, the ask price is the lowest price at which a seller is willing to sell the asset at any particular moment. It shows the market price at which a seller may purchase the security. In other terms, it is the amount of money that a seller is ready to take in order to sell an item to a buyer.
The bid-ask spread, defined as the difference between the ask and bid prices, defines how much it costs to buy or sell an item in the market. The
quantity of supply and demand for the item, as well as other market conditions, may all influence the bid-ask spread. Assets with higher levels of liquidity typically have bid-ask spreads that are closer together, whereas assets with lower levels of liquidity typically have wider spreads.
ITM (In-The-Money): If the option has a positive intrinsic value and the contract is set to expire today, it is referred to be an In-The-Money or ITM option. It is referred to be an ITM option for a call option if the underlying price is above the strike price, and a put option if the underlying price is below the strike price.
Out-Of-The-Money (OTM): A contract is considered out-of-the-money (OTM) if the intrinsic value of the option is less than the market price and the contract expires at that price. The spot price is lower than the strike price for call options and higher than the strike price for put options.
At-The-Money (ITM): An option is At-The-Money (ITM) if the strike price and current market price are the same. The same is true for call and put options.
on market mood and trends, as well as assist them evaluate the level of interest in a certain asset or contract.
When numerous market players are actively trading an asset or contract, it has a high open interest. This can increase liquidity while also making it easier for traders to initiate and exit positions. Conversely, low open interest may indicate that there is less interest in the asset or contract, making it more difficult to find counterparties to trade with and potentially leading to larger bid-ask spreads and less attractive pricing.
Furthermore, open interest might disclose information about potential future price movements. Increases in open interest, for example, may suggest higher interest in the asset or contract and a potential price increase, whilst decreases in open interest may signal declining interest and a potential price reduction. However, open interest alone cannot be used to anticipate price changes since it overlooks other elements that may influence market pricing, such as supply and demand dynamics, current economic circumstances, and geopolitical events.
A table or matrix that shows all available options for a certain underlying asset, such as a stock, index, or commodity, is known as an option chain. It gives a detailed breakdown of the various options contracts available for that asset, including strike prices, expiration dates, and option premiums. Option chains often comprise information such as the underlying asset's symbol or ticker, the date of the option contract, the option type (call or put), the strike price, the option premium or price, and the option's implied volatility. Other information, such as open interest and volume for each option contract, may also be included.
Option chains are a significant tool for options traders and investors due to their ability to quickly compare and analyse various options contracts based on characteristics such as strike price, expiration date, and implied volatility. Use these tools to identify potential trading opportunities, balance risk and return, and develop trading strategies.
Option chains are available on the majority of financial and trading platforms. As new options contracts are issued and existing contracts expire or are settled, these chains are updated in real time. The option chain is
provided free of charge by the National Stock Exchange (NSE), however users must refresh the page to obtain real-time data.
The rate of time decay is affected by the time till expiry, implied volatility, strike price, and current value of the underlying asset. Options with more time left before expiry frequently have a higher time value and, as a result, a slower rate of time decay, whereas options with less time remaining before expiration have a lower time value and a quicker rate of decay.
Time decay is an essential issue for options traders to grasp since it affects the profitability of options positions as well as trade timing. The impact of time decay on positions must be addressed when traders develop trading strategies in order to profit from a change in the underlying asset's price.
There are many things that can cause volatility, like changes in how people think about the market, the economy, or important events happening around the world. Volatility can be both good and bad for investors. It can
be risky because it's hard to predict what will happen, but it can also create opportunities to make money.
Investors and traders use volatility to understand how much risk there is and to make trading plans. They look at volatility to figure out how risky an investment is. They might also use it to find times when the price is low and buy, and times when it's high and sell.
There are two types of volatility: historical and implied. Historical volatility looks at how the price has changed in the past. Implied volatility (IV) tries to predict how much the price might change in the near future.
Another strategy is called a straddle. It involves buying both a call option and a put option with the same price and expiration date for a particular asset. This strategy also has two legs: buying the call option is one leg, and buying the put option is the other leg.
By looking at the legs of a strategy separately, traders can quickly understand the possible risks and rewards. They can make changes to their investments as needed to get the desired outcome.
Options spreads can take several forms, including:
Vertical spreads: These include the purchase and sale of option contracts with the same expiration date but differing strike prices. A bullish vertical spread is formed by purchasing a lower strike price call option and selling a higher strike price call option, whereas a bearish vertical spread is
formed by purchasing a higher strike price put option and selling a lower strike price put option.
The premium may be thought of as insurance since it protects the buyer from negative fluctuations in the price of the underlying asset. The seller, on the other hand, receives the premium and bears the risk that the buyer would exercise the option, resulting in a loss for the seller.
Lot size:
In general, lot size refers to the quantity of an item purchased for delivery on a given date. A lot size is the number of stocks purchased in asingle trading transaction. A lot is the smallest number of stocks that may be acquired or sold in an options trading transaction. SEBI (Securities and Exchange Board of India) determines the lot size for F&O traders. It regulates market price quotations by using lot size. Because the lot size is fixed, traders are constantly aware of the cost of each unit. There will be no price standardisation or bulk uniformity if no specified lots are used.
To better understand lot size, consider the following example.
A lot for ITC is made up of 1,600 shares. As a result, traders may only buy it in multiples of 1,600. The value of the options contract is determined by the product of the number of units and their respective prices. As a consequence, if the ITC option price is 10 and a 1,600-lot amount is purchased, the transaction is worth 10X1,600, or ₹16,000.
SEBI determines the lot size for each stock and index that is allowed for derivative trading. It is crucial to recognise that lot sizes vary. Shares come in a variety of lot sizes.
Intrinsic value:
In finance, intrinsic value is the actual value of an asset determined by its basic characteristics and underlying cash flows. In the case of a stock, the intrinsic value would represent the current value of the company's expected future profits and cash flows.The intrinsic value of an option is what the option would be worth if it were exercised immediately. In other words, it is the difference between the current market price of the underlying asset and the strike price of the option. The intrinsic value of any stock, is always positive and can never be negative.
The intrinsic value of an option acts as a minimum value or floor since the option's price should never be less than its intrinsic value. The remaining value of the option, if any, is known as the time value, and it indicates the potential rise in value if the price of the underlying asset changes before the option expires.
Extrinsic value:
Extrinsic value, often known as time value, is the portion of an option's premium that is due to variables other than intrinsic value. In other words, it is the premium that an option buyer is ready to pay in return for the possibility that the option could change in their favour before it expires.The time remaining before expiry, the predicted volatility of the underlying asset, and the level of interest rates all have an impact on extrinsic value. Changes in market conditions, such as changes in supply and demand for the option, shifts in market sentiment, or changes in the degree of implied volatility, can all have an effect on the extrinsic value of an option.
Extrinsic value is a variable amount that can change over time, as opposed to intrinsic value, which is a fixed amount based on the current market price of the underlying asset and the option's strike price. All else being equal, an option's extrinsic value tends to decline as it approaches expiration. This is because there is less time for the option to benefit the buyer and, as a consequence, less ambiguity about its potential value.
Strike price:
The strike price, also known as the exercise price, is the price at which the holder of an option can purchase or sell the underlying asset before or on the expiration date of the option, depending on the kind of option. A call option's strike price is the amount at which the holder has the right but not the obligation to buy the underlying asset. The strike price of a put option is the price at which the holder has the right but not the obligation to sell the underlying asset.A variety of factors, including the strike price, affect the intrinsic value of an option, which is the difference between the current market price of the underlying asset and the strike price. If the option is in-the-money (ITM), suggesting that it has intrinsic value, the option buyer might exercise it to profit. If the option was out-of-the-money (OTM), the buyer would not exercise it since it has no intrinsic value and would result in a loss.
The strike price is often specified when the option is issued, and it is one of the elements that determines the option's premium, along with the
current market price of the underlying asset, the time to expiry, and the predicted volatility of the underlying asset.
Spot price:
The word "spot price" refers to the asset's current market value at the time of the trade, such as the price of a commodity or financial instrument. The spot price, as opposed to the future price, is the price at which an asset can be acquired or sold for delivery at a later date.In the context of equities, for example, the spot price of SBIN is the current market price of SBI share price that may be purchased or sold for immediate delivery, in contrast to a futures price, which is the price at which the stock can be bought or sold for delivery at a future date.
Numerous factors, including supply and demand dynamics, geopolitical happenings, changes in interest rates or currency rates, and the overall state of the economy, can all have an influence on spot pricing. Spot pricing may be used as a benchmark or point of reference to determine the worth of other financial instruments or contracts on occasion.
Bid and Ask Price:
The bid price and ask price are two important prices mentioned in financial markets for assets such as stocks, bonds, derivatives, and currencies. These prices reflect the most recent highest asking price (bid price) a buyer is prepared to pay for an asset, as well as the most recent lowest offering price (ask price) a seller is willing to accept for the same item.At any given time, the bid price is the highest price that a buyer is willing to pay for a security. It shows the market price at which a buyer can sell the securities. In other terms, it is the amount of money a buyer is willing to pay to obtain an asset from a seller.
In contrast, the ask price is the lowest price at which a seller is willing to sell the asset at any particular moment. It shows the market price at which a seller may purchase the security. In other terms, it is the amount of money that a seller is ready to take in order to sell an item to a buyer.
The bid-ask spread, defined as the difference between the ask and bid prices, defines how much it costs to buy or sell an item in the market. The
quantity of supply and demand for the item, as well as other market conditions, may all influence the bid-ask spread. Assets with higher levels of liquidity typically have bid-ask spreads that are closer together, whereas assets with lower levels of liquidity typically have wider spreads.
Moneyness:
Moneyness is the current price of an underlying asset in relation to the strike price of a derivative contract. It exposes the intrinsic value of a particular choice in the present. It notifies the option buyer whether or not exercising the contract will result in a profit or loss. Moneyness is classified into three categories based on where the spot price is in reference to the strike price. As an example:ITM (In-The-Money): If the option has a positive intrinsic value and the contract is set to expire today, it is referred to be an In-The-Money or ITM option. It is referred to be an ITM option for a call option if the underlying price is above the strike price, and a put option if the underlying price is below the strike price.
Out-Of-The-Money (OTM): A contract is considered out-of-the-money (OTM) if the intrinsic value of the option is less than the market price and the contract expires at that price. The spot price is lower than the strike price for call options and higher than the strike price for put options.
At-The-Money (ITM): An option is At-The-Money (ITM) if the strike price and current market price are the same. The same is true for call and put options.
Open interest:
Open interest refers to the total number of contracts for a certain futures or options contract that are still open and have not yet been resolved by delivery, offset, or expiration. In other words, it represents all open contracts that have yet to be closed or completed. Open interest is a helpful statistic for determining the degree of activity and liquidity in a certain futures or options market. It may provide traders and analysts with insightson market mood and trends, as well as assist them evaluate the level of interest in a certain asset or contract.
When numerous market players are actively trading an asset or contract, it has a high open interest. This can increase liquidity while also making it easier for traders to initiate and exit positions. Conversely, low open interest may indicate that there is less interest in the asset or contract, making it more difficult to find counterparties to trade with and potentially leading to larger bid-ask spreads and less attractive pricing.
Furthermore, open interest might disclose information about potential future price movements. Increases in open interest, for example, may suggest higher interest in the asset or contract and a potential price increase, whilst decreases in open interest may signal declining interest and a potential price reduction. However, open interest alone cannot be used to anticipate price changes since it overlooks other elements that may influence market pricing, such as supply and demand dynamics, current economic circumstances, and geopolitical events.
Option chain:
A table or matrix that shows all available options for a certain underlying asset, such as a stock, index, or commodity, is known as an option chain. It gives a detailed breakdown of the various options contracts available for that asset, including strike prices, expiration dates, and option premiums. Option chains often comprise information such as the underlying asset's symbol or ticker, the date of the option contract, the option type (call or put), the strike price, the option premium or price, and the option's implied volatility. Other information, such as open interest and volume for each option contract, may also be included. Option chains are a significant tool for options traders and investors due to their ability to quickly compare and analyse various options contracts based on characteristics such as strike price, expiration date, and implied volatility. Use these tools to identify potential trading opportunities, balance risk and return, and develop trading strategies.
Option chains are available on the majority of financial and trading platforms. As new options contracts are issued and existing contracts expire or are settled, these chains are updated in real time. The option chain is
provided free of charge by the National Stock Exchange (NSE), however users must refresh the page to obtain real-time data.
Time Decay:
Time decay, also known as theta decay, is the progressive decrease in the value of an option contract as its expiration date approaches. It indicates how rapidly the extrinsic value or time value of an option depreciates as the option approaches its expiration date. Time decay happens because options have a finite lifespan, and as the expiry date approaches, there is less time for the underlying asset to move in a positive direction for the option to be lucrative. This decrease in time to expiry decreases the amount of time value left in the option, lowering the option's total value.The rate of time decay is affected by the time till expiry, implied volatility, strike price, and current value of the underlying asset. Options with more time left before expiry frequently have a higher time value and, as a result, a slower rate of time decay, whereas options with less time remaining before expiration have a lower time value and a quicker rate of decay.
Time decay is an essential issue for options traders to grasp since it affects the profitability of options positions as well as trade timing. The impact of time decay on positions must be addressed when traders develop trading strategies in order to profit from a change in the underlying asset's price.
Volatility:
Volatility means how much a price changes over time. It helps us understand how risky or uncertain an investment is. We measure volatility by looking at how much an investment's price has gone up and down in the past. If volatility is low, it means the price is more stable and won't change a lot. But if volatility is high, the price is more likely to go up or down quickly.There are many things that can cause volatility, like changes in how people think about the market, the economy, or important events happening around the world. Volatility can be both good and bad for investors. It can
be risky because it's hard to predict what will happen, but it can also create opportunities to make money.
Investors and traders use volatility to understand how much risk there is and to make trading plans. They look at volatility to figure out how risky an investment is. They might also use it to find times when the price is low and buy, and times when it's high and sell.
There are two types of volatility: historical and implied. Historical volatility looks at how the price has changed in the past. Implied volatility (IV) tries to predict how much the price might change in the near future.
Legs:
In options trading, the term "legs" means the different parts of a strategy that uses multiple options contracts. For example, when you do a spread strategy, you buy one call option with a lower price and sell another call option with a higher price. This strategy has two legs: buying the cheaper call option is one leg, and selling the more expensive call option is the other leg.Another strategy is called a straddle. It involves buying both a call option and a put option with the same price and expiration date for a particular asset. This strategy also has two legs: buying the call option is one leg, and buying the put option is the other leg.
By looking at the legs of a strategy separately, traders can quickly understand the possible risks and rewards. They can make changes to their investments as needed to get the desired outcome.
Spread:
A spread is a multi-leg options strategy that includes simultaneously buying and selling two or more options contracts on the same underlying asset. A spread is employed to possibly improve a trader's potential profits while lowering their risk exposure.Options spreads can take several forms, including:
Vertical spreads: These include the purchase and sale of option contracts with the same expiration date but differing strike prices. A bullish vertical spread is formed by purchasing a lower strike price call option and selling a higher strike price call option, whereas a bearish vertical spread is
formed by purchasing a higher strike price put option and selling a lower strike price put option.
Horizontal spread:
This is the purchase and sale of option contracts with the same strike price but separate expiration dates. A horizontal spread can be used to profit from differences in implied volatility across options contracts with different expiry dates.
Diagonal spread:
This involves buying and selling options contracts with different strike prices and expiration dates. A diagonal spread can be used to create a risk/reward profile tailored to the trader's specific objectives.
Tags:
Option Trading