Updated: Apr 8, 2021
Welcome to yet another article on Futures and Options. In the previous article, we had discussed the basics of futures trading. In this article, we will discuss the technical jargon or terms used in options trading. If you are a beginner in the field of options trading, then you must be aware of this jargon. These terms often come in the way if you want to trade in futures and options. Before we go for any kind of advanced level, we have to understand the basics of options trading.
In the following section, we will endeavor to comprehend the call options in a little bit more detail. Nonetheless, before we continue additionally let us interpret a couple of essential jargons. Examining these jargons at this stage won't just fortify our adapting however will make the approaching conversation on the options simpler to understand.
Now, I am going to explain some frequently used technical terms or jargon in the Options Market. If you love the stock market and have a basic knowledge of the stock market, then you must have heard about these terms like strike price, underlying price, option expiry, option settlement, etc.
So without wasting time, let’s discuss in detail what these terms are.
Derivative Market: - If you break the term derivative, it’s derived from the underlying asset. Futures and options are also called the derivative market. It derives its value from the underlying asset, that’s why it is called a derivative market. Derivatives can either trade exchanged or exchanged over the counter. Trade refers to the officially settled stock trade wherein securities are exchanged and they have a characterized set of rules for the participants.
Though over the counter is a vendor/dealer situated market of securities, which is a disorderly market where trading occurs via telephone, messages, and so on. Derivatives exchanged on the trade are normalized and controlled.
Then again, over the counter derivatives comprises a more extent of derivatives contracts; however, it conveys higher risk and is unregulated. These monetary instruments help in making a benefit by just betting on the future estimation of the underlying asset. Subsequently, the name derivative gets the worth from the underlying asset.
Strike Price: - In options trading, there are two types of people who trade. One is option buyer and the second is option seller. The meaning of strike price is different for both people. So if you can learn one meaning then the other one just inversely proportional to the other.
Consider the strike price as the cost at which the two-person (buyer and seller) consent to go into an option arrangement. For all 'Call' options, the strike price addresses the cost at which the stock can be bought on the expiry day of the option.
For example, if the buyer is willing to buy the Reliance Call Option of Rs. 2000 (2000 being the strike price) then it indicates that the buyer is willing to pay a premium today to buy the rights of ‘buying Reliance at Rs. 2000 on expiry’. Needless to say, he will buy Reliance at Rs. 2000, only if Reliance is trading above Rs. 2000.
Premium – It is the price that the buyer is willing to pay to a seller and the seller will receive the price. Since we have talked premium a couple of times previously, I presume you would now be clear about a few things about the ‘Option Premium’.
Premium is the money that needs to be paid by the option buyer to the option seller or option writer. Against the payment of premium, the option buyer buys the right to exercise his wish to buy (or sell in the case of a put) the asset at the strike price upon expiry.
We will begin to understand a new viewpoint on option premiums. At this stage, I guess it is important to understand that the whole world of options trading lying upon ‘Option Premium’. Option premiums play a very important role when it comes to option trading. As we progress through this article, you will see that the discussions will be around on the option premium.
OTM, ITM, ATM – The full form of these are - OTM (Out of the money), ITM (In the money), and ATM (At the money). These are the method which classifies each option strike price deploy on how much money a trader is probably to make if he were to exercise his option contract today.
Understanding these options, strike categorization is very easy. You just have to figure out the intrinsic value of an option. If the intrinsic value is a non-zero number, then the option strike price is pondered “in the money”. If the intrinsic value is zero, then the option strike price is called “out of the money”. The strike, which is nearest to the market price, is called “at the money”.
You may have already observed the conclusion (for call options) that exists here, however, just give me time to tell you again
All option strikes prices that are higher than at the money strike price are considered out of the money.
All option strikes prices that are below at the money strike price are considered in the money.
Contracts: - There are 3 contracts. Near, Next, Far. If the option is of the current month, it is near contract. If the option is of the next month, it is the next contract and the next month is called a far contract.
Type of option exercise: - There are two types of exercise. American exercise and European exercise. India follows European Exercise. Exercising an option contract is the act of declaring the right to buy the options contract at the end of the expiry day.
If you ever hear the line “exercise the option contract” in the situation of a call option, it means that one is declaring the right to buy the stock at the accepted strike price. You should do it only if the stock is trading above the strike price.
Option settlement - All futures and options contracts are settled either by cash or delivery. These contracts, therefore, have to be settled in cash or delivery. Futures and options on separate securities can be delivered as in the market price. However, it has been currently necessary that stock options and futures would also be cash-settled.
Expiry date – Just like a futures contract, an options contract also has an expiry date. The expiry date of the future and option are on the last Thursday of every month. Just like futures contracts, option contracts also have the idea of the near month, next-month, and far month.