Skip to main content

What are option contract.

Option contract....

What are option contract / Call and Put Options Definitions and Examples.

option contract.
Option contract.
               

          Option is a contract that gives the right, but not an obligation, to buy or sell the  underlying asset on or before a stated date/day, at a stated price, for a price. The party  taking a long position i.e. buying the option is called buyer/ holder of the option and the  party taking a short position i.e. selling the option is called the seller/ writer of the  option.  The option buyer has the right but no obligation with regards to buying or selling the  underlying asset, while the option writer has the obligation in the contract. Therefore,  option buyer/ holder will exercise his option only when the situation is favourable to  him, but, when he decides to exercise, option writer would be legally bound to honour  the contract. 

   Option, which gives buyer a right to buy the underlying asset, is called Call option and  the option which gives buyer a right to sell the underlying asset, is called Put option.  
        * Call Options  * Put Options

Call option and put option
Call Option And Put Option
                                               

Types of option :


1) Index option: 

These options have index as the underlying asset. For example options on  Nifty, Sensex, etc.   

2) Stock option: 

These options have individual stocks as the underlying asset. For example,  option on ONGC, NTPC etc.  

3) Buyer of an option: 

The buyer of an option is one who has a right but not the obligation  in the contract. For owning this right, he pays a price to the seller of this right called  option premium’ to the option seller. 

4) Writer of an option: 

The writer of an option is one who receives the option premium  and is thereby obliged to sell/buy the asset if the buyer of option exercises his right.  American option: The owner of such option can exercise his right at any time on or  before the expiry date/day of the contract. 

5) European option:

 The owner of such option can exercise his right only on the expiry  date/day of the contract. In India, Index options are European. 

What is Expiration Day in Option contract. 


 The day on which a derivative contract ceases to exist. It is the last  trading date/day of the contract. Like in case of futures, option contracts also expire on  the last Thursday of the expiry month . In our example, since the last Thursday (i.e., May 29,  2018) is a trading holiday, both the call and put options expire one day before that i.e.  on 28 May, 2018. Weekly Options are the Exchange Traded Options based on a Stock or an Index with  shorter maturity of one or more weeks. If the expiry day of the Weekly Options falls on a  trading Holiday, then the expiry  will be on the previous trading day.

What are Spot price and Strike price

sopt price vs strike price.
Strike vs Sopt.



1) Spot price: 

It is the price at which the underlying asset trades in the spot market. In  our examples, it is the value of underlying viz. 10154.20. 

2) Strike price or Exercise price :

Strike price is the price per share for which the  underlying security may be purchased or sold by the option holder. In our examples,  strike price for both call and put options is 10000.

What are ITM, ATM OTM contract :

in the money , at the money , on the money
ITM,ATM,OTM
                                          
1) In the money (ITM) option:

  This option would give holder a positive cash flow, if it were  exercised immediately. A call option is said to be ITM, when spot price is higher than  strike price. And, a put option is said to be ITM when spot price is lower than strike  price. In our examples, call option is in the money.  

2) At the money (ATM) option:

 At the money option would lead to zero cash flow if it  were exercised immediately. Therefore, for both call and put ATM options, strike price is  equal to spot price.  

3) Out of the money (OTM) option: 

Out of the money option is one with strike price worse  than the spot price for the holder of option. In other words, this option would give the  holder a negative cash flow if it were exercised immediately. A call option is said to be  OTM, when spot price is lower than strike price. And a put option is said to be OTM  when spot price is higher than strike price. In our examples, put option is out of the  money. 
call potion put option

Uses of Options contract :

Traders an important decision that a trader needs to make is which option he should trade: inthe‐money, at‐the‐money or out‐of‐the‐money. Among other things, a trader must also  consider the premium of these three options in order to make an educated decision. As  discussed earlier there are two components in the option premium – intrinsic value and  time value. If the option is deeply in‐the‐money, the intrinsic value will be higher and so is the option value/premium. 

 In case of at‐the‐money or out‐of‐the‐money options  there is no intrinsic value but only time value. Hence, these options remain cheaper  compared to in‐the‐money options. Therefore, option buyer pays higher premium for  in‐the‐money option compared to at‐the‐money or out‐of‐the‐money options and thus,  the cost factor largely influences the decision of an option buyer.   
For ATM options, the uncertainty is highest as compared to ITM or OTM options. This is  because  we  know  that  when  an  option  is  ITM  or  OTM,  even  if  the  price  moves  somewhat, in any direction, still the option will largely remain ITM or OTM as the case  may be. 

  But in case of ATM options, even a small price movement in either direction can tip the  option from ATM to ITM or OTM. There is a huge uncertainty here and this uncertainty  is a function of time to expiry and volatility of the underlying, both of which are  captured in the time value 
********
The analogy I have used might not be 100% correct but it’s easy to understand things with a simpler analogy.

That’s it for this post. Do check out my other posts to gain more knowledge about finance



Labels:

Comments

Post a Comment

Most popular post

What is Financial market.

  Financial market : A market is define as a place where any type of trade take place with the major depedent of two participants- buyer and sellers. This market vary in form,scale,location,type of participant and as well as the type of good and services taded hence there is non exhaustive list of market. Classification of financial market. 1) Money market 2) Capital market. 1 Money market    The money market is the market for financial assets which are the close substitude for money. It is a market for short term debt instrument that have a maturity period of less than or up to one year. It include treasury bills, commercial paper, banker acceptance, certificate of deposit. 2 capital market     Capital market is a market for long term securities such as equity and debt. This market aims at raising capital on long term basis for a period over one year. it act as a platformwhere the public and private sectors often sell there stakes to raise fund.
3 comments
Read more

what is Index Derivative.

Introduction to Index What is index Derivatives.   Index is a statistical indicator that measures changes in the economy in general or in  particular areas. In case of financial markets, an index is a portfolio of securities that  represent  a  particular  market  or  a  portion  of  a  market.  Each  Index  has  its  own  calculation methodology and usually is expressed in terms of a change from a base  value. The base value might be as recent as the previous day or many years in the past.  Thus, the percentage change is more important than the actual numeric value.  Financial  indices are created to measure price movement of stocks, bonds, T‐bills and other type  of financial securities. More specifically, a stock index is created to provide market  participants  with  the  information  regarding  average  share  price  movement  in  the  market. Broad indices are expected to capture the overall behaviour of equity market  and need to represent the return obtained by typica
Post a Comment
Read more

What is Derivative market.

Indian Derivatives Market /  What is Derivative Trading - Futures & Options Trading What is derivative market /  About Trading Derivatives Markets Globally  Over the last four decades, derivatives market has seen a phenomenal growth. Many  derivative contracts were launched at exchanges across the world. Some of the factors  driving the growth of financial derivatives are:Increased fluctuations in underlying asset prices in financial markets. Integration of financial markets globally. Use of latest  technology in  communications  has  helped  in  reduction  of  transaction costs.  Enhanced  understanding  of  market  participants  on  sophisticated  risk  management tools to manage risk.  Frequent innovations in derivatives market and newer applications of products. Products in Derivatives Market   Forwards   It is a contractual agreement between two parties to buy/sell an underlying asset at a  certain future date for a particular price that is pre‐decided on t
3 comments
Read more