An ‘Option’ is an agreement between two parties. The buyer purchases the right to sell or buy stocks of an underlying asset, at a preset price to or from the seller within a fixed period. An option is a way of trading, unlike stocks –
- Options have an expiration date
- Options derive value from something else, so fall under the derivative category
- Options are not fixed numbers
- Option owners don’t have the right to vote in a company
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Get to know the options lingo
- Strike price – A predetermined price at which the stock can be sold or bought.
- Premium – It is an upfront payment made to buy and enjoy options contract privileges
- Underlying asset – It can be stocks,futures, currency, index or commodity
- Expiration date – The last day on or before which an option holder can execute the options contract. The duration can differ from weeks to months or years.
- Options style – American options need to be executed any time before the date of expiration. European options can be executed only on the expiration date.
- Options moneyness – It defines the connection between the strike price and existing an underlying stock price.
- ITM – In-the-money
Call – Strike Price is lower than the underlying instrument price
Put – Strike Price is higher than the underlying instrument price
- OTM – Out-of-the-money
Call – Strike Price is higher than the underlying instrument price
Put – Strike Price is lower than the underlying instrument price
- ATM – At-the-money
The strike price and the underlying stock price are equal
Call and Put are the two types of options. You will need to understand bot options from buyers’ and sellers’ viewpoints.
From buyer’s perspective
- Call option – When a trader finds the market bullish and hopes for the price of a specific instrument to increase within the defined expiration time, a call option is purchased.
- Put option – When a trader finds the market bearish and hopes for the price of a specific instrument to fall within the defined expiration time, a put option is purchased.
The buyer’s loss in put & call option is limited to the premium paid. If the trader’s prediction is correct, the profit is unlimited.
From seller’s perception
- A put option is sold in return for the premium charged and the trader is obligated to purchase the underlying instrument at the strike rate.
- A call option is sold in return for the premium charged and the trader is obligated to sell the underlying instrument at the strike rate.
The four strategies traders use in option –
- Short Call – When the trader feels that the underlying instruments price will sharply fall, he shorts the call.
- Short Put – When the trader feels that the underlying instruments price will sharply increase, he shorts the put.
- Long put – It is a position you buy, which predicts the price will crumble.
- Long call – It is a bet you buy, which indicates the price will rise.
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