Excellent Trading School - 17- Understanding Options Contracts

Options Contracts, Mechanism and Applications

An option gives the holder of the option the right to do something in future. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves or are obligated to meet their commitments as specified in the contract. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment (called Option premium payable to option seller).

Option Terminology

• Index options: Have the index as the underlying. They can be European or American.

They are also cash settled.

• Stock options: They are options on individual stocks and give the holder the right to buy or sell shares at the specified price. They can be European or American.

• Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/ writer.

• Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

There are two basic types of options, call options and put options.

• Call option: It gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

• Put option: A It gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

• Option price/premium: It is the price, which the option buyer pays to the option seller. It is also referred to as the option premium.

• Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

• Strike price: The price specified in the options contract is known as the strike price or the exercise price.

• American options: These can be exercised at any time upto the expiration date.

• European options: These can be exercised only on the expiration date itself. European options are easier to analyze than American options and properties of an American option are frequently deduced from those of its European counterpart.

• In-the-money option: An in-the-money (ITM) option would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

• At-the-money option: An at-the-money (ATM) option would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

• Out-of-the-money option: An out-of-the-money (OTM) option would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

• Intrinsic value of an option: The option premium has two components – intrinsic value and time value. Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time. The intrinsic value of a call is Max[0, (St — K)] which means that the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0, K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price.

• Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value.