Options Glossary – Important Words Used in Option Trading

Option Glossary

In the previous chapter, we have understood some important principles of call options, such as-

Buying a call option is a better option when you are expecting an increase in the price of the underlying.
If the underlying price remains stable or goes down, the buyer of the call option incurs a loss.
The buyer of a call option incurs a loss of the same amount as the premium (agreement fee) he pays to the writer/seller of the call option.

In the next chapter, we will understand Call Option in more detail. But before doing this, it is important that we understand the terminology associated with it. Doing this will make it easier for us to understand the next chapters. The words we will try to understand the meaning of are-

• strike price
• underlying price
• exercise options contract
• option expiry
• option premium
• option settlement

Remember that for now, we are understanding the meaning of these words only in the context of call options.

Strike price

You can consider the strike price as the basis on which both the buyer and the seller have decided to enter into the option agreement. For example, in the example “Ajay-Venu” from the previous chapter, the anchor price was Rs 5 lakh, which was also the strike price of that deal. We also took the example of a stock where the anchor price was Rs 75 which was also the strike price. In all call options, the strike price is the price at which the stock can be bought on the day of expiry.

For example, if one wants to buy a call option of ITC Ltd at Rs 350 (here 350 is the strike price), it indicates that the buyer is willing to pay a premium today to buy ITC at Rs 350 on the expiry day. Keep in mind that he will buy ITC at 350 only if ITC is selling above 350.

I have taken a screenshot of the different strike prices and premiums associated with ITC from the NSE website which you can see below.

What you see in the table above is called an option chain. The option chain shows the premium of a contract at different strike prices. Apart from this, there is much other information for trading in the option chain, such as open interest, volume, bid/ask quantities, etc. My advice is that for now you ignore this information and focus only on the highlighted part in the table –

• The area highlighted in red shows the spot price of the underlying. As you can see ITC was selling at Rs 336.9 per share when this image was taken.
• All available strike prices are shown in the blue highlighted section. As we can see the strike prices ranging from Rs 260 to Rs 480 are showing every Rs 10 difference.
• Remember that no strike price is related to any other strike price. You can enter into an option agreement at any cost, you just have to pay the premium associated with it.
• For example, you can take a call option of 340 by paying a premium of Rs 4.75 paise. It is shown above in red.
• This will give the buyer an option to buy ITC shares at Rs 340 till the end of the expiry.

Underlying Price

As we know that the price of any derivative contract is determined by the price of its underlying asset. The underlying price is the price at which the underlying asset is selling in the spot market. For example, in the example with ITC, ITC is selling at Rs 336.90 in the spot market. This is the underlying price. In any call option, the buyer makes money only when the underlying price rises.

Exercise options contract

Exercising an option contract means that you exercise the right to buy the option at the end of expiry. Whenever you hear of an option contract being exercised, it simply means that the buyer has taken the option to buy at a pre-determined strike price. It should be clear to you by now that he will do this only if the stock is selling above the strike price. One very important thing that you should remember here is – you can exercise your option contract only on the day of expiry and not before the expiry.

Suppose 15 days before expiry, someone took a call option of ITC at 340 while ITC was at 330 in the spot market. Now if the ITC price reaches Rs 360 on the next day, the buyer of the option cannot settle his call option. The settlement will take place only on the day of expiry and that too at the price at which the asset is being sold in the spot market on the day of expiry.

Option expiry

Like futures contracts, options contracts also have an expiry. In fact, both futures and options contracts expire on the last Thursday of the month. Like futures contracts, options contracts also have current month, mid-month, and far-month contracts. Look at the picture below-

The picture shows Ashok Leyland Ltd. being sold at Rs.3.10 at a strike price of Rs.70. As you can see there are 3 expiry options shown – 26 March 2015 (Current Month), 30 April 2015 (Mid Month), and 28 May 2015 (Far Month). When the expiry closes, the premium of the option also changes. We will discuss about this in further detail but for now, you should remember 2 things – like futures, there are 3 expiry options here, and each expiry has a different premium.

Option premium

Premium is the amount that the buyer of the option pays to the seller/writer of the option. In exchange for the payment of the premium, the buyer of the option gets the right to exercise his option on the day of expiry and buy the asset at a pre-determined strike price.

If you understand everything so far, then your learning speed is good, and now we can understand the new approach to premium. Also, it is important for you to know that the entire option theory rests only on the option premium. Option premium plays a very important role in options trading. As we progress in this module, we will talk more and more about option premium.

Let us once again look at the example of Ajay and Venu. Recall under what circumstances Venu had taken a premium of Rs 1 lakh from Ajay-

News Flow– The news of the highway project coming up was just a guess and no one knew for sure that the project would come.

We discussed 3 possible options out of which 2 were beneficial for Venu. So according to the statistics also Venu was more likely to benefit and as this news was not confirmed, he was more likely to benefit.

Time– It took 6 months to get clear whether the project will come or not.

Time is really beneficial to Ajay. The longer the time, the more things will be expected to turn in Ajay’s favor. For example, if you have to run 10 km, will you be able to complete the race easily in 20 minutes or in 70 minutes? Obviously, more time gives you a chance to turn things in your favor.

Now let us look at these two issues separately and try to understand how they will affect the premium of the option.

News– When the deal was done between Ajay and Venu, the news was not confirmed. So Venu readily accepted a premium of Rs.100,000. But suppose a local leader had announced in a press conference that a highway is being considered in this area, then this news would not have remained just a rumor, but the possibility of the highway being built would have increased.

Would Venu have accepted a premium of 100,000 in this scenario? Probably not, as he would have known that the possibility of a highway being built was very high and that the land prices would rise because of it. It could have been that he would still have done this deal if he had got a premium of 175,000 instead of 100,000 because he was taking more risk in this position so he could expect a higher premium.

Now let’s look at this from the point of view of the stock market. Suppose Infosys is running at 2200. A call option of Rs 2300 which expires after 1 month is selling at Rs 20. Now put yourself in the place of Venu (Option Writer) and think about whether you will accept the premium of Rs.20 per share.

If you enter into this option agreement, you are giving the buyer the right to buy Infosys after one month at Rs 2,300.

Suppose there is no such event in the next one month that the price of Infosys will go up. In such a situation, you may also accept a premium of Rs 20.

But if there is an event like quarterly results due to which the share price goes up, will the option seller still charge a premium of Rs 20? It is clear that for 20 rupees he will not take that much risk.

But what if someone pays a premium of Rs 75 instead of Rs 20, despite knowing the date of the quarterly results? I think that much risk can be taken at Rs 75.

Now coming to the second issue – time

When it was 6 months, Ajay knew very well that there was enough time to come out with confirmation about the highway project. But what if it was 10 days instead of 6 months? Because time is short and that much time is not enough to uncover the bottom of any incident. In such circumstances (when time is not in Ajay’s favor), would Ajay pay a premium of Rs.100,000 to Venu? I don’t think so because Ajay would have no reason to pay such a premium. Perhaps Ajay would have paid a lower premium then, like Rs 20,000.

Well, what I want to say here keeping in mind the news and time is that – there is no fixed rate of premium. It depends on different reasons. For some reasons the premium increases, for some reasons the premium may drop. All these factors in the stock market are acting together, at the same time, which affects the premium. Actually, 5 factors affect the premium. They are called ‘Option Greeks’. We will understand about them further in this module.

For now, I want you to remember these things related to option premium-

• Option theory completely rests on premium.
• The premium is never fixed. It depends on many factors.
• The premium in the stock market changes every minute.

Here highlighted in green, here is the buy call option of Jaypee Associates for Rs.25. Its expiry is 26 March 2015. The premium is Rs 1.35 (in red), and the market lot is 8000 shares. As highlighted in green, this is a Call Option to buy JP Associates at Rs.25/-.

Let’s say there are two traders – Trader A and Trader B. Trader A wants to buy this agreement (option buyer) and Trader B wants to sell it. Let’s assume that the agreement is for 8000 shares, then the cash flow will be something like –

Since the premium is Rs 1.35 per share, then Trader A has to pay a total of Rs.

= 8000 * 1.35

= Rs 10,800 as a premium to be paid to trader B

If Trader A decides to exercise the agreement, Trader B will have to sell 8000 shares of Jaypee Associates on March 26, 2015, as Trader B has received the premium from Trader A. However, this does not necessarily mean that trader B should have 8000 shares on March 26. In India, the settlement of options is done in cash, which means if Trader A exercises his right on March 26, Trader B has to pay only cash difference to Trader A.

Let us understand this better with an example. Suppose Jaypee Associates is trading at Rs.32 on March 26. This means that the option buyer (Trader A) will exercise his right to buy 8000 shares at Rs.25. This means that he is getting shares of Jaypee Associates trading at Rs.32 at Rs.25.

Generally, the cash flow should look like this –

• On 26th Trader A exercises his right to buy 8000 shares from Trader B.
• The price at which this deal is to be done, that price has already been fixed at Rs 25 (strike price). The price at which the transaction will take place is pre-decided at Rs.25 (strike price)
• Trader A gives Rs 200,000 (8000 * 25) to trader B.
• After receiving the payment, trader B gives 8000 shares to trader A at the rate of Rs.25.
• Trader A immediately sells these shares in the open market at Rs 32 per share and gets Rs 256,000.
• Trader A makes a profit of Rs 56,000 (256000 – 200000) from this transaction.
• In another way, it can be seen that the option buyer is making a profit of Rs 7 per share (32-25). Since the option is settled in cash, instead of giving 8000 shares to the option buyer, the option seller directly pays the amount as would be the profit to the option buyer. This means that Trader A will get…

= 7*8000

= Rs 56,000 (from trader B)

It is obvious that if the option buyer has initially spent Rs 10,800 to buy the right, then his profit will be

= 56,000 – 10,800

= Rs 45,200

If we see the return in percentage then it will be 419% (without annualize).

Such asymmetric returns are what make options an attractive instrument for trading. This is one of the reasons why options are so popular among traders.

Highlights of this chapter

• Buying a call option is only appropriate when the asset price is expected to move up.
• The strike price is the price at which the option buyer and option writer (seller) settle the deal.
• The spot price of the asset is considered as the underlying price.
• Exercising an option contract means that you exercise the right to buy the option at the end of the expiry.
• Like futures contracts, options contracts also have an expiry. Options contracts expire on the last Thursday of every month.
• Options contracts have different expirations – current month, mid-month, and far-month contracts.
• The premium is not fixed, it actually depends on many factors.
• The settlement of options in India is done in cash.