An Option Contract is an agreement between buyer and seller to exchange shares at a certain price and at a certain time in future.
The price at a future date at which shares would be exchanged is known as strike price
The future date on which shares would be exchanged is known as expiry date.
The Option Seller collects some amount from option buyer to enter into an agreement and for carrying the risk. This amount is known as Option Premium.
The person who pays premium and buys an option contract is termed as buyer of an option.
The person who receives premium and sells an option contract/or creates an option contract is termed as seller of an option.
The instrument on which an option contact is made is called as an Underlying.
The manner in which options can be exercised depends on the style of the option.
American style options can be exercised any time before expiration while European style options can only be exercised on expiration date itself.
A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.
A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
If an option Buyer is bullish on the underlying, he will buy a call option else if he is bearish on the underlying, he will buy a put option. An option seller does the reverse in this case; he sells a call option if he is bearish and sells a put option if he is bullish.
If the underlying of an option is an index such as nifty 50/bank nifty, it is called as an Index Option
If the underlying of an option is a stock such as Infosys etc. it is called as a Stock Option
For example Mr.Ronak is bullish on Infosys and enters an agreement to buy shares of Infosys on October 26th 2017 at 2000 rupees from Mr.Shashank. This agreement was made on 6 October 2017 and the market price of Infosys on 6th Oct 2017 is 918.
Here, October 26th 2017 is called as expiry date and 2000 rupees is termed as strike price and Infosys is called as underlying.
Shashank collects a nominal amount from Ronak to enter into an agreement which is called an option premium.
Now, since Mr. Ronak was bullish on Infosys, the agreement will be called as a call option.
Moneyness of an Option:
A Call option is said to be in-the-money (ITM) option when the price of an underlying is greater than its chosen strike price (i.e. underlying price / spot price > strike price). If the underlying price is much higher than the strike price, the call is said to be deep ITM.
A Put option is said to be in-the-money (ITM) if the underlying price is below the strike price i.e. underlying price / spot price < strike price). If the underlying price is much lower than the strike price, the put is said to be deep ITM.
If an in-the-money option is exercised immediately it would lead to a positive cash flow.
At-the-money option: An Call/Put option is said to be at-the-money when the current underlying price equals the strike price (i.e. underlying price / spot price = strike price).
An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately.
Out-of-the-money option: A call option is said to be out-of-the-money when the current underlying price is less than the strike price (i.e. spot price < strike price). If the underlying price is much lower than the strike price, the call is said to be deep OTM.
A put option is said to be OTM if the underlying price is above the strike price. An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately.
Intrinsic value of an option: The option premium can be broken down into two components – intrinsic value and time value. The intrinsic value of a call is Max[0, (Spot — Strike)] which means the intrinsic value of a call is the greater of 0 or (Spot — Strike). Similarly, the intrinsic value of a put is Max[0,Strike — Spot],i.e. the greater of 0 or (Strike — Spot).
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. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option doesn’t have any time value.
Time Value = Premium – Intrinsic Value