WITH the exit of badla from the coming month, the stock market will see the introduction of options and futures in a big way. For investors who have difficulty in understanding the terminologies associated with options and futures as well as its modes of working, here's some lucid explanation.
What are options?
An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date).
What are Call Options?
A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date.
The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.
What are Put Options?
A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date.
The seller of the put option (one who is short put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.
Explain In the Money, At the Money and Out of the money Options.
An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls.
A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is 'in-the-money', when the spot Sensex is at 4100 as the call option has value.
The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price.
On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700.
A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100.
Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value.
Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.
What is the Intrinsic Value of an option?
The intrinsic value of an option is defined as the amount by which an option is in-the-money or the immediate exercise value of the option when the underlying position is marked-to-market.
For a call option: Intrinsic Value = Spot Price - Strike Price
For a put option: Intrinsic Value = Strike Price - Spot Price
The intrinsic value of an option must be a positive number or 0. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.