The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indices. In financial terms, an option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.
In most cases, the underlying asset is a stock, but it can also be an index, a currency, a commodity, or any other security. There are two types of options Call and Put:. Having a long position in a call option of a specific share is similar to buying that particular share, thus the buyer of call hopes that the price of the underlying share will increase.
Having a long position in a put option of a specific share is similar to selling that particular share, thus the buyer of put hopes that the price of the underlying share will decrease.
Strike price also known as exercise price is the price at which the underlying asset is to be bought or sold when the option is exercised. Importantly, there may be a gap or difference between the strike price of an option and the spot price of its underlying which is known as moneyness. Through moneyness, one can estimate the current state of the option in terms of money value i. In case of a call option, the market price of the underlying share has to be higher than its strike price to be in-the-money.
Whereas, for a put option, the market price of the underlying share has to be lower than its strike price to be in-the-money. In case of a call option, the market price of the underlying share has to be lower than its strike price to be out-of—the-money.
Whereas, for a put option, the market price of the underlying share has to be higher than its strike price to be out-of-the-money. In case of a call as well as a put option, the market price of the underlying share has to be the same as its strike price for the option to be at-the-money. It is also known as the option price.
Market price, volatility and time remaining primarily determine the premium. The time value of an option decreases as its expiration date approaches and becomes worthless after that date. Option contracts have certain characteristics similar to those of future contracts. The expiry takes place on the last Thursday of the month of expiry.
In case if the last Thursday happens to be a trading holiday, expiry will occur on the previous trading day. One may hold on to the position till its expiry date or square it off before that. Options also give the trader a choice to take a long buy or a short sell position in them. For writing an option, the trader is required to deposit a particular margin amount as specified by the exchange and broker.
The margin amount to be deposited varies from option to option depending upon the underlying share as well as the size of the lot. When a trader writes an option, he earns the premium paid by the option buyer.
During the life of the option, the trading account of the position holder is credited or debited on a daily basis depending on profits or losses incurred in the position as per the closing price of the option.
In case if the option is out-of-the-money, then be it a call or a put option, the value of the contract will diminish to zero. Whereas, if the option expiring is in-the-money then the option will be exercised and the amount that will be credited or debited to the option holder or writer will be the difference between the spot price of the underlying and the strike price of the option.
After squaring off your position, your profits will be returned to you or losses will be collected from you. Skip to main content. There are two types of options Call and Put: There are two components of the options premium, time value and intrinsic value.More...