Basic Terminologies in Options Trading

Options are contracts where a buyer and seller place a price and trade an asset delivered in the future. An option has an expiration date, and on that particular date, the seller has to provide the asset when the investor exercises the option of physical delivery as a settlement.

On the other hand, the investor is not obliged to buy the asset at the end of the time period. This is how futures and options differ. A futures contract is similar to options, but both parties are duty-bound to carry out the settlement at the expiration date.

The below terminologies which provide basic knowledge of option trading and also acts as a beginner’s guide to trading options

Terminologies

1. Call Option:

• A call option gives the buyer the right, but not the obligation, to buy the underlying asset at a predetermined price (strike price) within a specific period (until expiration).

2. Put Option:

• A put option gives the buyer the right, but not the obligation, to sell the underlying asset at a predetermined price (strike price) within a specific period (until expiration).

3. Strike Price:

• The strike price is the price at which the underlying asset can be bought (for call options) or sold (for put options) when the option is exercised.

4. Expiration Date:

• The expiration date is the date on which the option contract expires and becomes invalid. Options must be exercised before or on this date.

5. Premium:

• The premium is the price paid by the option buyer to the option seller for the right to buy or sell the underlying asset. It represents the cost of the option contract.

6. In-the-Money (ITM):

• For call options, ITM refers to the situation when the market price of the underlying asset is above the strike price. For put options, ITM refers to when the market price is below the strike price.

7. Out-of-the-Money (OTM):

• For call options, OTM refers to when the market price of the underlying asset is below the strike price. For put options, OTM refers to when the market price is above the strike price.

8. At-the-Money (ATM):

• ATM describes the scenario when the market price of the underlying asset is equal to the strike price of the option.

9. Exercise:

• Exercise is the act of utilizing the right granted by an option contract to buy (for call options) or sell (for put options) the underlying asset at the strike price.

10. Assignment:

• Assignment occurs when the option seller (writer) is obligated to fulfill their obligation by buying (for put options) or selling (for call options) the underlying asset at the strike price.

11. Premium Decay:

• Premium decay refers to the reduction in the value of an option over time, primarily due to the time decay component of its pricing.

12. Implied Volatility (IV):

• Implied volatility is a measure of the market's expectation of the future volatility of the underlying asset, as implied by the option's price.

13. Delta:

• Delta is a measure of the change in the option price relative to the change in the price of the underlying asset.

14. Gamma:

• Gamma is a measure of the rate of change of an option's delta relative to the change in the price of the underlying asset.

15. Theta:

• Theta is a measure of the rate of change in an option's price due to the passage of time.

16. Vega:

• Vega is a measure of the sensitivity of an option's price to changes in implied volatility.

17. Open Interest:

• Open interest is the total number of outstanding option contracts for a particular strike price and expiration date.

18. Volume:

• Volume is the total number of option contracts traded during a specified period.

Understanding these fundamental terms is crucial for anyone engaging in options trading, as they form the basis for analyzing, pricing, and executing options transactions effectively.

These detailed explanations of options trading terminologies are essential for developing a comprehensive understanding of options markets and effectively participating in options trading activities.

Frequently Asked Questions

How to Trade in Options?

1. Options trading primarily occurs on exchanges and is conducted online, much like traditional stock trading.

2. It is possible to trade options on various exchanges such as the National Stock Exchange, Bombay Stock Exchange, Multi Commodity Exchange, and others.

3. Privately traded options offer flexibility, allowing for customized agreements between two parties to meet their specific requirements.

4. Participating in online options trading necessitates having a trading account with an options brokerage like Enrich Money.

5. Options are traded on commodities rather than equities, primarily due to the requirement for asset delivery upon expiration

What is a Stop Loss Order in Options Trading ?

A stop loss order in options trading is a preset instruction to sell a security when it reaches a specified price, aiming to limit potential losses. It acts as a risk management tool, automatically triggering a sell order if the option's price falls to or below the predetermined level. Stop loss orders help investors minimize losses and protect their investment capital during market downturns. They are commonly used alongside other trading strategies to mitigate downside risk and enhance overall portfolio management.

What is Standard Deviation In Options Trading?

Standard deviation in options trading is a measure of the dispersion of a set of values from its mean. It quantifies the volatility of the underlying asset's price movements. A higher standard deviation implies greater price volatility, increasing the risk associated with the option. Traders often use standard deviation to assess the potential price fluctuations and adjust their strategies accordingly. It helps in understanding the range of possible outcomes and managing risk in options trading.