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All you need to know about options terminology

7 Mins 30 May 2023 0 COMMENT

When you look back at your college days, which is the one time that stands out for being both exciting and stressful? You’re right—it’s the time when companies come to your institution for campus placements. There is so much to be done, from ensuring you know all the technical aspects of the job to improving your responses to questions like, "Where do you see yourself five years from now?" Campus placement is a time when everyone in college is driven to a frenzy. And then, lo and behold, you receive your first offer letter! However, do you stop there and start partying? Not really. You start exploring how you can be better prepared for the job so that you will have all the relevant information beforehand at the time of joining. But your learning is usually linear—you start as a trainee at your workplace, learn the ropes, and then move up the ladder. After all, even a lion does not hunt as a newborn; it takes months or a few years of observation and training before it can go on the prowl. Similarly, before executing any options trades, you need to understand options terminology first, which is what we will be doing in this article. So here are some of the terms you need to know before beginning your options trading journey.

1. Lot size:

The term lot size indicates the same thing in both options and futures contracts—it is the minimum quantity that you can trade in or in multiples of that. For example, if you look at the TCS options contract, you will see that the lot size is 175 shares. The term refers to the total number of units in a single contract.

2. Expiry date:

Options contracts expire on the last Thursday of the month. If you’re keen on weekly expiry contracts, these are also available in the market and expire on Thursday every week.

3. Number of available contracts:

In options, you have the following contracts available to you. For index weekly options, seven weekly expiry contracts (excluding the expiry week of the monthly contract) are available for trading. Three monthly contracts are also available for index options. For stocks, three monthly expiry contracts are available. Long-term index options of Nifty are also available with three quarterly expiries (March, June, September, and December cycles) and the next eight half-yearly expiries (June and December cycles).

4. Strike price:

The next term you must know is the strike price, which refers to the rate at which a trader has entered into the options contract. So, this is the rate at which you want to trade, and this can be both lower or higher than the spot price of the stock or index.

5. Options premium:

This is the price that the option buyer or holder pays to acquire the right (but not the obligation) to either buy or sell the underlying asset. So, if you’re a call option buyer, you are purchasing a right to buy an underlying asset. Therefore, you do not have to face any risk except the premium paid. However, since the seller is taking the risk, you have to pay them a premium to offset possible losses. The amount of the option premium depends on factors like the strike price, price of the underlying asset, volatility of prices, and time to expiry.

6. The concept of margins in options:

As an options buyer, you don’t have to pay any margin amount because you are exposed to limited risk, which is already compensated for with the premium paid. On the other hand, the option seller is exposed to unlimited risk; therefore, the seller needs to deposit a margin with the broker, and that is equivalent to a future margin, which is usually in the range of 10 to 30 percent of the lot value.

7. Intrinsic value:

Now let us look at the term intrinsic value. Option premium equals intrinsic value plus time value. You can calculate the intrinsic value of a call option by subtracting the strike price from the current market price. Therefore, the term refers to the amount you receive if you end up exercising the option. In the case of a put option, intrinsic value equals the subtraction of the spot price from the strike price. You should note here that the intrinsic value of a call or put option can never be below zero, because the option buyer will not exercise the option unless it results in positive cash flow. Let me give you an example to make this concept simpler. Suppose there’s a company named ABC Limited. The call option of ABC Limited with a strike price of ₹1000 is available at ₹50. If the current market price of ABC is ₹1020, its intrinsic value can be calculated as the spot price minus the strike price—that is, 1020 minus 1000, which is ₹20.

8. Time value:

The term time value refers to the falling value of an options contract over a period of time. At its expiry, the time value of the contract will become zero, since it has no time left. The time value can be calculated by deducting the intrinsic value from the premium. So, the greater the volatility and time of the option, the higher its time value would be. Therefore, if you’re looking at two options, one with a week’s expiry and the other expiring next month, then the second option has a greater time value. In the previous example, the time value of an option would be premium minus intrinsic value—that is, 50 minus 20 equals ₹30.