Key Options Trading Definitions: Options trading is a form of speculative trading that is quite loved by the trading community because of its potential to make huge money along with safeguarding the portfolio through hedging. Nonetheless, whenever a newbie enters the world of options trading, they get confused with different options trading definitions like Strike […]

The post 21 Key Options Trading Definitions – Must Know Options Terms for Beginners! appeared first on Trade Brains.

**Key Options Trading Definitions: **Options trading is a form of speculative trading that is quite loved by the trading community because of its potential to make huge money along with safeguarding the portfolio through hedging. Nonetheless, whenever a newbie enters the world of options trading, they get confused with different options trading definitions like Strike Price, Call/Put, ATM, ITM, OTM, etc.

In this article, we’ll look into some of the key options trading definitions and try to discuss what exactly these options trading terminologies (or jargon) mean. Keep reading to understand 21 of the most important options trading definitions. However, let’s first start with the basics.

**What is Options Trading?**

Options are a derivative instrument that gives the Options buyers a right to buy the underlying asset at a pre-decided price from the option seller on or before a pre-defined date (also known as the expiry day).

However, here, the options buyer is not obligated to honor the contract upon expiry i.e. he has the right to buy the asset only if he chooses to. Nonetheless, the Options Seller is obligated to honor the contract.

This is because the option seller receives compensation in the form of this fee (also known as the premium) to give up his right to underlying assets till the expiry of the contract. If the buyer does not want to buy the asset from the seller, he will simply lose the premium paid beforehand.

**Options trading is the system of buying or selling these options contracts.**

Now that you’ve understood the basic meaning of options trading, let’s deep dive into key options trading definitions or terms.

**21 Key Options Trading Definitions That Every Beginner Should Know**

Though there are hundreds of jargon used by options traders, here are the 21 key options trading definitions that every options trader should know and understand in order to start trading options.

**1) Options Buyer**

An option buyer is a trader/investor who buys the option from the seller. It means that the buyer buys the right to buy an underlying asset at a pre-decided price from the seller on or before expiry. The option buyer pays a premium (fee or compensation) to the options seller for this contract and hence is not obligated to exercise the option, unlike the seller.

Options buyers have limited risk (i.e. only up to the premium paid), however, the potential reward is unlimited to them theoretically.

**2) Options Seller or Writer**

For every transaction, there is a buyer and seller. Options sellers are those investors or traders, who receive the premium from the buyer to get into the agreement and have the obligation to honor the contract if the buyer wishes to exercise the option before expiry. Options sellers are also known as Options writers.

The maximum profit for the Options writers is only till the premium is received, however, they can incur an unlimited amount of loss theoretically.

**3) Call Options**

A call option is a type of option that gives the buyer the right to buy an underlying asset at a pre-determined price at a future date. The buyer of a call option generates profits only when the value of the underlying asset is rising upwards.

Basically, the real purpose of buying a call option is that the trader is expecting the price of the involved security to move up in the near future.

On the contrary, the trader who sellers (or writes) a call option, has an opposite (bearish) view that the price of the asset will not go higher than that pre-determined price.

**4) Put Options**

A Put option is a type of option that gives the buyer the right to sell the underlying asset at a pre-determined price at a future date. The buyer of a put option generates profits when the value of the underlying asset is falling.

In simpler terms, a trader or investor buys a put option when he expects the price of the involved asset to fall in the near future. The trader who sells (or writes) a put option has an opposite (bullish) view that the price of that asset will not go below that pre-determined price.

**5) Options Expiry**

Options Expiry is the last date of an option contract till which the buyer or holder of the options may exercise their rights.

The options contracts in the Indian stock market typically expire at the end of the business hours of every Thursday of the month for the weekly index expiry and on the last Thursday of every month for the stock options.

**6) Underlying Price**

The Spot Price or the underlying price is the current price in the marketplace of the asset from which the options are derived and can be bought or sold for immediate delivery at this price.

For example, suppose someone buys a call option from ABC Company. If ABC Company is currently trading at Rs 15 per share, the spot price or the underlying price would be Rs 15. The difference between the underlying price and the strike price greatly influences the option premium.

**7) Strike Price**

The Strike Price is the pre-determined and exercisable price of the options contract at which the Options buyer and seller agree on a contract. While trading in options, the buyers get options to buy different strike prices, based on their view.

The call option holder makes money if upon expiry the spot price is above the agreed strike price. On the other hand, the Put option holder makes money if the spot price is below the agreed strike price.

For example, let’s suppose a trader has bought a Call option contract of ABC Company for Rs. 75 Strike Price. Over the duration of the contract till expiry, the call option holder has the right to buy the shares at Rs. 75. If upon the expiry, the price of the share goes to Rs 125, the option holder will make a profit of (=Rs 125-Rs 75) Rs 50 per share on the trade.

**8) Index Option**

Similar to stocks, investors and traders can also trade in Indexes in options trading. An option contract whose underlying security is an index (like Nifty, Bank Nifty, or Finnifty) and not shares of any particular stock, are known as Index options.

Nifty and Bank Nifty Options Trading is quite popular in the Indian stock market.

Note: Want to learn Options Trading from Scratch? Enroll in this best-selling Options trading course at FinGrad

**9) In the Money (ITM)**

In the Money (ITM) contracts would simply mean something which already is making money. ITM is an option contract whose spot price of the underlying asset is above the strike price for the call option and below the strike price in the case of the Put option.

ITM: Spot Price > Strike Price (For Call Option)

ITM: Spot Price < Strike Price (For Put Option)

For index Options, let’s say Nifty is trading at 18,000 levels in the spot. Here, the call options of 17,950, 17,900, 17,850, or lower are ITM call options.

**10) At the Money (ATM)**

An At The Money Option contract is one whose spot price and the strike price of the underlying asset are the same. The options premiums are at their most crucial stage when the options contract is trading ATM.

For example, if XYZ stock’s spot price is Rs 75, then the XYZ 75 Call Option (CE) is at the money. Even the XYZ 75 Put Option (PE) is also at the ATM.

Similarly, if Nifty is trading at 18,000 levels in the spot and you buy an 18000 Call Option or 18000 Put option, you’re trading in At the Money contracts.

**11) Out of the Money (OTM)**

A contract is called OTM when the strike price of a call option is above the spot price of the underlying asset. In the case of a Put option, a contract is called Out of Money when the strike of the underlying asset is below the spot price of an option contract.

OTM: Spot Price < Strike Price (For Call Option)

OTM: Spot Price > Strike Price (For Put Option)

For example, in the case of index Options, let’s say Nifty is trading at 18,000 levels in the spot. Here, the call options of 18,050, 18,100, 18,150, or above strike prices are ITM call options.

**12) Intrinsic Value**

The Intrinsic Value of an options contract measures how much profitable it is based on the difference between the strike price and its spot price in the market. It basically means how much ‘in the money’ the contract is currently.

For example, if you have bought a call Option contract with a strike price of Rs 300 and it is currently priced at Rs 400 on the spot, the intrinsic value of the Call Option will be Rs 100 (i.e. 400-300)**.**

The intrinsic value of Out of The Money (OTM) contracts are zero and Intrinsic value cannot be negative.

**13) Time Value**

Time value is the additional money that an option buyer is willing to pay on the premium over the intrinsic value based on the underlying asset’s expected volatility and additional time until the expiration date.

Basically, if the contract has time and is far from its expiration date, it has the potential to be in the money, and the buyer has to compensate for this time value. The time value approaches zero as the options contract comes near the expiration time.

**14) Options Premium**

The option premium is the fee paid by the buyer of the option to the option seller for having a right to an underlying asset before expiry. It is thus the maximum loss that can be incurred by the options buyer and the maximum profit that is received by the seller.

Options Premium = Intrinsic Value + Time Value

If the option expires In the Money then the option buyer has the right to exercise the option contract and make profits. If the option expires Out of money, then the option buyer may not exercise his right and stands to lose the premium paid. The premium is the income generated by an option seller if the contract expires at OTM.

For example, let’s assume the stock price of XYZ Company on 10th April 2023 is Rs 500.

An option buyer buys 530 Call options at Rs 15 from an option seller. Upon expiry, if the price of XYZ is 575, then the income made by the option buyer is Rs 30 (Spot price – Strike Price – Option Premium i.e. 575 – 530 – 15).

Further, in another scenario, let’s assume that upon expiry, the spot price of XYZ Company has been reduced to Rs. 520. Here, the option will expire worthless for the option buyer and the buyer will not exercise his right to buy the asset. The premium will be income earned by the option writer/seller.

In the third scenario, if the price of XYZ shares upon expiry goes to Rs 540, then the contract expires ITM for the option buyer but he still loses money.

Here, the Strike Price is Rs 530, the Option premium paid is Rs 15 and the Spot Price upon expiry is Rs 540. The total Income of the Option Buyer will be (Spot price – Strike Price – Option Premium) i.e. Rs. (540- 530-15) which is Rs -5. So the intrinsic value will be 0.

On the other hand, the total Income of Option Seller will be Rs (530+15-540) i.e. Rs 5.

**15) Options Settlement**

Let’s understand this with the help of an example. There is a call option to buy for XYZ at Rs 50 with the expiry of 30th Jan 2020 (last Thursday). The premium is Rs 4 and one market lot has 7,000 shares.

Assume there are two traders: Trader A and Trader B. Trader A wants to buy (Option buyer) and Trader B wants to sell (write) this agreement. Here is how the money movement will happen

Since the premium is Rs 4 per share, Trader A is required to pay a total of 7,000 * 4 = Rs 28,000 as a premium amount to Trader B.

Because Trader B has received this Premium from Trader A, he is obligated to sell Trader A, 7000 shares of XYX on 30th Jan 2020, if Trader A decides to exercise his agreement. However, this does not mean that Trader B should have 7000 shares with him on 30th Jan.

Options are cash-settled in India. This simply means on the last day if Trader A wants to use his right to exercise his option, in that case, Trader B is obligated to pay just the cash differential.

To help you understand this better, consider on the last Thursday (expiry day) of January XYZ is trading at Rs.65. This means the option buyer (Trader A) will exercise his right to buy 7000 shares of XYX at Rs 50. In other words, he is getting to buy XYZ at 50, when the same is trading at Rs 65 in the open market.

Another way to look at it is that the option buyer is making a profit of Rs.15 per share (65-50). Because the option is cash-settled, instead of giving the option buyer 7000 shares, the option seller directly gives him the cash equivalent of the profit he would make, which means Trader A would receive = 15*7,000 = Rs 1,05,000 from Trader B.

Also note that the option buyer had initially spent Rs.28,000 towards purchasing this right, hence his real profit would be Rs (1,05,000-28,000) = Rs 77,000.

The fact that one can make such a large exponential return is what makes options an attractive instrument to trade. This is one of the reasons why Options are one of the most favorite trading instruments amongst Traders.

**16) Options Chain**

An Options chain is basically the listing of all option contracts and comes with Call and Put sections. The options chain is available on the NSE India website. Knowledge of how to read the Options Chain is crucial for both Options buyers & Sellers.

**17) Options Greek**

Options Greeks are ingredients of the recipe which help in pricing the options and are various factors that help options traders in trading options. Knowledge of Greeks can help you in understanding the price of options premium, volatility, managing risks & more. Types of option Greeks: Delta, Gamma, Theta, Vega, and Rho. The Options Greeks are used in the analysis of options portfolios and understanding of the sensitivity of the option’s price to its underlying asset.

**18) Delta**

Delta is an Options Greek that measures the change in the value of premium with respect to the change in the value of underlying. For a call option, the value of Delta varies between 0 and 1, and for a Put option, the value of Delta varies between -1 and 0.

**19) Theta**

Theta is an important factor in deciding option pricing. They use time as an ingredient in deciding the premium for a particular strike price. Time decay eats into the option Premium as it nears expiry. Theta is the time decay factor i.e., the rate at which option premium loses value with the passage of time as we near expiry.

**20) Gamma**

Gamma measures the change in the value of Delta with respect to the change in the value of underlying. Gamma calculates the Delta gained or lost for a one-point change in the value of underlying. One important thing to remember here is that Gamma for both Call and Put options is positive.

**21) Vega**

Vega as a Greek is sensitive to the current volatility. Volatility in simple terms is the rate of change. Vega simply signifies the change in the value of an option for a 1% change in the price of the underlying asset. Higher the volatility of the underlying asset, the more expensive it is to buy the option and vice versa for lower volatility.

**(Bonus) Moneyness**

In simple terms, the moneyness of an option explains the amount of money the option holder was to make if he were to exercise his right immediately. It simply explains the intrinsic value (i.e. the amount received by the buyer) of an option.

**Relationship between Various Terminologies**

For call options, the further away the strike price from the spot price, the more economical the option. The following table shows the various strike price and premiums and other factors for a stock trading at Rs 50.

Strike Price | Moneyness | Call option premium | Intrinsic value | Time Value |
---|---|---|---|---|

35 | ITM | 15.5 | 15 | 0.5 |

40 | ITM | 11.25 | 10 | 1.25 |

45 | ITM | 7 | 5 | 2 |

50 | ATM | 4.5 | 0 | 4.5 |

55 | OTM | 2.5 | 0 | 2.5 |

60 | OTM | 1.5 | 0 | 1.5 |

65 | OTM | 0.75 | 0 | 0.75 |

Conversely, for put options, the following table shows the various strike price and premiums, and other factors for a stock trading at Rs 50.

Strike Price | Moneyness | Call option premium | Intrinsic value | Time Value |
---|---|---|---|---|

35 | OTM | 0.75 | 0 | 0.75 |

40 | OTM | 1.5 | 0 | 1.5 |

45 | OTM | 2.5 | 0 | 2.5 |

50 | ATM | 4.5 | 0 | 4.5 |

55 | ITM | 7 | 5 | 2 |

60 | ITM | 11.25 | 10 | 1.25 |

65 | ITM | 15.5 | 15 | 0.5 |

## Key Takeaways

In this article, we discussed a few of the frequently used stock options trading definitions or jargon like Strike price, Underlying price, In The Money, At The Money, and Out Of Money. Here are the key takeaways from this post:

- It is advisable to buy a call option only when one anticipates an increase in the price of an asset.
- The strike price should be as close as possible to the current price to avoid quick premium decay because of the time factor.
- The underlying price is simply the spot price of the asset.
- Weekly options contact expire every Thursday and monthly Option contracts expire on the last Thursday of every month. If Thursday is a holiday then it expires the previous day.
- Option Greeks like Delta, Gamma, Theta, Vega, volatility, etc have their own pivotal role in finding the exact pricing of the option.
- Options are cash-settled in India

That’s all for this article on the key options trading definitions and terminologies. If you’ve got any more questions on other options trading terminologies, do comment below. We’ll try to explain them. Have a great day and happy trading!!

The post 21 Key Options Trading Definitions – Must Know Options Terms for Beginners! appeared first on Trade Brains.