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What are Options?
Options are derivative contracts which enable the holder to sell the underlying asset at a predetermined price
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Why are Options called So
The holder of an option contract is not mandated to exercise the option. If the market movement is adverse, he or she may stay out of exercising the contract. However, the writer of an option contract must exercise his side of obligation in case the holder exercises the option. Thus, options create one sided obligation.
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What's a Premium
Premium is the upfront amount the writer demands from the holder for writing the options contract
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What is a Strike Price
Strike price is the pre determined price at which the option contract can be exercised.
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Maturity Period
Date on or before (American option) or date on(European option) which the option can be exercised is called maturity period.
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What is an Underlying Asset?
An underlying asset can be anything from stocks, bonds, interest rate swaps etc.
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What are Call Options and Put Options
Call options is an options contract for buying the underlying asset.
Put options is an options contract for selling the underlying asset.
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What is moneyness
Comparison of the option contract with the market movement is called moneyness. It is of three types
1) In the money
2)Out of money
3) At the money
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Definitions of Moneyness
In the Money- if the holder of an option can profitably exercise the option, then it is called In the money.
Out of Money- if the holder of an option cannot profitably exercise the option, then it is called Out of money
At the Money- if there is no profit or loss from exercising the option, then it is called at the money
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Moneyness of Put Option
In the money: if the forward price is lower than strike price
Out of money: if the forward price is higher than strike price
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What is Volatility
- It is the movement of the underlying asset in the market. It is measured by taking ln(Spot rate of today/spot rate of day before). Log is taken as the distribution is log normal in nature.
- Upon which we calculate the standard deviation.
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Intrinsic value of Option
In practise, all option contracts are cash settled. Means there is no delivery of the underlying asset except in case of stocks.
The cash value a holder gets upon exercising the option at current spot rate is called intrinsic value
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Calculating Intrinsic Value of an Option
For example, an investment bank agrees to write a call option with 100 google stocks at $100.00 per share and the current market price is $120.00. The intrinsic value is $20 per share
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What is Time Value
Time value is the amount that an investor is willing to pay for the possibility that the option will be in-the-money before it expires. It represents the potential future value of the option. It is calculated from standard deviation based on volatility
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Put Call Parity
Put-call parity is a fundamental relationship in european options pricing that states that the price of a put option, the price of a call option, the underlying asset price, and the strike price are all related. The formula for put-call parity is:
C + K = P + F
C is the price of the call option
K is the strike price of the option
P is the price of the put option
F is the price of the underlying asset
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