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

Intrinsic value of Option

Strike price is the pre determined price at which the option contract can be exercised.

What is a Strike Price

Premium is the upfront amount the writer demands from the holder for writing the options contract

What's a Premium

Call options is an options contract for buying the underlying asset. Put options is an options contract for selling the underlying asset.

What are Call Options and Put Options

An underlying asset can be anything from stocks, bonds, interest rate swaps etc.

What is an Underlying Asset?

Date on or before (American option) or date on(European option) which the option can be exercised is called maturity period.

Maturity Period

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 + FC is the price of the call optionK is the strike price of the optionP is the price of the put optionF is the price of the underlying asset

Put Call Parity

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.

Why are Options called So

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 moneyAt the Money- if there is no profit or loss from exercising the option, then it is called at the money

Definitions of Moneyness 

<ul><li>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.</li><li>Upon which we calculate the standard deviation.</li></ul>

What is Volatility

Premium=intrinsic value+time value.

Formula For Premium

Options are derivative contracts which enable the holder to sell the underlying asset at a predetermined price

What are Options?

Comparison of the option contract with the market movement is called moneyness. It is of three types 1) In the money2)Out of money3) At the money

What is moneyness

In the money: if the forward price is lower than strike price
Out of money: if the forward price is higher than strike price

Moneyness of Put 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

Calculating Intrinsic Value of an Option

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

Formula For Premium

Similar ideas to Formula For Premium

What is Margin of Safety?

Value investing

1. Pricing at a premium.