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Options, Volatility and Pricing

Options, Volatility and Pricing

Options

An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.

Options are of two types – Calls and Puts options :
Calls” give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a given
future date.
Puts” give the buyer the right, but not the obligation to sell a given
quantity of underlying asset at a given price on or before a given future
date. All the options contracts are settled in cash.

Options

Option Terminology

  • Index Option : where asset is Index example sp500 , nifty.
  • Stock Option : Where asset is individual stock belongs to particular company example reliance , apple , tesla, hdfc, etc.
  • Buyer of option : the buyer of an option is one who has right but not the obligation in the contract.
  • Writer of option : the writer of an option is one who receives the option premium and thereby obliged to sell/buy the asset if the buyer of the option exercises his right.
  • European option : the owner of such option can exercise his right only on the date of expiry .
  • American Option : the owner of such option can exercise his right anytime on or before the expiry of contract.
  • Option price/ Premium: it is the price which the option buyer pays to the option seller.
  • Lot size : Lot size is the number of units of underlying asset in a contract.
  • Expiration day : The day on which a derivative contract ceases to exit.
  • Spot price : Price of underlying asset in current market.
  • Strike price or exercise price : strike is the price per share for which the underlying security may be purchased or sold by the option holder.
  • In- the- money options (ITM) – An in-the-money option is an option that would lead to positive cash flow to the holder if it were exercised immediately. A Call option is said to be in-the-money when the current price stands at a level higher than the strike price. If the Spot price is much higher than the strike price, a Call is said to be deep in-the-money option. In the case of a Put, the put is in-the-money if the Spot price is below the strike price.
  • At-the-money-option (ATM) – An at-the money option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is said to be “at-the-money” when the current price equals the strike price.
  • Out-of-the-money-option (OTM) – An out-of- the-money Option is an option that would lead to negative cash flow if it were exercised immediately. A Call option is out-of-the-money when the current price stands at a level which is less than the strike price. If the current price is much lower than the strike price the call is said to be deep out-of-the money. In case of a Put, the Put is said to be out-of-money if current price is above the strike price.

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