Option Terminologies

In this chapter, we will focus on explaining the workings of an option, describing its specifications, understanding payoffs and more.

As mentioned in the previous chapter, an option gives its buyer (holder) the right to buy/sell an underlying instrument at a predetermined price from the option writer (seller). This predetermined price is called the strike price or exercise price. The strike price is specified in the option contract.

One underlying instrument can have multiple strike prices based on the expectations of different market participants.

For example, if company A is trading for Rs 300, it can have option contracts with different strike prices like Rs 280, Rs 300, Rs 310 etc.

The concept of three different strike prices can be understood by introducing moneyness of an option.

In simple words, moneyness of an option essentially tells you how profitable your current option contract may be or what the current scenario of your bet looks like. Before we begin, for the purpose of simplicity, current market price of the stock in the cash market is termed as spot price.

Moneyness can be classified into three categories:

1. In the Money

• Call option: If spot price of the underlying instrument is above the strike price of the option, the option is said to be in the money.
• Put option: If the spot price of the underlying instrument is below the strike price of the option, the option is said to be in the money.

2. At the Money

• Call option: If the spot price of the underlying instrument is equal to the strike price of the option, the option is said to be at the money.
• Put option: If the spot price of the underlying instrument is equal to the strike price of the option, the option is said to be at the money.

3. Out of the Money

• Call option: If the spot price of the underlying instrument is below the strike price of the option, the option is said to be out of the money.
• Put option: If the spot price of the underlying instrument is above the strike price of the option, the option is said to be out of the money.

Let’s understand each of these scenarios with examples:

Imagine you buy a call option for Company A which is currently trading at Rs 300. If you opt for the call option with a strike price of Rs 280, your option will be in the money as the spot price of Rs 300 is above the strike price of Rs 280. This in turn will enable you to buy the share for Rs 280 instead of Rs 300 and leave some profit on the table assuming zero cost of brokerage and premium paid.

If you opt to go long the call option with a strike price of Rs 300, your option will be said to be at the money as the spot price of Rs 300 is equal to the strike price. This position is preferred by investors who expect the price of the option to increase but do not wish to pay hefty premiums. We will explain the concept of premium as we move ahead.

If you opt to go long the call option with a strike price of Rs 310, your option will be termed as out of the money as the spot price of Rs 300 is below the strike price. It is possible that this option may have been in the money at the initiation of the option contract, but the stock price may have spiralled down resulting in the option going out of the money.

Similarly, if you opt to go long a put option for Company A with a strike price of Rs 310, your option will be said to be in the money as the spot price of Rs 300 is below the strike price. One can sell the share for Rs 310 instead of Rs 300 in this case.

If you buy the put option with a strike price of Rs 300, your option will be said to be at the money as the spot price of Rs 300 is equal to the strike price of Rs 300.

If you buy the put option with a strike price of Rs 280, your option will be said to be out of the money as the spot price of Rs 300 is above the strike price of Rs 280.

In order to give the option holder this right to exercise at will, the option writer charges an amount called the premium from the buyer of the option.

The premium is the amount that the option holder pays to the option writer to buy the option contract or buy the right to exercise at will.

For instance, on the exchange the call option with a strike of Rs 280 could be trading for Rs 10. This Rs 10 in this case would be the premium payable by the buyer to the seller.

Just like any contract, an option contract too has an expiry date which happens to be the exercise date of an option. It is the day the holder of the contract decides to exercise their option or in case they do not, the option will expire on its pre-determined date as mentioned in the contract.

Option contracts have lot sizes. Lot size refers to the number of shares/units of the underlying in one option contract.

A lot size of 100 for a call option on company B would mean that the buyer of the option will have a right to buy 100 shares of company B at the pre-determined price.

For simplicity purpose, we will assume a lot size of one in all our examples in our upcoming chapters.