Option Trading Basics and Market Jargon
Hola Traders!!
Recent changes in international and national market caused too much ups and downs in market, this is not new for honed traders who already feeling heat but new traders who are just starting or common people for whom market is still that fast forwarded disclaimer at end of Mutual Fund advertisement
“Mutual funds are subject to market risk. Please read the offer documents carefully before investing”
is kind of whole bible. Most of people fall under Muggle categories for trading . So let’s introduce these people what is trading magic? and what they can achieve?
Why Trading?
There are 60 major stock exchanges throughout the world, and their range of sizes is quite surprising. At the high end of the spectrum is the mighty NYSE, representing $18.5 trillion in market capitalization, or about 27% of the total market for global equities. At the lower end? Stock exchanges on the tiny islands of Malta, Cyprus, and Bermuda all range from just $1 billion to $4 billion in value. Even added together, these three exchanges make up just 0.01% of total market capitalization.
Two stock exchange players in India are NSE(National Stock Exchange) and BSE(Bombay Stock Exchange) The NSE is the world’s 12th-largest stock exchange as of March 2016 with market capitalization of more than US$1.41 Trillion. The BSE has an overall market capitalization of $1.83 Trillion as of March, 2017, making it one of the world’s 11th-largest stock exchanges.
For Forex Market According to the Bank for International Settlements, foreign-exchange trading increased to an average of $5.3 trillion a day (Feb 2016) In 2016, global GDP amounted to about 75.4 Trillion U.S. dollars and that is only 15-Days worth trading in Forex Market. That much money and only few people able to handle trading just because lack of knowledge about trading and some unconventional myths
Following and upcoming post will be related to making common people and new traders aware of basics of Market, How they can minimize their losses? and increase profit amount without further delay let’s learn some common jargon present in Option Market
What is Option?
Option is a contract between seller and buyer. These contracts contain rights (either to buy or to sell) related to asset. It means that seller sells these rights to buyer in exchange of premium (for now consider it as price buyer pay for rights). Options will have strike price ( price for which underlying asset will be traded), expiration date (till this date option will be valid)
Detailed explanation of some gibberish sounded words from above definition
Who is buyer of option?
Buyer of an option is the one who pays option premium to buy rights either to buy underlying asset or to sell underlying asset but not an obligation to use those rights. Buyer exercise option on seller/writer.
Who is seller or writer of option?
Seller or writer who creates contract and sell in exchange of option premium and seller has obligation to buy or sell asset depending upon which option buyer want to exercise
What is option premium?
It’s price of an option which buyer pays to seller
What is expiration date?
It’s date specified on option it’s also called exercise date, strike date or maturity
What is Strike price?
It is price mentioned in contract, it is also called exercise price.
What does Exercise mean?
Exercise means to put into effect the right specified in a contract. In options trading, the option holder has the right, but not the obligation, to buy or sell the underlying instrument at a specified price on or before a specified date in the future. If the holder decides to buy or sell the underlying instrument (rather than allowing the contract to expire worthless or closing out the position), he or she will exercise the option, and make use of the right available in the contract.
Below are some more definition which commonly used in market
1. American Option
American options are options that can be exercised any time upto the expiration date
2. European Option
European options are options that can only be exercised on expiration date
3. Index option
These options have index as underlying asset . In India these options has European style settlement.
4. Stock option
These options have individual shares of stock as underlying asset. In India these options have American style settlement.
What is Call Option?
Option is a contract between seller and buyer. These contracts contain rights (either to buy or to sell) related to asset. Contract which contain rights to buy are called Call Option.
What is Put Option?
Contract which contain rights to Sell are called Put Option.
What is In-The-Money option(ITM)?
In the money option or ITM is an option which leads to positive cash flow towards holder if exercised immediately. A call option is said to be in-the-money option if spot price is greater than strike price i.e. spot price > strike price. If strike price is too much low than spot price then it is called deep ITM. Similarly, a put option is In-The-Money option if spot price is smaller than strike price mentioned in option i.e. Strike price > Spot price.
What is Out-The-Money(OTM) option?
Out-The-Money option is an option which leads to negative cash flow if exercised immediately. A call option is said to be OTM option if spot price is lower than strike price i.e. Strike Price > Spot Price, if difference between Strike Price and Spot Price is much larger then it’s called as deep OTM. In case of Put option Strike Price is lower than Spot Price i.e. Strike Price
What is At-The-Money option?
At-The-Money option is an option which leads to zero cash flow if exercised immediately. An option for index is At-The-Money when spot price is equal to strike price i.e. Spot Price = Strike Price.
What is Intrinsic value of an option?
Option premium can be broken down into two parts one is Intrinsic value and other is time value. Intrinsic Value for call option is the amount the option is ITM if it’s ITM. If the call is OTM Intrinsic value is zero. Putting in other way Intrinsic value is Max of [0, St — K ] in case of call option and in case of Put option intrinsic value is Max of [0, K — St]
What is time value of an option?
Time value option is difference between option premium and Intrinsic value. Both calls and puts have time value, in case OTM or ATM has only time value. Usually maximum time value exist when option is ATM. The longer the time to expiration for an option greater the time value for option, all else equal. At expiration time, an option should have no time value.
this is enough for now please comments for any changes and suggestions in next post we will learn about Options payoff characteristics and Payoff profiles…till that time
Adios Amigos!!
