Important Options Terminology You Should Know Today

In order to get to grips with the options market, it is necessary to understand the basic options terminology.

An option is basically a contract that gives the holder the right (i.e. can choose to), but not the obligation (i.e. not have to), buy or sell a fixed quantity of shares, on or before a given date. This right can be exercised if the holder wishes to or not as the case may be if it is not in the holder's interest to do so.

The holder of the option would only use that right when the price of the option moves beyond the fixed "exercise price" plus the cost of the option, then the option can be sold at a profit, or alternatively it can be exercised. If not, since there is no obligation to exercise the right, the option may be left to expire and the buyer would forfeit his premium (or cost of the option).

An option is more valuable the further away it is to the expiry date, since there is greater probability of a profitable movement of the underlying share as there is more time for the underlying share to move. This component of the option is called time value, so the greater the time to expiry, the greater the time value of the option. The closer to the expiry, the lesser the time value of the option.

Calls and puts behave differently for a given movement of the underlying share price. If the share price goes up, the call option price will generally go up because the fixed-price "option to buy" becomes more valuable.

Likewise a put option gives the right to sell the shares at a particular price and its price will generally rise if the underlying shares fall in value. And if the underlying shares rise, then put options would generally fall in price.

In other words, call options move in the same direction as the underlying shares and put options move in the opposite direction.

From an investor or traders point of view, they would buy calls if they are of the view that the underlying shares would go up and puts if they thought the shares would go down.

For each holder of an option, there must be someone who takes the opposite position. When an option buyer buys the right but not the obligation in a contract, it follows that the person on the other side of the transaction must assume the obligation but not the right. This person is known as the "writer". The writer takes on the obligation to make delivery of the underlying stock if the holder exercises his call and takes delivery of stock in the case of a put.

For assuming his obligations, the writer gets paid a premium i.e. the price that the buyer pays for. The option premium is determined not only from demand and supply but also with reference to variables such as time remaining till expiry, price of the underlying shares, relative to the exercise or strike price of the option.

Other factors include, dividends on the underlying shares, interest rates, and volatility. The premium is normally determined by the buyers and sellers but normally corresponding to the theoretical price as devised by various mathematical models such as Black Scholes or binominal distribution. Such software is available and a search on the internet should reveal such models.

Exercise in the financial context, is the use of the right by the option holder to purchase the shares at exercise price if the option is a call, or to sell the underlying shares at the exercise price if the option is a put. When a call is exercised, the writer of the option is obliged to make delivery of the underlying shares at the exercise price, and the holder of option must take delivery of the shares. When a put is exercised, the writer must take delivery of the underlying shares at the exercise price and the holder of the option is obliged to make delivery.

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