Part 4 Institutional Trading Key Terms in Options Trading
Understanding options requires familiarity with several technical terms:
Strike Price: The predetermined price at which the underlying asset can be bought (call) or sold (put).
Expiration Date: The last date on which the option can be exercised. Options lose value after this date.
Premium: The price paid to purchase the option, influenced by intrinsic value and time value.
Intrinsic Value: The difference between the underlying asset’s price and the strike price if favorable to the option holder.
Time Value: The portion of the premium reflecting the probability of the option becoming profitable before expiration.
In-the-Money (ITM): A call is ITM if the underlying price > strike price; a put is ITM if the underlying price < strike price.
Out-of-the-Money (OTM): A call is OTM if the underlying price < strike price; a put is OTM if the underlying price > strike price.
At-the-Money (ATM): When the underlying price ≈ strike price.
How Options Trading Works
Options trading involves buying and selling contracts on exchanges like the National Stock Exchange (NSE) in India, or over-the-counter (OTC) markets globally. Each contract represents a fixed quantity of the underlying asset (e.g., 100 shares per contract in equity options).
The price of an option, called the option premium, is determined by multiple factors:
Underlying Price: Directly impacts call and put options differently. Calls gain value as the underlying price rises; puts gain as it falls.
Strike Price: The relationship of the strike to the current asset price defines intrinsic value.
Time to Expiration: More time increases the option’s potential to become profitable, adding to the premium.
Volatility: Higher expected price fluctuations increase the chance of profit, making options more expensive.
Interest Rates and Dividends: Slightly affect option pricing, especially for longer-term contracts.
Options traders use strategies to profit in various market conditions. They can combine calls and puts to create complex structures like spreads, straddles, strangles, and iron condors.
Popular Options Trading Strategies
Covered Call: Holding the underlying asset and selling a call option to earn premium. It generates income but limits upside potential.
Protective Put: Buying a put on a held asset to limit losses during downturns. Essentially an insurance policy.
Straddle: Buying a call and a put at the same strike price and expiry, betting on high volatility regardless of direction.
Strangle: Similar to a straddle but with different strike prices, cheaper but requires larger movements to profit.
Spreads: Simultaneously buying and selling options of the same type with different strikes or expiries to reduce risk or capitalize on specific movements. Examples include bull call spreads and bear put spreads.
These strategies allow traders to tailor risk/reward profiles, hedge portfolios, or speculate with leverage.
