Summary: Being well-versed in elementary phrases and values is essential for facilitating an entry in options trading. Here are some key concepts.
Equity investments are prone to several risks, such as market, company-specific and interest rate uncertainties. In the short and medium term, equity markets are unpredictable, which puts investors with corresponding goals at a grave risk. In such cases, options are helpful as they cover the risk arising from incorrect judgement or unfavourable market movements.
However, one needs to be well-versed in concepts like ITM, ATM, OTM, time value and intrinsic value to trade in options. These are directly linked to the price (premium) one pays for buying an options contract. Let us consider some of these concepts:
IN THE MONEY (ITM) OPTION: An ITM call option is one where the strike price is less than the market (spot) price of the underlying stock/index, that is, the spot price is more than the strike price. The ITM put option is one where the strike price is more than the spot price of the underlying stock/index.
If the ITM option is exercised, it results in a positive cash inflow as a call buyer can purchase the underlying security at less than the market price and a put buyer can sell the underlying at more than the market price.
AT THE MONEY (ATM) OPTION: The ATM call and put options are ones where the strike price is equal to the market or spot price. There is no cash flow for the call and put buyers if they exercise the at the money option.
OUT OF THE MONEY (OTM) OPTION: An OTM call option is one where the strike price is more than the spot price. An OTM put option is one where the strike price is less than the spot price, that is, the market price of the underlying security is more than the strike price.
If the OTM option is exercised, it leads to a negative cash flow for the buyer. This is because a call buyer purchases the stock at a price higher than the market price and a put buyer sells at a price lower than the market price.
INTRINSIC VALUE OF AN OPTION: It is defined as the amount by which an option is an ITM. The OTM options have no intrinsic value. The intrinsic value of a call option is the maximum of zero and the difference between the spot price and strike price, that is, Max (0, Sp-St). This is because a call option is valuable as long as the buyer can purchase the underlying stock/index at a price less than the market price.
The intrinsic value of a put option is the maximum of zero and the difference between the strike price and spot price, that is, Max (0, St-Sp). This is because a put option is valuable as long as the buyer can sell the underlying stock/index at a price higher than the market price. If the spot price falls below the strike price (in case of a call buyer) or the spot price rises above the strike price (in case of a put buyer), the buyer will let the option expire worthless, and so, its value cannot be less than zero.
TIME VALUE OF AN OPTION: This is the difference between an option's price (premium) and its intrinsic value. Technically, it is defined as the risk premium that the writer of the option requires for granting a right to the buyer. The options that have only zero intrinsic values (ATM or OTM) comprise time values.
Reproduced From Money Today. Copyright 2009. LMIL. All rights reserved.
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|Publication:||Money Today (New Delhi, India)|
|Date:||Sep 1, 2009|
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