An option is a contract sold (written) by one person to another. This contract grants the buyer the right, but not the obligation, to buy (in the case of a Call Option) or sell (in the case of a Put Option) a particular asset at a specified price (strike price/exercise price) in the future.
In exchange for the option, the seller collects a payment (the premium) from the buyer. Exchange-traded options, which are standardized and traded on public exchanges like the NSE, offer settlement guarantees by the Clearing Corporation, thereby reducing counter-party risk. Options serve various purposes, including hedging, speculation on market direction, arbitrage, and implementing income-generating strategies under different market conditions.
Option Terminology:
Index options: These options use an index as the underlying asset. In India, they typically have a European-style settlement, e.g., Nifty Options, Mini Nifty Options.
Stock Options: These options are contracts based on individual stocks. A stock option gives the holder the right to buy or sell the underlying shares at a specified price in the future. They usually have an American-style settlement.
Buyer of an Option: The buyer pays the option premium and acquires the right (but not the obligation) to exercise the option on the seller/writer.
Writer/seller of an Option: The writer/seller receives the option premium and is obligated to sell/buy the asset if the buyer exercises the option.
Call Option: It gives the holder the right (but not the obligation) to buy an asset by a specified date at a certain price.
Put Option: It gives the holder the right (but not the obligation) to sell an asset by a specified date at a certain price.
Option price/premium: The amount the option buyer pays to the option seller, also known as the option premium.
Expiration date: The specified date in the options contract, also known as the expiration date, exercise date, strike date, or maturity.
Strike price: The price specified in the options contract, also known as the strike price or exercise price.
American Options: Options that can be exercised at any time up to the expiration date.
European Options: Options that can be exercised only on the expiration date itself.
In-the-money Option: An option that would result in a positive cash flow if exercised immediately.
At-the-money Option: An option that would lead to zero cash flow if exercised immediately.
Out-of-the-money Option: An option that would result in a negative cash flow if exercised immediately.
Intrinsic value of an Option: The amount the option is in-the-money.
Time value of an Option: The difference between the option's premium and its intrinsic value.