Unit
- Call option: A contract that gives the buyer the right, but not the obligation, to purchase an underlying asset at a predetermined strike price on or before expiration. The seller (writer) of a call option assumes the obligation to deliver the asset if the buyer exercises. Calls are typically purchased when the holder expects the underlying asset's price to rise.
- Put option: A contract that gives the buyer the right, but not the obligation, to sell an underlying asset at a predetermined strike price on or before expiration. The seller of a put option must buy the asset if the buyer exercises. Puts are used to profit from or hedge against a decline in the underlying asset's price.
- Underlying asset: The financial instrument on which the option is based, such as stocks, indices, ETFs, futures, or currencies. The value of the option is derived from the price movements of this asset.
- Strike price: The fixed price at which the option holder can buy (call) or sell (put) the underlying asset. It is set at contract initiation and remains constant throughout the option's life.
- Expiration date: The last day on which the option can be exercised. After expiration, the option becomes worthless. American-style options can be exercised any time before expiration; European-style options only at expiration.
- Premium: The price paid by the buyer to the seller for the option contract. It represents the maximum loss for the buyer and the maximum profit for the seller. Premiums are determined by factors including the underlying price, strike, time to expiration, volatility, and interest rates.
- Option styles: American options allow early exercise, while European options restrict exercise to expiration. Most exchange-traded equity options in the US are American-style, but index options may be European. This distinction affects pricing and operational handling.
- Intrinsic vs. time value: Intrinsic value is the difference between the underlying price and the strike price for in-the-money options. Time value is the portion of the premium beyond intrinsic value, reflecting the possibility of the option becoming more profitable before expiration.
- Open interest: The total number of outstanding option contracts that have not been exercised, assigned, or closed. It is a key indicator of market liquidity and participation levels. Higher open interest in a specific strike and expiration typically leads to tighter bid ask spreads and more efficient execution for operational teams managing trade settlements and risk.
- Assignment risk: The risk that an option seller will be required to fulfill the contract obligations. For call writers, assignment means delivering the underlying shares at the strike price. For put writers, assignment means buying the shares at the strike price. Assignment typically occurs when options are deep in the money or near expiration, particularly for American style options.
- Margin requirements: Option sellers must post margin to cover potential losses. Margin calculations consider the option's premium, the underlying price, volatility, and out of the money amount. Maintenance margin is the minimum equity required to keep a position open. Understanding margin rules is critical for operational risk management and avoiding forced liquidation.
- Option Greeks: Measures that quantify the sensitivity of option prices to different factors. Delta measures price change relative to the underlying. Theta measures time decay. Vega measures sensitivity to implied volatility. Gamma measures Delta's rate of change. Rho measures sensitivity to interest rates. Traders and operations teams use Greeks to manage risk exposure and adjust hedging strategies.
Financial Formula
Option Premium Decomposition
Premium = Intrinsic Value + Time Value
Premium = Intrinsic Value + Time Value
Where:
- Intrinsic Value (call): max(0, Underlying Price - Strike Price)
- Intrinsic Value (put): max(0, Strike Price - Underlying Price)
- Time Value: Premium minus intrinsic value, affected by time to expiration and volatility
Quick Revision
- Call options give the right to buy; put options give the right to sell at the strike price.
- The premium is the cost of the option and is the buyer's maximum loss.
- Option styles (American vs. European) determine exercise flexibility.
- Intrinsic value is the in-the-money amount; time value captures the potential for future gains.